Future Accountant

7/29/2019 Future Accountant

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FUTURE ACCOUNTANT

Capital, Profit, Loss :: An Understanding

Learning Accounting through an

example

A poor unemployed person (we shall call him Oberoi) thought of making his livelihood by selling

vegetables going around houses in a locality. He could only garner a small amount say Rs. 200/- with

which he could start the business.

• Business

In a very simple sense, business implies something that is carried on with a motive to earn profit/income. Profit motive is inherent in business. Not that every business generates profits, but themotive behind every act/transaction in a business would be making profit.

• Capital

The amounts and other resources with which a business is started or carried on is called Capital.

Owned Capital

The amounts and other resources employed in the business which belong to the owner/ownersthe business are together called owned capital.

Loaned Capital

The amounts and other resources employed in business which are borrowed by theowner/owners of the business from outside persons or organisations are together called loaned

capital.

Oberoi's Capital = Rs. 200/-

Oberoi's daily routine

He used to go to the wholesale market early in the morning to buy fresh vegetables which are generall

available during that time. He bought vegetables from wholesale vendors. He then roamed around a

locality selling the vegetables to various households. To make a profit he sold the vegetables at a pricearrived at by adding a certain amount over his purchase price.



• Profit and Loss

Profit = Selling price — Cost price and

Loss = Cost price — Selling price

Profit is a numerical figure. It can either be positive (when there is a profit), negative (when there is aloss) or zero when there is neither profit nor loss. A loss is also expressed as a negative profit.

In a similar way, loss is also a numerical figure. It can either be positive (when there is a loss), negativ

(when there is a profit) or zero when there is neither profit nor loss. A profit can also be as a negativeloss, but is seldom done.

At the beginning and during the course of Day One

Oberoi, went to the wholesale market, bought vegetables with the Rs. 200 (his capital) and then set ouon his trip around the locality selling vegetables. Since the Rs. 200 he invested enabled him to buy asmall quantity of vegetables, he could remember the prices at which he bought the various varieties. H

was selling his stock by adding certain amount over the cost at which he purchased them.

• Price and Value

Value = Price × Quantity Price = Value ÷ Quantity⇒

Value of a unit quantity is the price.⇒

Eg: The values of 5 kg goods is Rs. 80 The price of goods is Rs. 16/kg⇒

End of day One

By evening, Oberoi, sold all the vegetables he purchased in the morning. He counted the cash with himat the end of the day. It was Rs. 280. Where did the extra Rs. 80 (280 − 200) come from? It is on

account of the profit he made by selling vegetables.

Beginning of day two

What is the capital Oberoi has? Since he has Rs. 280 at the end of day one, he can use all that for purchasing vegetables on day two. Therefore his capital is Rs. 280.

What happened to his capital? Why? How?

His capital has increased from day one to day two by Rs. 80. The reason for this increase is the profit made on day one.



From this we learn one of the fundamental understandings in accounting/business.

• Profit increases Capital

As we make profits our capital increases.

During the course of Day Two

Oberoi, went to the wholesale market, bought vegetables with the Rs. 280 (his capital for day two) an

then set out on his trip around the locality selling vegetables. Even on day two he was selling his stock

by adding certain amount over the cost at which he purchased them.

Towards the end of the day he noticed that there was certain stock left over which if he is unable to sewould get spoilt and he would get nothing out of it. Therefore he sold them by reducing the price. Thi

price at which he sold the vegetables was far less than the price at which he bought them.

End of day Two

Oberoi, counted the cash with him at the end of the day. It was Rs. 260. Why a shortage, what happento his Rs. 280/-. The shortage of Rs. 20/- (280 - 260) is on account of the loss he incurred in selling th

vegetables.

Beginning of day three

What is the capital Oberoi has? Since he has Rs. 260 at the end of day two, he can use all that for purchasing vegetables on day three. Therefore his capital is Rs. 260.

What happened to his capital? Why? How?

His capital has decreased from day two to day three. The reason for this decrease is the loss he incurre

on day two.

From this we learn one another fundamental understanding in accounting/business.

• Losses decrease Capital

As we incur losses our capital decreases.



Drawings, Debtors, Creditors, Owned/Loaned

Capital

Learning Accounting through an exampleDuring Day Three

Oberoi, went to the wholesale market, bought vegetables with Rs. 260 and then set out on his triparound the locality selling vegetables.

End of day Three

Oberoi, counted the cash with him at the end of the day. It was Rs. 300. The extra Rs. 40 (300 −

260) is on account of the profit he made on day three.

He then recollected that he used Rs. 40 from the sale proceeds for buying provisions for hishousehold. Had he not used that Rs. 40 for his own use, he would have had Rs. 340 with him,

whereby his profit would have been Rs. 80 (340 − 260).

• Drawings

The amount used by the owners of business for personal purposes is termed drawings.

Influence of drawings on capital

Had Oberoi not used up the Rs. 40 as drawings he would have been left with a capital of Rs. 340 for

starting his business affairs on day four. Since he used up Rs. 40 as drawings his capital is now less by Rs. 40 i.e. Rs. 300 on day four.

From this we learn one another fundamental understanding in accounting/business.

• Drawings decrease CapitalAs we withdraw amounts from business for personal purposes, the amount of capital available for business would get reduced.

Profit and Loss. Drawings and ?



As profits increase capital and losses decrease capital, what is the term that implies an increase in

capital that is opposite in nature to drawings??

Putting in additional funds as capital is the act that is opposite in nature to drawings. There is nospecific term that is used to identify this. We just call it capital or to be more specific "Additional

Capital".

Recollect

Profits increase capital Losses decrease capital

Drawings decrease capital

Additional Capital increases capital

During Day Four

Oberoi, had a capital of Rs. 300 with him. He went to the wholesale market, bought vegetables for

Rs. 350 taking a credit of Rs. 50 from the wholesale vendor. He then set out on his trip around the

locality selling vegetables.

End of day Four

Oberoi, counted the cash with him at the end of the day. It was Rs. 400. What would be his profit

now, is it Rs. 100 (400 − 300) since his capital is Rs. 300 only or Rs. 50 (400 − 350) since the cost

of the vegetables he sold is Rs. 350.

