Accounting notes Page# 1

Definition, Purpose and Terminology

Introduction to Accounting
Accounting deals with communicating the business activities of a firm to
individuals and various sections within the firm and also to outsiders. We can say
that technique of recording, process of identifying, method of measuring and
language of communicating business transaction is accounting. From the above
definition we ascertain that Accounting is:
1: Recording of data All business and other organization cannot keep all details
in their mind so they have to keep record of it. They will not only record cash
receive and paid also record good bought and sold. It is called recording of data.
2: Classifying and Summarizing When data is recorded it has to be sorted out
so as to be most important and useful to business. This is called classifying and
summarizing data. By classifying we can work out how much profit or loss is
made, also show what resources owed by business.
3: Communicating information From the sorted data, someone skilled in
accounting should be able to tell whether or not business is performing well
financially. He should be able to ascertain strengths and weakness of business.
Finally he should be able to tell or communicate his result to owners of business
or to others allowed to receive this information.

Objective of Accounting The information communicated by accounting is

needed for following purposes:
1: Owners of business wants to know their result of activities i.e. profit or loss
suffered and financial strength of business.
2: Prospective investor and creditors are interested to know profitability and
financial status of business.
3: Employees want to know the stability and future prospects and scope of
business.
4: Management needs various kind of classified informations for decision-making
techniques.
5: Various Government agencies are also interested in firm activities and
incomes.

Basic Terminology
In every field of life some words are used with their specific meanings. These are
called terms. In accounting, also some basic term are used. These term and their
meaning are:

Business: Any activity undertaken for purpose of earning profit such as buying
and selling of merchandise called merchandise concern, rendering services
called service concern and manufacturing goods called manufacturing concerns.

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Transaction: Any dealing between two people, which can be measured in terms
of money, is called transaction. Like buying some item, selling some item ,
receive money from someone, pay to someone.

Voucher: Documentary evidence of business transaction is called voucher. It

can be cash memo ,bill, invoice, etc.

Merchandise: Things bought by firm for purpose of reselling them in same

condition is called merchandise or goods.

Purchases: Cost of merchandise bought is called purchases. When price of

goods purchase is paid in cash it is called cash purchase and when it is paid in
future date it is credit purchase.

Sales: The selling price of goods sold is called sales. If this price is received in
cash it is called cash sales and when receive on any future date it is called credit
sales.

Revenue: All sort of income received or accrued is called as Revenue. This

revenue may earn from sale of merchandise or by rendering services for
customers. It is also earned in shape of commission, interest, discount, etc.

Expenses: To achieve objective of business certain payments or obligations are

created. These payments are expenses of business, examples of such expenses
are freight, cartage, salaries, rent, advertisement etc.

Assets:
Anything valuable possess by a firm with following three characteristics qualifies
as asset:
• Legal title of ownership
• Right to use
• Right to dispose
Examples of assets are cash, building, furniture and fixtures, machinery and
plant, account receivables, notes receivables, investments, inventories, etc.
Asset can be subdivided into following groups:

• Current Assets:
Which are either cash or easily convertible into cash. They are created
with a view to convert or sell them for cash. Examples of such assets are cash in
hand, cash at bank, account receivables, notes receivables, merchandise
inventories, etc.
• Non current Assets:
These are assets which are acquired with a view to hold them and earn
income other than business income. Example is investment, shares of other
companies, Government securities, etc.

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• Fixed Assets:
These assets are acquired to retain and use in business operations e.g. land,
building, machinery and plant, motor vehicles, etc.

• Intangible Assets:
These assets though not physically touchable but still valuable for business
enterprise, e.g. preliminary expenses, trademark, goodwill etc.

Equities:
The right possessed by owners or outsiders against the assets of firm are called
equities. These are divided into two categories:
Owner Equity:
It is capital invested by proprietors/owners of business. It is claim of owner on
assets of enterprise.
Liabilities:
It is claim of outsiders against assets of enterprise. It can be of following two
types:
Short term liability
Liability which are payable in near future are called short-term liabilities. For e.g.
account payable, notes payable, bills payable, bank overdrafts.
Long term Liabilities
These are loans which are raised for permanent finance of firm. These are
payable after number of years. Examples are long period bank loans, securities,
mortgage loans, etc.

Drawing
Cash or commodities withdrawn by owner for his personal use from business are
known as drawings.

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Questions

1: Tick the correct Answer:

a. Capital refer to equity of owner in a firm T/F
b. Liabilities are claim of outsiders in a business. T/F
c. Merchandise are current assets. T/F
d. Revenue means income. T/F
e. Commission receive is an income. T/F
f. Building purchase for office will be included in purchase. T/F

2. Fill in the blanks:

a. Any action undertaken for purpose of earning profit is called --------------
b. Art of measuring, communicating, interpreting financial activities is called ------
c. Any dealing between two persons in term of money is called --------------
d. Goods sold in course of trading is called --------------
e. Any documentary evidence in support of business transaction is called as -----
f. Amount of cash and goods which owner of business invest is called ------------.

3: Classify following as Assets, liabilities and Owners equity.

Account Receivable Account Payable Loan from Bank
Capital Building Machinery
Expenses Payable Net Income

4: Classify as Expenses and Revenue

Commission received Discount Paid Salaries paid Rent Received
Advertisement bill Custom duties Sale of good Purchase of
goods.

