Recording of transactions:

The primary objective is to know whether business has made a profit or suffered a loss after a certain
period.
Nature of Transaction

Cash transaction Credit transaction

With a cash transaction, the buyer pays for the goods or services immediately as they are received
or possibly in advance. Cash is directly involved in a cash transaction e.g., payment through bank or
payment through cash in hand.

With a credit transaction, the buyer doesn't have to pay for the goods or services on receipt but is
allowed some time. Cash is indirectly involved in a credit transaction. Payments and receipts are
postponed for somne future time (credit period) e.g. business buys goods for resale and payment is
made after one month.

Parties to a Credit Transaction

Receivable Payable
(A person who owes money to (A person to whom business owes
business) money).

TYPES OF ACCOUNTING

ACCOUNTING

Financial Accounting Management Accounting

Production of summary financial Preparation of accounting reports
statements / accounting reports for internal users e.g.
for external users Management, employees.
Prepared annually (six-monthly Normally prepared on monthly
or quarterly in some countries). basis.
Generally required by law. Not mandatory.
Reflects past performance and Production of detail accounts,
current position. used by management to control
Information is calculated and the business and plan for the
presented in accordance with future.
International Financial Includes budgets and forecast of
Reporting Standards (IAS or future activities as well as
IFRS) reflecting past performance.
Companies are more complex and have the following characteristics:
Owned by shareholders (or members)

Limited companies are of two types:

1. Public (shares issued to general public)
2. Private (share issue restricted to friends and family)

A company is a legal entity in its own right, and therefore the shareholders have only limited liability
for any losses a company makes.
Non-business entities
It is not just businesses that will need to have accounting information and prepare financial statements
also charities, clubs and government (or public sector) organisations need it.

BUSINESS TRANSACTIONS
A transaction is an exchange of goods or services between two persons or parties.

Every business buys and sells goods or services and gets paid for what it sells and has to pay for what it
buys. Many businesses have employees and have to pay for their work. All businesses incur expenses for
services they receive such as electricity, water, telephone services. They all are business transactions.
Thus, it is an event (measurable in terms of money) that changes the financial position of a business
entity e.g. sale / purchase of goods or services etc.

Event (Anything that happens)

Monetary events (e.g. Non-monetary events (e.g.

daily shopping, buying/ Winning a game, delivering a
selling of goods etc) lecture in a meeting)

Only those events are considered in accounting which can be measured in monetary terms, as stated by
the Money Measurement Concept.

Event (Anything that happens)

External Internal
(e.g. Purchase of furniture from (e.g. loss of furniture by fire,
Mr. A) decrease in value of a car due to
wear and tear etc).
 INTRODUCTION TOACCOUNTING
Accounting isthe system of recording and summarizing business and financial transactions and analyzing,
verifying, and reporting the results.
Recording means that the transactions should be recorded as they occur to provide up to date
information to the management.

Summarizing means that the transactions for a period are summarized to provide information to the
concerned parties.

WHO NEEDS ACCOUNTING?

Any organization/business/individual that needs to keep track of their income, expenses, assets and
liabilities

BUSINESS
Any activity undertaken with the intention to make profit, but result can be profit or loss. Thus, it is an
organization which sells something or provides a service with the objective of earning profit.
ORGANIZATION
It is a place where a group of people are working together to achieve a common goal.

TYPES/FORMS OF BUSINESS ORGANIZATION

Sole-proprietorship/ Partnership Limited company

Sole-trader
Sole Trader
Asole trader is the simplest form of business where it is owned and managed (operated) by one person
(although there might be any number of employees). The sole trader and their business are legally the
same entity and therefore the sole trader is fully and personally liable for any losses of the business.
E.g. small retailer, painter and decorator.

Partnership
A partnership is where a business is owned jointly by a number of partners (minimum 2). Somne, or all, of
them will be actively involved in the business. Partners share profits and losses in accordance with their
agreement. The partners and their business are legally the same entity and therefore the partners are
jointly and severaly liable for the losses of their business.

E.g. accounting firms, solicitors, estate agents.

Companies
Company is: a business owned by many people and operated by many (though not necessarily the same)
people.
 KEEPING ARECORD
Transactions are recorded in accounts. The system of recording transactions is therefore called the
accounting system. It is also called the book keeping system and sometimes ledger accounts.

Ledger
Ledger is a book of Account in which all different accounts are maintained.

Accounts (T-Accounts)
An account is a summarized record in which financial transactions of similar nature are recorded.

Accounting consists of three main steps.