It would be appropriate to think that the profit is Rs. 50 and not Rs. 100. The capital that Oberoiinvested from his own sources is Rs. 300. He also invested Rs. 50 additionally by taking credit from

the wholesaler. Both Rs. 300 from his own sources and Rs. 50 from loaned sources are capital for

the business.

• Owned Capital

Amounts and other resources invested in the business by the owners of the business as their

contribution towards Capital.

• Loaned Capital

Amounts and other resources borrowed by/for the business from outsiders also forms capital for the

business which we call loaned capital. The owner/owners of the business are collectively

responsible for the loan.

These are also called debts or debts owed by the business.



• Total Capital = Owned Capital + Loaned

Capital

The capital employed in the business is a sum total of the capital from own sources and capital from

loaned sources. That is the reason the profit should be calculated by comparing the amount Oberoi

has with Rs. 350 and not with Rs. 300.

Own Loaned Capital is Owned Capital

The owners of the business may invest in the business by taking loans personally and investing that

in their name as capital contribution. The responsibility for this amount lies with the person who is

borrowing the amount and not the business. This should not be misunderstood as loaned capital for

the business.

• Creditors

The person to whom we (i.e. the business organisation here) owe money are called creditors.

Eg: In the illustration above, the wholesale vendor who gave vegetables on credit to Mr. Oberoi,

is a creditor to Mr. Oberoi.

End of day Four

Oberoi, repaid the amount due (cleared the debt) to the wholesale vendor i.e. Rs. 50 and used Rs. 20towards drawings. He is left with Rs. 330 (400 − 50 − 20) as capital for the fifth day.

During Day Five

Oberoi, went to the wholesale market, bought vegetables with Rs. 330 and then set out on his trip

around the locality selling vegetables.

End of Day Five

Oberoi, counted the cash with him at the end of the day. It was Rs. 330. There is no surplus or

shortage, which implies he has made neither profit nor loss.

He then recollected that one of the customers, Mrs. Vimla, did not give him the amount she had to

(Rs. 10) since she was not having change. Since she was a regular customer, he offered to take theamount the next day. Had she given that amount also he would have been left with Rs. 340 which



would have resulted in a profit of Rs. 10 (340 − 330).

• Debtors

The persons who owe money to us (i.e. the business here) are called debtors.

Eg: In the illustration above, Mrs. Vimla who owes an amount to Mr. Oberoi is a debtor to Mr.Oberoi or his business.

Do Debtors/Creditors Increase/Decrease Capital ?

By increase or decrease in capital that we have learned earlier, we mean increase or decrease in

owned capital. When we just say capital we always mean owned capital. Creditors no doubt wouldincrease loaned capital and that should be seen as a different entity.

Please do not consider the idea of increase/decrease in capital in relation to Debtors/Creditors.

Income, Expenditure, Receipts, Payments

Learning Accounting through an example

End of day Five

On counting the cash with him, Oberoi found it to be Rs. 330. He used Rs. 20 towards drawings andis left with Rs. 310 (330 - 20) as capital for the sixth day.

In addition to this amount, he has Rs. 10 with Mrs. Vimla. Had that amount also been collected, he

would have been left with an amount of Rs. 320 which would have been used by him for buyingvegetables.

Thus, we say that the total Capital employed by Mr. Oberoi in the business for the sixth day is Rs.

320 (Rs. 310 in the form of Cash and another Rs. 10 in the form of debtors).

During Day Six

Oberoi, went to the wholesale market, bought vegetables with Rs. 350 by taking Rs. 40 worth of vegetables on credit from the wholesale merchant. Therefore his expenditure on buying vegetables,

would be Rs. 350 (310 + 40). He then set out on his trip around the locality selling vegetables.

End of day Six



Oberoi, counted the cash with him and found it to be Rs. 420. He also recollected that his customer

Mrs. Vimla who was due to him the previous day repaid the amount due. In addition, two other

customers, Mrs. Sheela and Mr. Daniel still owe him Rs. 15 each for the purchases made during theday.

Now he worked out the profit for the day this way. He had Rs. 430 of which Rs. 10 was the previousday due and he is still to receive Rs. 30 (15 + 15). Therefore, his income for the day is Rs. 450 (430

- 10 + 30) and his profit would be Rs. 100 (450 - 350).

Towards the end of the day, he used up Rs. 30 as drawings and thereby is left with a cash of Rs. 400

(430 - 30) which he could use for purchase of vegetables on the seventh day.

Thus the total capital employed by Mr. Oberoi in the business for the seventh day would be Rs. 430

[Owned Capital - (Rs. 320 at the end of the sixth day + a profit of Rs. 100 for the sixth day - adrawings of Rs. 30 during the sixth day) + Loaned Capital - (Rs. 40 Credit taken from the

Wholesaler at the beginning of the sixth day)]. This exists (at the end of the sixth day) in the form of

Rs. 400 cash and Rs. 30 due from customers (debtors).

• Incomes vs. Receipts » All Receipts do not

form Income

Income and receipts are to be understood as different entities. Receipts are the amounts that we havereceived. They may relate to anything from receipts on account of sales, receipts on account of

capital, receipts on account of previous dues etc.

• Expenses vs. Payments » All Payments do notform Expenses

Expenses and payments are to be understood as different entities. Payments are the amounts thatwe have paid out. They may relate to anything from payment on account of purchases, payments on

account of capital, payments on account of previous dues etc.

• Income » Profit

Income is a term used to indicate the amount received or receivable that would be the source for earning profits. Profit is the surplus left after setting of Incomes against Expenses.

During Day Seven

Oberoi, having a cash of Rs. 400 with him, went to the wholesale market, bought vegetables worth

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Rs. 360 and paid Rs. 400 to the wholesale merchant, thereby clearing his previous due of Rs. 40

also.

His expenditure would be Rs. 360 only since the Rs. 40 he paid is towards the previous days dues.He then set out on his trip around the locality selling vegetables.