5: Classify as Current asset, Non current asset, Fixed asset, Intangible

asset:
Cash, Account receivable, Building, Investments,
Goodwill, Inventories, Copyright, Prize bonds,
Furniture, Electric fans, Sports Material.

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Accounting Equation

Accounting Equation
Whole of financial accounting is based upon accounting equation. For e.g. If a
firm is to setup and start trading than it needs resources. Let us assume that in
first place it is owner of business who has supplied all resources, This is
Resources in business = Resources supplied by owner
Amount of resources supplied by owner is called capital. Actual resources that
are than in business are called assets of business. So accounting equation can
be: Assets = Capital
However, people other than owner have supplied some of the asset. Liabilities
are name given to amount owing to these peoples for these assets. Equation
now will be: Assets = Capital + Liabilities
It can be seem that two sides of equation will have same total so:
Resources what they are = Resources who supplied them
Assets = Capital + Liabilities

Transaction and Accounting Equation

When a transaction take place it effects in term of increase or decrease of three
components of accounting equation. Consider following illustrations:

1: Mr Irfan started business of printing by introducing Rs: 2,00,000 in name of

Irfan Printing press.
Effect of these transaction is that cash increase 2,00,000 and capital also
increase 2,00,000.
Asset = Equities
Cash = Capital
+2,00,000 = +2,00,000

2: Irfan purchase building Rs:1,00,000 and paid cash for same.

Now Cash will decrease 1,00,000 and building will increase by 1,00,000.
Asset = Equities
Cash Building = Capital
1: 2,00,000 = 2,00,000
2: -1,00,000 1,00,000 =

Bal: 1,00,000 1,00,000 = 2,00,000

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3: Irfan Purchase Machinery worth Rs: 1,50,000 from Liaqat and paid Rs: 50,000
in cash
Now Machinery(asset) will increase by 1,50,000 A/P(Account Payable) to liaqat
will be 1,00,000 increase and cash will decrease 50,000

Asset = Equities

Cash Building Machinery = Capital A/P

1: 2,00,000 = 2,00,000
2: -1,00,000 1,00,000 =
3: -50,000 +1,50,000 = +1,00,000

Bal: 50,000 1,00,000 1,50,000 = 2,00,000 1,00,000

Example:1
Given effect of following transaction of trader incurred during month of
May, 1998 by means of Accounting Equation:
• Ali started business by introducing capital of Rs:25,000.
• Purchase building Rs:10,000.
• Purchase furniture Rs:14,000 on account from Qureshi Furniture.
• Earn Rs:1,39,000 receive the amount in cash.
• Following expenses were paid:
• Wages :1125
• Utilities: 250
• Tax paid: 130
• Ali withdraw from business 1200 in cash for personal use.

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Example 2:
• Salman start business with Rs:50,000.
• Purchase merchandise for cash Rs:10,000.
• Purchase furniture for cash Rs:8,000.
• Merchandise costing Rs:8000 were sold for Rs:10,000 on account
• Purchase merchandise for cash 14,000.
• Merchandise costing Rs:6,000 were sold 8,000 on credit
• Payment receive against the account receivable Rs:10,000
• Rent of shop for month was paid 500.
Record above transactions in an accounting equation

Example 3:
• Abasin start business with cash 50,000 on Jan 1986.
• Purchase office furniture for cash 2000.
• Purchase merchandise for cash 9,000
• Paid carriage on purchase of merchandise Rs:250
• Purchase merchandise from Saleem/Co Rs:7,000.
• Sold merchandise for cash Rs:1200, cost Rs:1,000.
• Sold merchandise to Rehman/sons Rs:15,000 costing 13,000
• Received cash from Rehman/Sons Rs:13,000.
• Paid cash to Salman/Co Rs:3,000
• Paid salaries for month 2500

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Exercise

Q 1: Identify By putting tick mark where following statement are true or

false
1 Revenue has effect of increasing capital T/F
2 Liabilities = Asset – Capital T/F
3 Liabilities are claim of outsider against of firm T/F
4 Equities means liabilities of business T/F
5 Account Receivable is a current asset T/F

Q 2: Encircle the answer which is correct.

1 Liabilities arising from purchase of goods on credit is called
 Loan  Account Payable  Bank overdraft

2 Asset must be equal to

 Capital  Liabilities  Capital+Liabilities

3 Expenses paid by business decreases

 Cash  Capital  Cash & Capital

4 When cash is receive from Account Receivable it increases

 Cash  Account Receivable  Capital

5 The difference between Sale price and Purchase price of merchandise is

added in
 Assets  Liabilities  Capital

Q 3: Show the effect of following transaction in an Accounting Equation:

1. Introduce cash as capital Rs: 20,000
2. Purchase merchandise for cash Rs:5000
3. Purchase typewriter for cash Rs:1000
4. Merchandise costing Rs;1400 were sold to Ahmad for Rs:1800 on account.
5. Purchase merchandise from Aftab for Rs:500
6. Receive Rs:1000 from Ahmad
7. Sold merchandise for cash Rs:800 which cost 750
8. Paid salaries in cash Rs:400

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