1. Recording in books of prime entry.
2. Classifying the transactions according their nature and posting them in their particular accounts
e.g. Sales transactions are posted to the sales account and expenses are posted to the expense
accounts.
3. Summarizing Accounting data is transformed into meaningful form and summarized commonlyin
two financial statements named as STATEMENT OF PROFIT OR LOSS AND OTHER
COMPREHENSIVE INCOME andsTATEMENT OF FINANCIAL POSITION.

KEY TERMS OF ACCOUNTING

ASSETS
Assets are useful or valuable things owned by a business to earn income and profit. A business gets
economic benefits out of these items.

Definition as per IAS 1

An asset is a resource controlled by the enterprise as a result of past events and from which future
economic benefits are expected to flow to the enterprise.
Types of Assets

Non-Current Assets Current Assets

The assets that are bought with The assets that are bought with the
the intention of use rather than intention of resale. These may be
resale. They are expected to be cash or expected to generate cash or
used by a business for more other economic benefits within 12
than a year help generate months. They change from day to
income. day in the normal course of trading
These may be tangible or e.g. stock, debtors, prepayments,
intangible e.g. furniture, bank, cash
building, software, goodwill etc.
LIABILITIES
Liability is the money owed by the business for resources supplied by people or organizations other than
the owner.

Definition as per IAS 1

A liability is a present obligation arising from past event, the settlement of which is expected to result in
an outflow of economic benefits.
 Types of Liabilities

Non-Current liabilities Current liabilities

Which are payable in more than Which are payable in less than 12
12 months' time from the months' time from the reporting
reporting date e.g. loan etc. datee.g. trade payable, overdraft
CAPITAL / EQUITY
Capital is the amount invested in a business by its owner (the sole trader). It may include:
Money initially injected by the sole trader to start the business up
Money subsequently injected by the sole trader
Profits made by the business, less
Money taken out of the business by the sole trader as drawings.

Note that profits made by a business are effectively a return for the sole trader on the moneythat they
initially invested. Any profits not taken out of the business as drawings are therefore in effect extra
capital.

Capital is a type of liability to the business, as the business theoretically owes this amount backto the
sole trader.
DRAWINGS
Drawings are reduction in the liability of business to the owner. Whatever the owner takes out of the
business for personal use, whether goods or cash, reduces the liability of the business towards owner, and
are thus called drawings.
EXPENSES
Expenses are decrease in economic benefits during the accounting period in the form of outflows or
depletion (decrease in value) of assets or occurrence of liabilities.

Expenses are cost of supply of goods or services i.e. cost of operating a business.

Types of Expenses

Capital Revenue
Capital expenditure
Capital expenditure is made when a business spends money either to:
Buy non-current assets for use in business and not for resale.
Add to the value of an existing non-current asset by improvement in its earning capacity (future
inflow of economic benefits).
They are mentioned as non-current assets in Statement of Financial Position.

Revenue expenditure
Revenue expenditures are expenses incurred either
In the ordinary course of the business i.e. operational expenses
To maintain the existing earning capacity of the business.
They are mentioned as Expenses in Statement of Profit or Loss and Other Comprehensive Income.

Error in recording
If the capital expenditure or revenue expenditure is mistaken one for the other, then gross profit or net
profit figure (or both) will be incorrectly stated, as will the statement of financial position figures.
If capital expenditure is treated as revenue expenditure, then the assets and profits are understated and
vice versa.

INCOME
Income means inflow of economic benefits (whether by sale for cash or on credit). The definition of
income covers both revenue and gains.

Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of
different names including sales and turnover.
Profit
The excess of income over expenditures is recognised as profit.
LOsS
The excess of expenditures over income is recognised as loss.
Purchases
Items which are purchased with the intention of resale are called purchases, whether these are on cash or
credit basis.

Inventory
Goods (purchased for resale) that remain unsold at the end of an accounting year i.e. unsold "purchases"
are called Stock or Inventory.

FINANCIAL STATEMENTS
The objective of financial statements to provide information about the financial position, financial
performance and cash flows of an entity that is useful to a wide range of users in making decisions. The
two most commonly made financial statements for sole traders are:

Statement of profit or loss and other comprehensive income

Statement of financial position
 ACCOUNTING EQUATION
THE BUSINESS ENTITY CONCEPT/ SEPERATE ENTITY CONCEPT
It states that the business entity must be treated separate from its owner. Accounting is done only for
business not for owner.

Thus, the financial accounts should show only the activities of the business and not the personal activities
of its owner.