End of day Seven

Oberoi, counted the cash with him at the end of the day. It was Rs. 400. He also recollected that both

the customers who were due to him the other day, i.e. Mrs. Sheela and Mr. Daniel (Rs. 15 each) paidup and another customer Mrs. Vimla has been given credit to the extent of Rs. 20 during the day.

Now he worked out the profit for the day this way. He had Rs. 400 of which Rs. 30 belonged to the

previous day and Rs. 20 is still due. Therefore, his income is Rs. 390 (400 - 30 + 20) and his profit

would be Rs. 30 (390 - 360).

Towards the end of the day, he used up Rs. 25 as drawings and thereby is left with a cash of Rs. 375(400 - 25) which he could use for purchase of vegetables on the eighth day.

Thus the total capital employed by Mr. Oberoi in the business for the eighth day would be Rs. 395

[Owned Capital - (Rs. 430 at the end of the seventh day + a profit of Rs. 30 for the seventh day - a

drawings of Rs. 25 during the seventh day) - (loaned Capital repaid Rs. 40)]. This exists (at the endof the seventh day) in the form of Rs. 375 cash and Rs. 20 due from customers (debtors).

The Need for Accounting

Learning Accounting through an example

From day eight to ....

Mr. Oberoi conducted his business the same way he did on the first seven days from day eight

onwards. He was able to save a certain amount regularly from the profits he made (after meeting hisexpenses). In a few months time, his savings reached a figure of Rs. 10,000.

Remembering the Dues

Since the customers to whom he sold were in direct contact with him and he visited the same set of

customers regularly, it faced no difficulty in remembering who had to give him money and to whomhe owed money. He did not find the need to keep anything in writing (initially).

As he had more capital he could buy more and is thus required to sell to a larger customer base. As



he started selling to more number of customers he noticed that he was finding it difficult to

remember the details of all those who owe him. He noticed that he was forgetting the details

sometimes.

Therefore, to overcome this problem, he started using a pocket sized note book wherein he startedrecording the details of those who owed him and to those whom he owed. He used to write down the

date, name and amount and would strike off the entry whenever the due is cleared.

One objective of business is growth!!

One important objective of business is to make profits. Along with it every business aspires to grow.Since Mr. Oberoi was also a business man (though his business is petty we can call him a

businessman since what he does constitutes business), he too thought on the same lines.

Since he had enough savings and he got well acquainted with the people of the locality in which he

was selling vegetables, he proposed to set up a shop at a central location within the locality. Almostall his customers encouraged his proposal and promised that they would come down to his shop and

buy vegetables daily since it was nearer to them.

He decided to invest his savings of Rs. 10,000 for the shop. He set aside Rs. 2,500 to buy vegetables

and spent the rest of the amount the shop. He paid Rs. 2,000 as advance for the shop which herented, purchased wooden racks to place vegetables with Rs. 4,000 and some stools with Rs. 1,000

and other decoration material for Rs. 500.

Need for another person in the business..

Mr. Oberoi, set up the shop and opened it on an auspicious day. He used to go to the wholesalemarket early in the morning and buy vegetables, come back to the shop, open it and make his sales

to the customers. Initially everything seemed fine.

Later on, he started identifying some problems. Some times he got struck up at the whole sale shopwhich resulted in a delay in opening the shop.

Since his customers knew him for a long time, they did not complain about this initially. However,

as the same problem started cropping up at frequent intervals, they started complaining. Some of

them even said that they would have to purchase from elsewhere if the same problem continues.

Since it was becoming impossible for him to conduct the affairs single handedly and the fact that hisfailure to open the shop in time would increase the risk of losing his customers have made him

realise that it was high time he bring in some help. There he felt the need for another person taking

part in his business affairs.

Ways to involve another person in his business...



Mr. Oberoi, had two alternatives to involve another person in his business.

One, taking in a partner who could assist him in his business affairs and

two, taking in an employee who could be entrusted, as his job responsibility, some of theaffairs of his business.

Mr. Oberoi took up the second option and employed Mr. Kallu singh as his assistant and entrusted

him the responsibility of opening the shop early in the morning, making sales whenever he is not at

the shop, attending to customers in his absence and any other function that he may entrust from timeto time.

He was promised a monthly salary of Rs. 2,000 and a commission of 5% of profits of the business.

Need for accounting felt...

Mr. Oberoi, now feels the need for accounting. The need arises on account of two reasons.

First, the magnitude of the affairs of the business are constantly increasing and it would beimpossible and improbable for Mr. Oberoi to think in terms of just remembering everything

or managing by simply noting down some things in a pocket note book as he had been

doing till that time. Secondly, earlier he was the only person involved in the business affairs. Now he has got an

employee involved. It would be appropriate on his part to think about accounting, so as to

ensure that there would not be any problem relating to any aspect in the business.

Even if he had involved the second person as a partner he would be required to think of accounting.

How to? and What to?

Mr. Oberoi did not have any idea of what account was and what to account for? He put a lot of

thought into it and has felt that if he knew everything that is happening in the business he would be

able to ensure that everything is going right. Thus he made arrangements to get everything that ishappening in his absence recorded (written) in a book.

Therefore we may conclude that accounting is nothing but recording of all the transactions relating

to the business.

• Accounting is recording the transactions

relating to business...

In its primary sense, accounting is nothing but a record of all the transactions relating to business. It

in effect is a diary of all the events or transactions of the business.



Therefore for the purpose of his organisations accounting needs, Mr. Oberoi, bought a record with

a number of pages. Each page had around 30 lines. He asked his assistant to write down the

business transactions, with each transaction starting on a new line along with the date of itsoccurrence.

Mr. Oberoi entrusted Kallu Singh with this responsibility.

• Business Transaction

Any event that occurs in relation to the business and has its effect on the business is called a

business transaction.

Concepts & Conventions :: Money

Measurement Concept

Business Transactions » Accounting

Transactions

Mr. Oberoi's Accounting Record

Kallu Singh started recording all the transactions relating to the business in the accounting record (a

record with ruled pages) as asked by his employer.

A record of a days Business Transactions as seen in Mr.

