1.4.1 Accounting

The prime motive for doing a business is to earn profit. To know the profit earned or loss incurred in a particular period, it is necessary to record the financial transactions for the same period. Financial accounting is an effective tool to record, classify, and summarize financial transactions. Accounting is the art of recording, classifying and summarizing financial transactions and analyzing & interpreting the results thereof. To maintain uniformity in accounting, certain accounting principles are followed. The accounting principles consist of accounting concepts and accounting conventions.

Accounting is a business language used to communicate the financial information of the business to the people concerned. This makes it important for accounting to be based on certain concepts. These concepts imply the necessary assumptions or conditions upon which accounting is based. These can be listed as:

Business Entity Concept

Dual Aspect Concept

Accounting Period Concept

Business Entity Concept

This concept holds prime importance in Financial Accounting. According to this concept, a business is a separate entity from its owner. Business transactions are recorded from the point of view of the business entity and not the owner. The business entity can be a company, firm or proprietorship.

Dual Aspect Concept

This concept indicates that each transaction has two aspects and is recorded in two different accounts. For example, if a business house purchases a machine on cash basis, the Machine account and the Cash account will be affected. The double-entry system of accounting is based on this concept. The basic presumption of this system is that every business transaction has two aspects. Under this system, both the aspects of a transaction are recognized and recorded.

Accounting Period Concept

The time period during which the transactions of a business are recorded is called the accounting period. It states that the indefinitely long period of the business life should be divided into shorter periods for summarizing accounting information. Accounts for a business are prepared for a specific period, generally a 12-month period. In India, the accounting period is generally, taken from April 1 to March 31.

After discussing the concepts of Accounting, let us discuss the various Accounting conventions. Conventions are the customs and traditions that act as a guide to the preparation of the final accounts. Following these conventions, results in the presentation of clear and meaningful final accounts. The conventions followed to prepare accounting statements are:

Convention of Consistency

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Convention of Conservatism

Convention of Consistency

According to the convention of consistency the accounting practices and methods should not be changed from one accounting period to another. For example, there are 2 methods to charge depreciation, Written Down Value method and Straight Line method. The method once chosen should be used consistently year after year. Consistency in accounting practices and methods makes the records of the company for different years comparable.

Convention of Conservatism

According to this convention the accounting records should present a realistic picture of the state of affairs of the business. All the prospective losses should be accounted for and all prospective gains should be ignored. For example, to present a realistic picture the closing stock is valued at market or cost price whichever is less. If the market price is Rs. 15 and the cost price is Rs. 10, then the closing stock will be valued at Rs. 10. On the other hand if the market price is Rs. 12 and cost price is Rs. 14, then the closing stock will be valued at Rs. 12.

Now that we have discussed the Accounting principles, let us move on to the accounting terms that are used frequently.

Account

An Account is a summarized record of various transactions pertaining to a particular account head. It is commonly referred to as a Ledger Account.

Debit & Credit

The terms debit and credit refer to the additions to or subtractions from an account. Debit is an accounting term that means ‘to owe’. It is used to describe a payment, debt, or an entry in recording a transaction, the effect of which is to decrease a liability, income, or capital account or increase an asset or expense account. Credit is the opposite of debit. It is an accounting term used to describe an entry that increases an income, liability or capital account, and decreases an expense or asset account.

Assets

Assets are resources owned by a business. It can be anything that enables a business to get benefit.

For example, land, building, stock of goods, and cash.

Liabilities

A liability can be defined as something that a business owes to a third party in the form of an obligation to pay. For example, when a loan is taken from a bank or a financial institution it raises a liability for the business.

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Capital

Capital is the money that the owner invests to start the business and can claim from the business. Thus, for the business it is a liability towards the owner since the owner is a separate entity from the business. It can also be defined as the positive difference of assets over liabilities.

Income

Income is money received by a person or organization because of effort or work done by the person.

In other words, it is return on work done or returns on investments.

Expense

Expense is the amount spent in order to produce and sell the goods and services, which produce the revenue.

Debtor

A debtor is a person or business concern that owes money to another business concern.

Creditor

A creditor is a person or business concern to which a business concern owes money.

Stock

Stock refers to the goods lying unsold on a particular date. The stock can be either opening stock or closing stock. Opening stock is the stock lying unsold at the beginning of the accounting period while closing stock refers to the stock lying unsold at the end of the accounting period.

Golden Rules of Accounting

For making accounting entries, you must remember the three Golden Rules of accounting. The rules are:

Rule 1: Debit the receiver and credit the giver

Rule 2: Debit what comes in and credit what goes out

Rule 3: Debit all expenses and losses and credit all income and gains