THE ACCOUNTING EQUATION

A consequence of the separate entity concept is that a business will buy assets using borrowed funds or
capital.
Therefore the accounting equation always holds true:

Assets = Liabilities + Capital

An assetis something that the business OWNS

A liabilityis something that the business OWES
Capitalis how much the business OWES to the owner. (a liability towards owner)

Assets - Liability = Capital / Net assets/ Equity

THE DUALITY CONCEPT/ DOUBLE ENTRY CONCEPT

This concept states that every transaction has dual effects, which are equal and opposite.
When the dual effect is taken into account, the accounting equation will remain true.
Sales and profit
When a sale is made at a profit, one asset (inventory) is replaced by another (cash or a receivable).
The amounts however are not equal - the difference being profit.
In order for the accounting equation to hold true after this transaction has been recorded, the profit must
be reflected in capital.
Effects of Some Important Transaction on Accounting Equation
1. Owner puts money into business ($1oo0)
Cash $1,000 Capital $1,000

2. Owner took loan from bank for business ($500)

Cash ($10o0 + $500) Capital $1000 + Loan $500
3. Purchase of building (S6o0)
Cash ($15s00 - $6oo) + Building $600 Capital $1000 + Loan $50o

Financial Accounting (FFA/F3) Notes Page #10

4. Purchase of goods $100 for cash and $100 on credit

Cash ($900 - S100) + Building $6oo + Capital $1000 + Loan $500 +
Inventory $200 Trade payable S100

5. Sale of all the stock goods for $30o ($200 on credit; $100 on cash)
Cash ($8o0 +$100) + Building $600 + Capital $1000 + Profit $100 +
Inventoryo + Trade receivable $200 Loan $5oo + Trade payable
$100

6. Payment to trade payable S100

Cash ($goo-$100) + Building S6o0 + Inventory Capital $1,00 + Loan $5oo +
o+ Trade receivables $200 Trade payable o

7. Owner took $200 of cash for personal use

Cash ($8oo - $20o) + Building $600 + = Capital ($1,100 - drawings $200)
Inventory o + debtors $200 + Loan $500

Ifa business makesa profit, its capital and net assets increase.
Ifa business makes a loss, its capital and net assets decrease.
Equation will always remain balanced because of dual efect of transactions but after every transaction
there is a change in financial position.
 DOUBLEENTRY BOOK KEEPING
RULES
ACCOUNTING CYCLE

Source documernt

Irregular natured Regular natured

transactions transactions

Financial Statements

Books of Prime
General
Iournal Entry

Extended Trial Balance

Transfer Journal Trial General

(Adjustments) Balance Ledger

General Ledger: (Main or Nominal Ledger)

The book which contains Ledger Accounts" of each type of asset, liability, revenue and expense.Hence,
the double entries for transactions are passed in this book.

THE DUALITY CONCEPT AND DOUBLE ENTRY

In the previous chapter, we learnt that each transaction has two equal and opposite effects such that the
accounting equation always proves correct:
Assets = Liabilities + Capital

Traditionally one effect is referred to as the Debit (abbreviated to Dr) and the other as the Credit
(abbreviated to Cr).

Ledger accounts, debits and credits

In practice it is far too time consuming to write up the accounting equation each time that the business
undertakes a transaction. Instead the two effects of each transaction are recorded in ledger accounts.

Transactions are recorded in ledger accounts (or T accounts).

Financial Accounting (FFA/F3) Notes | Page #13

There is a ledger account for each asset, liability, and income and expense item.
These individual ledger accounts are all held in the General ledger.

Format of the Ledger Account

The Ledger account (T' account)
Title of account

Amount Amount
Date Narrative Date Narrative

The left hand side is called the DEBIT side

The right hand side is called the CREDIT side.
We post entries to the Debit or Credit side depending if they are increases or decreases to the account.
Debit and credit rules
For every transaction the total amounts of debits must be egqual the total amounts of
credits. Whether an entry is to the debit or credit side of an account depends on the type of account and
the type of transaction:
 SED

All business transactions

Classify - put same types of transactions together

Returns Return
Cash receipts
Credit Credit Inwards Outwards Other
And
Sales Purchases (Sales (Purchase types
payments
returns) Sreturns)

Enter in Enter in Enter in Enter in cash

Enter in Enter in
Purchases returns returns received Book
Sales Day general
Day book inwards outwards and payment
book journal
Day book Day book Book

Enter in double entry accounts in the various ledgers

General ledger
Sales ledger
Purchases ledger
 NON-CURRENT ASSETS
NON - CURRENT ASSETS

A non-current asset is an asset which is intended for continued use in a business -generally meaning over
more than one accounting period. They are used to generate income directly or indirectly for a business
and are not normaly liquid assets (i.e. not easily and quickly converted into cash without a significant loss
in value)

Non-current assets can be tangible or intangible. In this chapter, you will study the accounting of Tangible
Non-current assets only.