Oberoi's Accounting Record

S.No Date Transaction

01. 10/06/2005 Came to the shop at 5 : 30 am

02. " Opened the shop and cleaned the premises by 6:30 a.m03. " Had a cup of tea, spent Rs. 1.50 for it

04. " Verified stock and arranged them neatly.

05. " Mr. Subba Rao came. He bought 1 kg brinjals for Rs 10.

06. " Mr. Raju came. He enquired about supply for his daughter's marriage party.

07. " Mrs. M came. She paid Rs. 20, the amount due for the stock purchased the

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previous day.

08. " Unloaded the vegetables brought by the Proprietor.

09. " Paid Rs. 10 to the rickshaw puller who brought the vegetables.

10.

"

Received Rs. 250, the balance from the amount taken by the proprietor while

going for purchases.

Some of the recordings seem to be "Not Necessary"!!!

All the above recordings made by Mr. Kallu Singh are no doubt business transactions as they relate

to the business and its conduct. However if we go through the list we do find that there are certain

entries in the list which seem and sound unnecessary.

The fact that the employer opened the shop at 5:30 may be useful information in general. Itenables Mr. Oberoi to know the time Mr. Kallu Singh is coming early in the morning. He

can make a random check of the timing by asking someone else to just watch the time theshop is being opened and verifying the time Mr. Kallu Singh has recorded. This enables him

to ensure that his shop is being opened early in the morning at the intended time.

But the fact that Mr. Kallu Singh has opened the shop early in the morning will not result in

Mr. Oberoi, either gaining or losing directly in monetary/value terms. If we are asked to

assess the transaction value, we will not be able to. Mr. Oberoi, may benefit in terms of thereputation the organisation may gain i.e. as being recognised as an early starter, punctual,

etc., but this will cannot be expressed in value terms.

• All Business Transactions are not AccountingTransactions

Every transaction relating to a business can be called a business transaction. But only those

transactions that can be assessed/expressed in value/monetary terms capable of being calledAccounting Transactions.

Business transactions which cannot be assessed/expressed in value/monetary terms are not to be

considered in Accounting.

A record of the days Accounting Transactions as seen in Mr.Oberoi's Accounting Record

S.No Date Transaction

03. 10/06/2005 Had a cup of tea, spent Rs. 1.50 for it

05. " Mr. Subba Rao came. He bought 1 kg brinjals for Rs 10.



07."

Mrs. M came. She paid Rs. 20, the amount due for the stock purchased the

previous day.

09. " Paid Rs. 10 to the rickshaw puller who brought the vegetables.

10."

Received Rs. 250, the balance from the amount taken by the proprietor while

going for purchases.

Practice Problems » Money Measurement Concept

Concepts and Conventions

Accounting is based on certain concepts and conventions.

Concepts = Idea, notion, thought, perception

Conventions = Habits, practices

Without being conscious that we have been dealing with aspects relating to a concept, we have dealtwith one of the simplest and fundamental concepts of accounting.

All Business Transactions do not form Accounting Transactions

Money Measurement Concept

Only those transactions which are capable of being measured in value or monetary terms are to be considered in accounting.

The Basic Purpose of Accounting

Deriving information needed from theaccounting records

The first 200 days of accounting..

As asked by his employer, Mr. Kallu Singh started recording all the transactions relating to the business, taking only those transactions which are capable of being measured in value terms (Based

on the "Money Measurement Concept"), in the accounting record (a record with ruled pages).

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Each page in the book provided by Mr. Oberoi, that Mr. Kallu Singh was using for recording had 30

lines. On an average there used to be around 30 transactions every day. Thus, recording a days

transactions resulted in a page getting filled up every day. This was carried on for around 200 days.

Mr. Oberoi in need of information

One day (after the accounting recorded was filled for 200 days), Mr. Oberoi, called Mr. Kallu Singh

and told him that he wanted to know whether Mrs. Vimla was due to them or if they had to pay

anything to Mrs. Vimla.

How would Kallu Singh derive the information Mr. Oberoi

needs?

At the time of writing the accounting records, whenever there was a transaction involving Mrs.

Vimla, Kallu Singh used to mention her name. Therefore he could derive the information needed byMr. Oberoi, by locating all the transactions where Mrs. Vimla's name appears and analysing them.

For deriving the needed information, Mr. Kallu Singh noted down the amounts relating to all those

transactions in which Mrs. Vimla got the benefit at a place (like when she bought vegetables on

credit). Simultaneously, time he noted down the amounts relating to all those transactions in whichMrs. Vimla gave the benefit at another place (like when she paid the amounts due by her).

While noting down the amounts he assigned a positive sign to the amounts related to all the

transactions in which Mrs. Vimla took the benefit and a negative sign to the amounts related to thetransactions in which Mrs. Vimla gave the benefit.

The data collected by Mr. Kallu Singh

Sales Made (+)

Date S. No Amount

2005 June 10th 04. 45

11th 09. 25

12th 02. 102

... ... ...

... ... ...

2005, Dec 8th 06. 76

10th 05. 56

Total amount Rs. 8,125

Amounts Received (−)

Date S. No Amount

2005, June 11th 05. 50

12th 11. 75

14th 15. 25

... ... ...

... ... ...

2005, Dec 6th 12. 125

8th 05. 55

Total amount Rs. 8,006



Adding up the two sets of amounts separately he could arrive at two sums. One a positive sum (+

Rs. 8,125) and another a negative sum (− Rs. 8,006) . Positive sum representing the total benefit

received by Mrs. Vimla from them and the negative sum representing the total benefit given by byMrs. Vimla (amounts paid by her) to them.

The two sums were set off and the remainder gave an idea of whether Mrs. Vimla owes them some

money or they owe her some amount.

The net resultant sum on setting off the two amounts would be + Rs. 119 (+ Rs. 8,125 − Rs. 8006).

This implies that Mrs. Vimla is due to the extent of Rs. 119 to them.

The mathematical signs could have been assigned to the amounts either way. Had Mr. Kallu Singh

taken the amounts due to them as negative, then the totals would have been − Rs. 8,125 and + Rs.

8,006 and the net figure would have been − Rs. 119. Whether the amounts due to them are

represented by a positive figure or negative figure is dependent on the signs attached. The signs are

only an indication of the opposing nature of the amounts.

