Fundamentals of Accounting: Principles and Financial Statements

1. Accounting Fundamentals

Accounting is the art of recording, classifying, analyzing, and interpreting the financial transactions of a business. It serves as the language of business, communicating the results of operations to various interested parties.

2. Basic Terms of Accounting

• Assets: Valuable properties owned by a business. Classified into Fixed Assets (long-term, e.g., land, buildings, machinery, furniture) and Current Assets (short-term, convertible to cash within a year, e.g., cash, stock, debtors, bills receivable).
• Liability: Obligations or debts owed by the business to others. Classified into long-term and short-term liabilities.
• Capital: The amount invested by the owner in the business.
• Drawings: Cash or goods withdrawn from the business for personal use.
• Stock: Unsold goods on a particular date.
• Inventory: Stock of raw materials, semi-finished goods, and finished goods meant for resale.
• Debtors: Persons who owe money to the business.
• Creditors: Persons to whom the business owes money.
• Turnover: The scale of goods sold during a specific period.
• Expenditure: Money paid or payable for acquiring assets or services.

Accounting Equation

The accounting equation is a statement of equality: Assets = Capital + Liabilities.

• Capital = Assets - Liabilities
• Liabilities = Assets - Capital
• Assets - Capital - Liabilities = 0

Accounts and Classification

An account is a summary of business transactions relating to a particular person, asset, expense, or income for a given period.

Types of Accounts

• Real Account: Accounts of assets (e.g., cash, machinery, furniture).
• Personal Account: Accounts relating to persons the business deals with.
  • Natural Persons: Human beings (e.g., Balan's a/c).
  • Artificial Persons: Created by law (e.g., company a/c, bank a/c).
  • Representative Persons: Indirectly representing a person (e.g., outstanding salary a/c).
• Nominal Account: Accounts related to expenses, income, profit, and loss (e.g., salary, rent, commission).

Rules of Debit and Credit

Traditional Approach:

• Real Account: Debit what comes in, credit what goes out.
• Personal Account: Debit the receiver, credit the giver.
• Nominal Account: Debit all expenses and losses, credit all incomes and gains.

Modern Approach:

Accounting Cycle

The accounting cycle is the continuous process of recording transactions, starting from the journal and ending with the balance sheet: Journal → Ledger → Trial Balance → Trading and P/L a/c → Balance Sheet.

Journal and Ledger

The Journal is the book of original entry where transactions are recorded chronologically. Journalising is the process of recording, and Narration is the brief explanation provided. A Compound Journal Entry involves more than one debit or credit. The Ledger is a collection of accounts where transactions are classified and summarized through Posting.

Final Accounts

Final accounts consist of the Trading Account, Profit and Loss Account, and Balance Sheet.

Trading Account

Prepared to find the trading result (Gross Profit or Gross Loss).

Profit and Loss Account

Prepared to ascertain the net result (Net Profit or Net Loss) by accounting for all indirect expenses and incomes.

Balance Sheet

A statement of assets, liabilities, and capital on a specific date, showing the financial position of the business.

Final Accounts with Adjustments

Adjustments ensure the accrual concept is followed and provide a true and fair view of the business. Every adjustment affects at least two accounts.

• Closing Stock: Credit side of Trading A/c and Assets side of Balance Sheet.
• Outstanding Expenses: Add to expense in P&L; show as liability.
• Prepaid Expenses: Deduct from expense in P&L; show as asset.
• Depreciation: Debit P&L A/c; deduct from asset.
• Bad Debts: Debit P&L A/c; deduct from Debtors.
• Interest on Capital: Debit P&L A/c; add to Capital.
• Interest on Drawings: Credit P&L A/c; deduct from Capital.