Learning objectives
- Explain the purpose of accounting and who uses financial information
- Apply the basic accounting concepts and conventions
- Show how every transaction affects the accounting equation
- Record transactions using debit and credit rules
- Post entries to ledgers and prepare a trial balance
- Make year-end adjustments, including depreciation
- Prepare a trading and profit and loss account and a balance sheet
Lesson 1: What accounting is and why it matters
Accounting is the process of identifying, recording, classifying, summarising and interpreting financial transactions so that people can make decisions.
Who uses accounting information?
| User | What they want to know |
|---|---|
| Owners and partners | Is the business profitable? How much can be withdrawn? |
| Banks and lenders | Can the business repay the loan and interest? |
| Tax authorities | What is the taxable income and GST liability? |
| Investors | What return will they earn? Is the business growing? |
| Management | Which products, branches or costs need attention? |
Bookkeeping vs accounting: bookkeeping is the day-to-day recording of transactions; accounting goes further and summarises, analyses and reports them.
Example: a shop records each sale in its sales book (bookkeeping). At the year end, the accountant totals sales, deducts costs and works out profit and tax (accounting).
Lesson 2: Basic accounting concepts and conventions
These assumptions make financial statements reliable and comparable.
| Concept | Meaning | Example |
|---|---|---|
| Business entity | The business is separate from its owner | The owner's personal car is not a business asset |
| Money measurement | Only transactions measurable in money are recorded | Staff morale is not recorded |
| Going concern | The business will continue in the foreseeable future | Machinery is shown at cost less depreciation, not scrap value |
| Accrual | Income and expenses are recorded when earned or incurred, not when cash moves | March salary paid in April is a March expense |
| Matching | Expenses are matched with the revenue they help earn | Cost of goods sold is matched with sales of the same year |
| Consistency | The same methods are used year after year | Do not switch depreciation methods without reason |
| Prudence (conservatism) | Anticipate losses, do not anticipate profits | Stock is valued at the lower of cost and net realisable value |
| Materiality | Small items may be treated simply | A Rs 200 stapler is expensed, not capitalised |
| Dual aspect | Every transaction has two equal effects | The basis of double-entry bookkeeping |
Companies must follow the accrual basis and double-entry system under section 128 of the Companies Act, 2013, and the notified Accounting Standards (AS or Ind AS).
Lesson 3: The accounting equation
Every transaction keeps this equation in balance:
Assets = Liabilities + Capital (Equity)
Capital increases with profits and fresh investment, and decreases with losses and drawings.
Worked example: Ravi starts a trading business.
| Transaction | Assets | Liabilities | Capital |
|---|---|---|---|
| Introduces Rs 5,00,000 cash | +5,00,000 (cash) | +5,00,000 | |
| Takes a bank loan of Rs 2,00,000 | +2,00,000 (cash) | +2,00,000 | |
| Buys furniture for Rs 1,00,000 cash | +1,00,000 furniture, -1,00,000 cash | ||
| Buys goods on credit Rs 80,000 | +80,000 (stock) | +80,000 (creditor) | |
| Sells goods costing Rs 50,000 for Rs 70,000 cash | +70,000 cash, -50,000 stock | +20,000 (profit) | |
| Withdraws Rs 10,000 for personal use | -10,000 (cash) | -10,000 (drawings) | |
| Closing totals | Rs 7,90,000 | Rs 2,80,000 | Rs 5,10,000 |
Check: 2,80,000 + 5,10,000 = 7,90,000. The equation balances after every transaction.
Lesson 4: Debits and credits: the rules
In double entry, every transaction is recorded with a debit in one account and an equal credit in another.
Modern (accounting equation) rules
| Type of account | Increase | Decrease |
|---|---|---|
| Assets | Debit | Credit |
| Expenses and losses | Debit | Credit |
| Liabilities | Credit | Debit |
| Capital | Credit | Debit |
| Income and gains | Credit | Debit |
Traditional (golden) rules
| Account type | Rule |
|---|---|
| Personal (people, firms, banks) | Debit the receiver, credit the giver |
| Real (assets) | Debit what comes in, credit what goes out |
| Nominal (expenses, income) | Debit all expenses and losses, credit all incomes and gains |
Both sets of rules give the same entries; use whichever you find easier.
Lesson 5: Journal entries with examples
The journal is the book of original entry. Each entry shows the date, accounts debited and credited, amounts and a short narration.
| Transaction | Debit | Credit | Amount (Rs) |
|---|---|---|---|
| Owner brings in cash | Cash A/c | Capital A/c | 5,00,000 |
| Goods bought on credit from Sita Traders | Purchases A/c | Sita Traders A/c | 80,000 |
| Goods sold for cash | Cash A/c | Sales A/c | 70,000 |
| Rent paid by bank | Rent A/c | Bank A/c | 15,000 |
| Paid Sita Traders by cheque | Sita Traders A/c | Bank A/c | 80,000 |
| Owner withdraws cash | Drawings A/c | Cash A/c | 10,000 |
| Machinery bought by bank | Machinery A/c | Bank A/c | 1,50,000 |
| Interest received from bank | Bank A/c | Interest Received A/c | 2,000 |
With GST: goods bought for Rs 1,00,000 plus 18% GST within the State are recorded as: Purchases A/c Dr 1,00,000; Input CGST A/c Dr 9,000; Input SGST A/c Dr 9,000; to Supplier A/c 1,18,000.
Lesson 6: Ledger, balancing and the trial balance
Journal entries are posted to ledger accounts, one account per item (Cash, Sales, Rent, each customer and supplier). At the period end, each ledger is balanced: the difference between the debit and credit sides is the closing balance.