What is Mr. Oberoi's need...

Mr. Oberoi is in need of information. The need to know how much is due from Mrs. Vimla or how

much is due to her. This we say is the need for (business/accounting) information relating to Mrs.Vimla

Difficulty in deriving the needed information..

Accounting as understood by Mr. Oberoi (initially) is nothing but recording all the businesstransactions based on the money measurement concept i.e. all the accounting transactions. But after seeing Mr. Kallu Singh conduct the exercise of deriving the small piece of information needed, Mr.

Oberoi, understood that the method he was using for maintain the accounting record had limitations.

One major limitation being that it could not provide the information he needed at on the fly or at aglance. For finding the small information relating to Mrs. Vimla, he had to get such a laborious

exercise done. He understood that it would not be prudent to think in terms of deriving whatever

information he wanted that way.

Therefore Mr. Oberoi, approached a professional accountant for advice. From what the accountanttold him he could understand that what he was trying to do was correct, but the format in which he

was getting it recorded was not appropriate.

The Basic purpose of Accounting

Why was Mr. Oberoi doing all this? Because he was in need of information. Moreover, it is also

found that recording accounting transactions enables us to derive the needed information. The onlylimitation that Mr. Oberoi had found was that the format in which he was getting the accounting

transactions recorded was not appropriate. If the records are in a manner as advised by the

professional accountant, then the information can also be derived in an easy and speedy manner.









Before we go to learn what these are and how these are maintained, we state the basic purpose of

accounting.

The Basic Purpose of AccountingThe basic purpose of Accounting is derivation of information.

Accounting is a tool that enables us to derive the financial information.

Accounting :: Objective, Elements/Aspects;

Separate Entity Concept

Specific Format for Accounting » Target

to be achieved

What should Mr. Oberoi's target be?

Now from what we have seen, we understand that the manner in which Mr. Oberoi was maintaining

the accounting records had a limitation of not being able to provide the information that he needed

at a place, ready hand, whereby he was compelled to think of alternative methods for recording theaccounting transactions.

What then, is the objective, that Mr. Oberoi should try to achieve, through the different format for

recording the accounting transactions?

Mr. Oberoi was trying to find the amount due to or due from Mrs. Vimla. It would have been

conveniently derived if he had all the information relating to Mrs. Vimla at a single place.

This is the objective he should try to achieve through the specific format for recording the

accounting transactions.

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Specific Format for Accounting »

Target to be achieved

The target to be achieved by maintaining a specific format for recording accountingtransactions is "To collect all the information relating to an element at a single place".

Elements in Accounting/Accounts »

Account Heads

• Element

Meaning = A small part of the total whole

Synonyms » constituent, part, building block, component, ingredient, factor, aspect

• An Element in accounting

An element for the purpose of accounting is that aspect relating to which we wish to find/know

information.Each element in accounting is identified as an account or an accounting head.

» Some examples of accounting elements

We wish to know

The amount of capital invested in the business.

• Capital is an element. — We identify it as Capital a/c.

The value of Furniture with us in the business.

• Furniture is an element. — We identify it as Furniture a/c.

The amount of expenditure on account of salaries.

• Salaries is an element. — We identify it as Salaries a/c.

The amount due to us from Mrs. Vimla.

• Mrs. Vimla is an element. — We identify it as Mrs. Vimla's a/c.

The amount we owe the wholesaler Mr. Rathod.



• Mr. Rathod is an element. — We identify it as Mr. Rathod's a/c.

The amount available in the bank.

• Bank is an element. — We identify it as Bank a/c.

The value of sales made by us.

• Sales is an element. — We identify it as Sales a/c.

This list can be endless...........

How many Elements/Accounting-Heads are

used in accounting?

The number of elements i.e. accounting elements used for the purpose of accounting for anorganisation is not a static figure. It is dependent on the amount and nature of information needed by

the organisation.

Where the organisation needs less detail, it may consider all the expenses as a single element calledexpenses (i.e. Expenses a/c). Where the organisation feels that it needs greater detail with regard to

expenses, it may sub divide it into smaller elements as Salaries a/c, Rent a/c, Telephone Charges a/c,

Miscellaneous Expenses a/c. All these together would form the total expenditure of the organisation.

We interpret the number of elements used for the purpose of accounting as "the number of elements

into which an organisation is divided for the purpose of accounting". This is dependent on the

amount of information that an organisation needs.

Greater the information needed, greater the number of accounting heads i.e. the number of elementsinto which the organisation is divided.

• The more the information we need,

The more the accounting heads we have to maintain.

(Or)

• The more the information we need,

The more the number of elements into which we need to divide the organisational

accounting.

Separate Entity

Concept

In accounting for business transactions, we should segregate ownership and business. The owner is

alien to business. The owner is a party from whom the business can take/receive and to whom it cangive.



If we do not see the owner and the business as separate entities, we cannot think of transactions

involving capital being brought in and amounts being withdrawn.

If the owner is not a Separate entity, then these would amount to the owner giving to himself and

taking from himself.

This forms one another important and fundamental concept of accounting "The Separate EntityConcept :: Ownership and business are not one and the same".

Separate Entity Concept

The owner is also an alien to the business.

Capital a/c, Drawings a/c »Special Elements

In finding the information relating to ownership we never use the owners name as an identifier, i.e.

element name or account head. Therefore Mr. Oberoi's name would not appear in the list of accountheads for his organisational accounting.

• Capital a/c

Capital is an element used to represent the owner of the business for recording information relating

to the amounts invested by the owner as his capital.

The amount of capital invested in the business by the owner or owners

• The amount given by the owner, to the organisation/business — Identified as the element Capital

or Capital a/c

• Drawings a/c

Drawings is an element used to represent the owner of the business for recording information

relating to the amounts withdrawn by the owner from the organisation for his personal purposes.

The amount withdrawn by the owner for personal purposes• The amount taken by the owner, from the organisation/business — Identified as the element

Drawings or Drawings a/c

Note:



If we do not wish to have the information relating to the capital brought in and amount withdrawn

separately, only one account is maintained by name Capital a/c in place of these two. In such a case,

the amount withdrawn by the proprietor for personal purposes would be treated as capital taken back by the proprietor.