TANGIBLE NON-CURRENT ASSETS

Have physical substance e.g. Land and buildings, Plant and equipment, Motor vehicles, Computers,
Fixtures and fittings etc.

The rules for accounting for tangible non-current assets are provided by IAS 16 Property, Plant and
Equipment. As per IAS 16, the recognition criteria of property, plant and equipment is:
a) It is probable that future economic benefits associated with the item will flow to the entity and
b) The cost of the item can be measured reliably

ACCOUNTING FOR TANGIBLE NON-CURRENT ASSETS

A non-current asset is purchased for continuing use in a business throughout its useful life. At the end of
this useful life (or possibly before), it is disposed of.
Throughout the next sections of the chapter, well consider the necessary accounting entries at each stage
of a non-current asset's life:
1. Initial purchase and subsequent recognition
2. Depreciation each year throughout the asset's useful life
3. A possible revaluation to reflect an increase in the asset's value
4. Disposal at the end of the asset's useful life

COST OF A NON-CURRENT ASSET

The cost of a non-current asset according to IAS 16 includes all costs directly attributable to bringing the
asset to the location and condition necessary for it to operate normally.
It therefore includes:
The initial purchase price of the asset
Delivery costs
Non-refundable import taxes after deducting trade discounts and rebates
Installation and assembly costs
Testing costs (Before asset goes into commercial production)
Costs of site preparation
Professional fee
 ACCRUALS AND PREPAYMENTS
INTRODUCTION

The Accruals Concept says that income and expenses should be included in the statement of profit or
loss account of the period in which they are earned or incurred, not when cash is paid or received.
Recording Expenditure and Income
Throughout the year, when an invoice for an expense incurred is paid, this is accounted for by:
Dr Expense
Cr Cash

Similarly, when income is received, this is accounted for by:

Dr Cash
Cr Income

At this stage, consideration is not given to the period to which the invoice or income relates.

Therefore if the following year's rent is paid in advance, for example, it is still recorded in the ledger
accounts this year even though it does not relate to the current accounting period.

ACCRUED EXPENSE
An accrual arises where expenses of the busines, relating to the year, have been incurred but not yet paid
by the year end. In this case, it is necessary to record the extra expense relevant to the year and create a
corresponding statement of financial position liability. If no invoice has been received, the amount must
be estimated: (called an accrual):

Dr Expense accournt X
Cr Accrued Expense X

The credit entry creates a current liability in the statement of financial position - an accrual expense.

The debit entry ensures that the statement of profit or loss includes the expense relating to the whole year,
thus reducing profit in it.
PREPAID EXPENSE
Expense which has not been incurred but has been paid in advance.

A prepayment arises where some of the following year's expenses have been paid in the current year. In
this case, it is necessary to remove that part of the expense which is not relevant to this year and create a
corresponding statement of financial position asset (called a prepayment):
Dr Prepaid expense
Cr Expense account X

The debit entry creates a current asset in the statement of financial position - a prepayment.
The credit entry removes the expense relating to the following year from the current year's statement of
profit or loss, thus increasing the profit for the year.
ACCRUED INCOME
Accrued income arises where income has been earned in the accounting period but has not yet been
received. In this case, it is necessary to record the extra income in the statement of profit or loss and
create a corresponding asset in the statement of financial position (called accrued income):
Dr Accrued income (SOFP) X
Cr Income (P&L) X

Accrued income is a current asset in the statement of financial position.

PRE-RECEIVED INCOME
Pre-received income (also known as Deferred Income) arises where income has been received in the
accounting period but which relates to the next accounting period (not earned yet). In this case, it is
necessary to remove the income not relating to the year from the statement of profit or loss and create a
corresponding liability in the statement of financial position (called pre-received income):
Dr Income (P&L) X
Cr Pre-received Income (SOFP) X

Pre-received income is a liability in the statement of financial position.

Accrued Expenses are Current liabilities and Prepaid Expenses are Current assets.
If we have incurred an expense in this period which will not be paid for until the next period, we use an
accrual to match the particular expense against the revenue of this period.