A trial balance lists every ledger balance. If total debits equal total credits, the arithmetic of the books is correct.
Example trial balance (extract)
| Account | Debit (Rs) | Credit (Rs) |
|---|---|---|
| Capital | 5,00,000 | |
| Bank loan | 2,00,000 | |
| Furniture | 1,00,000 | |
| Purchases | 3,00,000 | |
| Sales | 4,20,000 | |
| Rent | 60,000 | |
| Salaries | 1,20,000 | |
| Debtors | 90,000 | |
| Creditors | 40,000 | |
| Cash and bank | 4,90,000 | |
| Total | 11,60,000 | 11,60,000 |
Errors a trial balance does not reveal: errors of omission (entry missed completely), errors of commission (posted to the wrong person's account), errors of principle (capital expense treated as revenue), and compensating errors (two errors cancelling each other).
Lesson 7: Year-end adjustments and depreciation
Before preparing final accounts, adjust the books so that each year shows only its own income and expenses (accrual and matching).
| Adjustment | Entry | Effect |
|---|---|---|
| Outstanding expense (salary due Rs 10,000) | Salaries Dr / Outstanding Salaries Cr | Increases expense; liability in balance sheet |
| Prepaid expense (insurance paid in advance Rs 6,000) | Prepaid Insurance Dr / Insurance Cr | Reduces expense; asset in balance sheet |
| Accrued income (interest earned not received Rs 4,000) | Accrued Interest Dr / Interest Cr | Increases income; asset |
| Income received in advance (Rs 12,000) | Commission Cr reduced / Advance Commission (liability) Cr | Reduces income; liability |
| Closing stock (Rs 75,000) | Closing Stock Dr / Trading A/c Cr | Reduces cost of goods sold; asset |
| Bad debts and provision | Bad Debts Dr / Debtors Cr | Expense; debtors reduced |
Depreciation spreads the cost of a fixed asset over its useful life.
- Straight line method (SLM): (Cost - Residual value) / Useful life. Machine costing Rs 1,00,000, residual Rs 10,000, life 5 years: Rs 18,000 every year.
- Written down value (WDV): a fixed percentage of the opening book value. At 20%, year 1 = Rs 20,000; year 2 = 20% of Rs 80,000 = Rs 16,000.
Companies follow useful lives in Schedule II to the Companies Act, 2013. For income tax, depreciation is computed separately at the rates and block method prescribed under the Income-tax law.
Lesson 8: Final accounts: trading, profit and loss, and balance sheet
Trading account finds gross profit:
Sales - (Opening stock + Purchases + Direct expenses - Closing stock) = Gross profit
Profit and loss account finds net profit:
Gross profit + Other income - Indirect expenses (rent, salaries, depreciation, interest) = Net profit
Balance sheet shows the position on the last day:
| Liabilities side | Assets side |
|---|---|
| Capital (+ net profit - drawings) | Fixed assets (less depreciation) |
| Long-term loans | Investments |
| Creditors | Closing stock |
| Outstanding expenses | Debtors |
| Cash and bank, prepaid expenses |
Example: sales Rs 4,20,000, purchases Rs 3,00,000, closing stock Rs 75,000, no opening stock. Cost of goods sold = Rs 2,25,000; gross profit = Rs 1,95,000. After rent Rs 60,000, salaries Rs 1,30,000 (including Rs 10,000 outstanding) and depreciation Rs 10,000, there is a net loss of Rs 5,000.
Companies present financial statements in the format of Schedule III to the Companies Act, 2013 (statement of profit and loss, balance sheet, cash flow statement and notes).
Lesson 9: Capital vs revenue, and cash vs accrual
Capital expenditure creates a long-term asset or benefit: buying machinery, building, software licences for several years. It goes to the balance sheet and is depreciated.
Revenue expenditure is consumed within the year: rent, salaries, repairs, electricity. It goes to the profit and loss account.
| Item | Treatment | Why |
|---|---|---|
| New delivery van | Capital | Benefit over many years |
| Fuel for the van | Revenue | Used up in the year |
| Major engine overhaul that extends life | Capital | Increases useful life |
| Routine servicing | Revenue | Maintains existing condition |
Cash vs accrual basis: under the cash basis, income and expenses are recorded when money is received or paid. Under the accrual basis, they are recorded when earned or incurred. Companies must use the accrual basis; small businesses and professionals may use either for tax purposes, subject to the Income-tax law.
Quiz
1. A business buys a computer on credit. Which accounts change?
An asset is acquired and a liability is created; no cash moves.
2. Which concept says the owner and the business are separate?
The business entity concept separates personal and business transactions.
3. Under the modern rules, an increase in an expense is recorded as:
Expenses increase on the debit side.
4. Salary of March paid in April is an expense of:
Accrual: the expense belongs to the period in which it was incurred.
5. Which statement shows the financial position on a date?
The balance sheet shows assets, liabilities and capital at a point in time.
6. A machine costs Rs 1,00,000 with no residual value and a 10-year life. SLM depreciation per year is:
Rs 1,00,000 / 10 years = Rs 10,000.
7. Insurance paid in advance at the year end is shown as:
Prepaid expenses are assets until the benefit is used.
8. Which error is NOT revealed by a trial balance?
An omitted entry affects neither side, so the trial balance still agrees.
9. Major repairs that extend the life of a machine are:
They create a long-term benefit, so they are capitalised.
Study material
Further reading
- Accounting Standards issued by ICAI (AS 1, AS 2, AS 10)
- Section 128 and Schedules II and III, Companies Act, 2013
- Ind AS 1 for companies covered by Ind AS