Fundamental/Basic Accounting Equation ::

Capital + Liabilities = Assets

Accounting » Mathematical

Concepts used

Accounting is a concept involving mathematical ideas. The early developments of accounting

involved mathematicians.The first printed treatise of bookkeeping in the world is the "Summa de Arithmetica, Geometria, Proportioni etProportionalita" written by Luca Pacioli. The treatise was published in Venice in 1494, and was reprinted at Toscolanoin 1523. This work is one of the most important books on mathematics and has had an enormous impact on the field of accounting ever since.

• Equation

An equation is a term relevant to the field of mathematics. It is something without which the field of mathematics has no meaning and existence.. (Can you think of a topic in mathematics where you donot come across the "=" sign).

An equation is a statement of equality between two expressions (expression1 = expression2).

» Numerals and Literals

Numerals are numbers. Literals are alphabets used in place of (or to represent) numbers.

» Constants, Variables, UnknownsConstants are those which have a fixed value. Variables are those which are capable of having more

than one value. When the value represented by the constant is not known we call it an unknown.

Numerals are always constants whereas literals can be either constants or variables.



» Terms

Constants and variables combined together with the mathematical operations of multiplication (×)

and division (÷) form terms.

» Expressions

Terms combined together with the mathematical operations of addition (+) and subtraction (−) form

expressions.

The Fundamental Accounting Equation


The total idea of accounting is built around an equation which is a mathematical equation called the"Fundamental Accounting Equation". It is a statement of equality between assets and liabilities. For

a business Assets should be (and are) always equal to its liabilities.

• Isn't it Liabilities = Assets?

Yes, the fundamental accounting equation in its true sense should be Liabilities = Assets and it is

true even.

The explanation for the equation being written as Capital + Liabilities = Assets lies in the separateentity concept. Since the owner is also an alien to the business, the amount that is contributed by theowner towards his capital should also be treated as a liability to the business.

But since it is of a special nature and it is a liability which differs from the others in the sense that

it takes the maximum amount of risk in the business, it would be appropriate to show it separately

always.

Therefore the liabilities on the LHS of the accounting equation are divided into two as capital and

liabilities.

• Total Liabilities = Total Capital Employed (=

Owned Capital + Loaned Capital)

The total capital employed in the business comes from two sources. One the ownership of the

business (which we call owned capital) and two as liabilities (which we call loaned capital). Sincethe owners contribution is also to be treated as a liability we can say that total liabilities is equal to

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total capital.

What are Assets?

This can be a very big topic for discussion. In the initial stages of learning accountancy, it would be

better to have a simple understanding on what an asset is.

An asset is something capable of being liquidated and realised.

• Liquidation

The process of converting something into cash. The greater and faster an asset is capable of being

converted to cash, the more liquid it is.

Cash is the highest liquid asset as you need no time to convert into cash. Goodwill of a business is

the least liquid asset as it can generally be realised only when the business is disposed/sold.

Some examples of Assets

Motor Car, Buildings, Land, Furniture etc.

Debtors (those who owe us money) are also assets since they clear off their dues by paying

cash (which can be thought of as liquidation of debtors).

Goodwill is also an asset is it can also be sold and realised in cash at the time of sale of

business.

Effect of Transactions on the Accounting Equation

Accounting Transactions » Effect on the

Fundamental Accounting Equation

• Every Accounting Transaction effects the

Fundamental Accounting Equation

Every Business Transaction which is to be considered for accounting i.e. every AccountingTransaction, has its effect on the fundamental accounting equation.

Each transaction alters the expressions forming the equation in such a way that the accounting

equation is satisfied even after such an alteration. The values forming the various terms of the

expressions within the equation are altered in such a way that the basic fact/rule/equation (i.e.Capital + Liabilities = Assets) is always satisfied.

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» Illustration

Consider the following few transactions explained one after the other in relation to a business in thestarting stage.

1. A business proposed to be started by Mr. Oberoi.

Since the business has only been proposed and not yet started it has neither assets nor

liabilities.


0 + 0 = 0

The equation is satisfied.

2. He brought in Rs. 1,00,000 as his capital contribution for the business.

This transaction in accounting books is read and interpreted as Started Business with a

Capital of Rs. 1,00,000.

Since capital is being brought into the business in cash, the value of Capital has increased

from zero to Rs. 1,00,000 and the value of cash has also increased from zero to Rs. 1,00,000.Cash since it is capable of being liquidated is an asset.

Capital + Liabilities = Assets1,00,000 + 0 = Cash (1,00,000)


3. He then purchased some furniture for Rs. 25,000.

Accounting interpretation of the transaction » "Bought Furniture for cash Rs. 25,000."

Since Furniture is being bought by paying cash, the value of Furniture has increased from

zero to Rs. 25,000 and the cash available with the business would reduce by Rs. 25,000 to

Rs. 75,000. Furniture since it is capable of being liquidated is an asset. This transaction doesnot have any effect on either capital or liabilities.


1,00,000 + 0 = Cash (75,000) + Furniture (25,000)







4. He then purchased some goods for cash for Rs. 25,000 from M/s Roxy Brothers.

Accounting interpretation of the transaction » "Bought Goods for cash Rs. 25,000."

• Vendor Name irrelevant in CashPurchase

Though the goods have been purchased from M/s Roxy brothers, their name has no

relevance while the transaction is being considered for accounting purposes, since the purchase is for cash.

When we make a cash purchase, the party from whom the purchase is made is irrelevant

unless there is a time gap between the transaction of purchase and transaction of paying cash.

The vendor's name may also be considered if the organisation intends to have an accounting

record of who purchases what and how much, in which case the purchase is recorded as acredit purchase and the due cleared immediately.

Since goods are bought by paying cash, the value of Goods has increased from zero to Rs.

25,000 and the cash available with the business would reduce by Rs. 25,000 to Rs. 50,000.

Goods since it is capable of being liquidated is an asset. This transaction does not have anyeffect on capital, liabilities or furniture.


1,00,000 + 0 = Cash (50,000) + Furniture (25,000) + Stock (25,000)


5. He then purchased some goods valued Rs. 10,000 from Mr. Shyam Rao on credit.

Accounting interpretation of the transaction » "Bought Goods from Mr. Shyam Rao on credit

for Rs. 10,000."

Since goods are bought, the value of Goods has increased from Rs. 25,000 to Rs. 35,000.

Since they are bought on credit, the liabilities of the business would increase from zero toRs. 10,000. This liability is identified by the name of the vendor who gave the goods oncredit i.e. Mr. Shyam Rao. This transaction does not have any effect on capital, furniture or

cash.


1,00,000 + Mr. Shyam Rao = Cash (50,000) + Furniture (25,000) + Stock



(10,000) (35,000)


6. He then sold some goods for cash for Rs. 20,000 to Mr. Peter.

Accounting interpretation of the transaction » "Sold Goods for cash Rs. 20,000."

• Buyer Name irrelevant in Cash Sale

Though the goods have been sold to Mr. Peter, his name has no relevance while the

transaction is being considered for accounting purposes, since the sale is for cash.

When we make a cash sale, the party to whom the sale is made is irrelevant unless there is a

time gap between the transaction of sale and transaction of receiving cash.

The buyer's name may also be considered if the organisation intends to have an accountingrecord of who bought what and how much, in which case the sale is recorded as a credit sale

and the due cleared immediately.

Since goods are sold by taking cash, the value of Goods has decreased from Rs. 35,000 to

Rs. 15,000. The cash available with the business would increase from Rs. 50,000 to Rs.70,000. This transaction does not have any effect on capital, furniture or liabilities i.e. Mr.

Shyam Rao.


1,00,000 +Mr. Shyam Rao

(10,000)=

Cash (70,000) + Furniture (25,000) + Stock

(15,000)


Note

Please ignore the profit being made on sale of goods. If needed assume that they are being

sold at cost.

7. He then sold some more goods on credit to M/s Bharat & Co., for Rs. 10,000.

Accounting interpretation of the transaction » "Sold Goods on credit to M/s Bharat & Co.,for Rs. 10,000."

The value of Goods has decreased from Rs. 15,000 to Rs. 5,000. M/s Bharat & Co., being a

debtor (those who owe us money) can be liquidated and therefore can be considered as an



asset. Thus, a new asset in the form of M/s Bharat & Co., is created. The new asset is

identified by the name of the organisation which purchased the goods on credit. This

transaction does not have any effect on capital, furniture, liabilities i.e. Mr. Shyam Rao, or cash.


1,00,000 + Mr. Shyam Rao

(10,000)

= Cash (70,000) + Furniture (25,000) + Stock

(5,000)

+ M/s Bharat & Co (10,000)


Note

Please ignore the profit being made on sale of goods. If needed assume that they are beingsold at cost.

8. He then opened a bank account and paid Rs. 60,000 cash into the bank account.

Accounting interpretation of the transaction » "Paid Cash into Bank Rs. 60,000."

Since cash is paid into bank, the available cash reduces from Rs. 70,000 to Rs. 10,000. Theamount paid into the bank is held by the bank on our behalf. The bank has to pay us the same

whenever we ask for it. The bank therefore stands in the position of a debtor to us (those

who owe us money).

The new asset is identified as "Bank" if there is only one bank account. Where there aremore than one bank account, each bank is identified by its name. Since "Bank" can be

liquidated (converted into cash) by withdrawing money from it, can be treated as an asset.

This transaction does not have any effect on capital, furniture, stock, Mr. Shyam Rao or M/sBharat & Co..



(10,000)


(5,000)

Bank (60,000) + M/s Bharat & Co (10,000)


9. He then paid Rs. 5,000 cash to Mr. Shyam Rao.

Accounting interpretation of the transaction » "Paid Cash to Mr. Shyam Rao, Rs. 5,000."



Since cash is paid to Mr. Shyam Rao, the available cash reduces from Rs. 10,000 to Rs.

5,000 and the liability in the name of Mr. Shyam Rao (the amount due to him) also reduces

from Rs. 10,000 to Rs. 5,000. This transaction does not have any effect on capital, furniture,stock, M/s Bharat & Co., or Bank.


1,00,000 + Mr. Shyam Rao (5,000) = Cash (5,000) + Furniture (25,000) + Stock

(5,000)

Bank (60,000) + M/s Bharat & Co (10,000)


10. He then received Rs. 8,000 payment from M/s Bharat & Co.

Accounting interpretation of the transaction » "Received cash from M/s Bharat & Co., onaccount, Rs. 8,000."

Since cash is received from M/s Bharat & Co., the available cash increases from Rs. 5,000 to

Rs. 13,000 and the asset identified as M/s. Bharat & Co (the amount receivable from them)also reduces from Rs. 10,000 to Rs. 2,000. This transaction does not have any affect on

capital, furniture, stock, Mr. Shyam Rao or Bank.



(5,000)


(5,000)

Bank (60,000) + M/s Bharat & Co (2,000)


Conclusion

Each and every accounting transaction has its effect on the accounting equation. Every transaction

alters the components present in the equation in such a way that the equation is satisfied after everysuch alteration..

We can conclude that the account equation is satisfied at any point of time during the life time of anorganisation.

Practice Problems » Fundamental Accounting Equation

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Dual Entity Concept

Constituents of the Accounting Equation

Consider the following accounting equation


1,00,000 + Mr. Shyam Rao(5,000)

= Cash (13,000) + Furniture (25,000) + Stock (5,000) + Bank (60,000)

+ M/s Bharat & Co (2,000)

The accounting equation being a mathematical equation should be a statement of equality betweentwo expressions. Thus "Capital + Liabilities" is an expression and "Assets" is another expression.

An expression is formed by one or more terms combined together using the mathematical operations

of addition and subtraction.

Thus the sub divisions into which we break down the expressions within the accounting equation

would be an equivalent of terms in mathematics. Each such term in the equation is nothing but anelement of accounting.

We should understand that certain elements are part of the expression called Liabilities, certain other

are part of the expression called Assets. Where Liabilities are segregated as "Capital" and

"Liabilities", each of these would be an expression in itself.

Elements affected by the Transactions

• Effect of a Transaction

Every business transaction which is to be considered for accounting i.e. every accounting

transaction has its effect on the elements (called accounts or account heads) of accounting thus

affecting the constituents of the accounting equation.

» Illustration:

Consider the earlier example of business transactions relating to Mr. Oberoi. The elements that are

affected by each transaction are marked in bold within the equation.

The business is proposed to be started.

Since the business has only been proposed and not yet started it has neither assets nor liabilities.

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0 + 0 = 0


Started Business with a Capital of Rs. 1,00,000.

Since capital is being brought into the business in cash, the value of Capital has increased

from zero to Rs. 1,00,000 and the value of cash has also increased from zero to Rs. 1,00,000.


Capital 1,00,000 + 0 = Cash (1,00,000)


Bought Furniture for cash Rs. 25,000.

Since Furniture is being bought by paying cash, the value of Furniture has increased from

zero to Rs. 25,000 and the cash available with the business would reduce by Rs. 25,000 toRs. 75,000..


1,00,00

0+ 0 = Cash (75,000) + Furniture (25,000)


Bought Goods for cash Rs. 25,000 from M/s Roxy Brothers.

Since goods are bought by paying cash, the value of Goods has increased from zero to Rs.

25,000 and the cash available with the business would reduce by Rs. 25,000 to Rs. 50,000.


1,00,00

0 + 0 =Cash (50,000) + Furniture (25,000) + Stock

(25,000)


• Vendor Name irrelevant in Cash Purchase



Though the goods have been purchased from M/s Roxy brothers, their name has no

relevance while the transaction is being considered for accounting purposes, since the

purchase is for cash.

When we make a cash purchase, the party from whom the purchase is made is irrelevantunless there is a time gap between the transaction of purchase and transaction of paying cash.

The vendor's name may also be considered if the organisation intends to have an accounting

record of who purchases what and how much, in which case the purchase is recorded as a

credit purchase and the due cleared immediately.

Bought Goods from Mr. Shyam Rao on credit for Rs. 10,000.

Since goods are bought on credit, the value of Goods has increased from Rs. 25,000 to Rs.

35,000. The liabilities of the business would increase from zero to Rs. 10,000. This liability

is identified by the name of the vendor who gave the goods on credit i.e. Mr. Shyam Rao.


1,00,00

0+

Mr. Shyam Rao

(10,000)=


(35,000)


Sold Goods for cash Rs. 20,000 to Mr. Peter.

Since goods are sold by taking cash, the value of Goods has decreased from Rs. 35,000 toRs. 15,000. The cash available with the business would increase from Rs. 50,000 to Rs.

70,000.


1,00,00

0+

Mr. Shyam Rao

(10,000)=


(15,000)


• Buyer Name irrelevant in Cash Sale

Though the goods have been sold to Mr. Peter, his name has no relevance while the

transaction is being considered for accounting purposes, since the sale is for cash.

When we make a cash sale, the party to whom the sale is made is irrelevant unless there is a













time gap between the transaction of sale and transaction of receiving cash.

The buyer's name may also be considered if the organisation intends to have an accounting

record of who bought what and how much, in which case the sale is recorded as a credit sale

and the due cleared immediately.

Sold Goods on credit to M/s Bharat & Co., for Rs. 10,000.

Since goods are sold on credit, the value of Goods has decreased from Rs. 15,000 to Rs.

5,000. A new asset in the form of a debtor (those who owe us) is created. The new asset is

identified by the name of the organisation which purchased the goods on credit i.e. M/sBharat & Co.


1,00,000

+ Mr. Shyam Rao(10,000)

= Cash (70,000) + Furniture (25,000) + Stock (5,000)

+ M/s Bharat & Co (10,000)


Paid Cash into Bank Rs. 60,000.

Since cash is paid into bank, the available cash reduces from Rs. 70,000 to Rs. 10,000. The

amount paid into the bank is held by the bank on our behalf. The bank has to pay us the same

whenever we ask for it. The bank therefore stands in the position of a debtor to us (thosewho owe us money).

The new asset is identified as "Bank" if there is only one bank account. Where there are

more than one bank account, each bank is identified by its name.


1,00,000

+ Mr. Shyam Rao(10,000)

= Cash (10,000) + Furniture (25,000) + Stock (5,000)+ Bank (60,000)

+ M/s Bharat & Co (10,000)


Paid Cash to Mr. Shyam Rao, Rs. 5,000.

Since cash is paid to Mr. Shyam Rao, the available cash reduces from Rs. 10,000 to Rs.5,000 and the liability in the name of Mr. Shyam Rao (the amount due to him) also reduces







• Double Entry System

The process of accounting that we are learning about is called the "Double Entry System of

Accounting". This is so called based on the dual entity concept which states that every transactionrelating to business has its effect on two elements. A better explanation can be given after learning

what a LEDGER is.

Account Types or Kinds of Accounts ::

Personal, Real, Nominal



• Element

Meaning = A small part of the total whole

Synonyms » constituent, part, building block, component, ingredient, factor, aspect

• An Element in accounting

An element for the purpose of accounting is that aspect relating to which we wish to find/know inform

Each element in accounting is identified as an account or an accounting head.

» Some examples of accounting elementsWe wish to know

The amount of capital invested in the business.

• Capital is an element. — We identify it as Capital a/c.

The value of Furniture with us in the business.

• Furniture is an element. — We identify it as Furniture a/c.

The amount of expenditure on account of salaries.

• Salaries is an element. — We identify it as Salaries a/c.

The amount due to us from Mrs. Vimla.

• Mrs. Vimla is an element. — We identify it as Mrs. Vimla's a/c.

The amount we owe the wholesaler Mr. Rathod.

• Mr. Rathod is an element. — We identify it as Mr. Rathod's a/c.

The amount available in the bank.

• Bank is an element. — We identify it as Bank a/c.

The value of sales made by us.

• Sales is an element. — We identify it as Sales a/c.



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