4.

1Accounting
Accounting can be explained as a process of providing information required by the
interested parties ofa business for their decision making. Financial information is
very important in decision making in a business. Accounting that mainly provides
financial information is called as Financial Accounting.

4.2Objectives and need of Accounting

As mentioned above, Accounting is needed to provide useful information to
interested parties of a business for their decision making. Further, the business
activities also impact various other parties. All these parties including owners and
debt holders are named as interested parties (stakeholders) of a business. Owners,
debt holders, investors, customers, suppliers, employees and the government are
usually considered as key interested parties among other parties. Each party takes
decisions in various nature and for that they require information. Accordingly,
providing information for decesion making is the main objective of accounting.
Based on this main objective, there are various other objectives and few of such
objectives are given below.
* To know whether the business has earned an adequate profit

* To know whether the financial position of the business is sound

* To fulfill legal requirements (presentation of financial reports is a

mandatory requirement by law for some organisations)

*To minimize disadvantages arising through ommission and commission

of transactions, and to organize financial activities

In order to fulfillabove objectives, accounting provides various types of reports to

the interested parties. These reports are generally termed as Financial Statements.
These financial statements are based on business transactions.
4.3 Business transactions
When a business carries out its activities, it requires to exchange resources with
various parties. For example, when a business purchases goods on cash basis, cash
and goods are exchanged between the business and the supplier. Accordingly, a
transaction can be identified as an exchange of resources between a business and
other parties.
In a business, there can be various types of transactions. Among those transactions,
the transactions of which their value can be measured in terms of money, are
considered in accounting.

Examples;
Sales of goods for Rs 100 000
Monthly salary payment of Rs 50 000
Obtain a bank loan of to Rs 300 000
Electricity payment of Rs 5 000
In addition, to the exchange of resources mentioned above, some events that had
occurred in businesses are also considered in accounting.
Examples i
Damage of trade stocks - Rs. 10 000
A trade receivable that becomes a bad debt - Rs. 3 000

These events are also considered as transactions in a broader sense in accounting.

Most of the transactions that occur in a business are associated with purchases
and sales of goods and providing services. Such transactions could be made either
on cash or credit basis. If the value of the transaction is settled at the point of the
transaction, it will be considered as a transaction on cash basis. On the other hand,
if the settlement is made later, it will be considered as a transaction on credit basis.

4.4 Assets, liabilities, equity, income and expenses, that

arise from various transactions

As a result of transactions following accounting elements arise.

* Assets * Equity
* Liabilities ** Income and Expenses.
Assets
The resources that are generated as a result of a past transaction are simply called
assets.

Examples :
Purchase of a machine by a business
Purchase of a motor vehicle by a business
In order to recognize an asset in accounting reports, its cost/value should be able
to be measured reliably. Assets generate future economic benefits to the business.
Examples -
If a machine that had been purchased by a business is used to
manufacture and sell goods, the cash that flows to the business in
future from that machine.

The profits that are generated by the future sale of purchased stocks.

If any item does not generate future economic benefits, that item cannot be
considered as an asset. Further, the item should be controlled by the business. This
means, the business should be able to use that asset according to the discretion of
the business and to take decisions on the asset. For example, the above mentioned
machine and the stock should be able to be used by the business according to the
discretion of the business. A building on a rental basis cannot be considered as an
asset as it is not controllable by the business.

The following characteristics are observed of an asset.

* Arose as a result of a past transaction

* Controlled by the business
* Inflow of future economic benefit to the business

Accordingly,
an asset could be defined as follows.

An asset is a resource controlled by the business as a result of a past transaction

and from which future economic benefits are expected to flow to the business.
 Examples :
Land and buildings, machinery, furniture, equipment, stocks,
debtors including receivables, cash at bank, cash in hand.

The assets of a business can be categorised into two types as follows.

* Current Assets
* Non-current Assets

Current Assets
The assets that are expected to be used, sold or converted into cash within a short
time period as 12 months in the ordinary activities of a business are classified as
current assets.

Examples :
Stocks to be resold, Trade receivable that needs to be
recovered within 12 months.

Non-current Assets
All the assets that cannot be considered as current assets are considered as
non-current assets.

Examples :
Land and buildings, machinery, furniture, equipment, motor vehicles.

Liabilities

Payables of a business that had arose as a result of past transactions could be

simply considered as liabilities.
Examples ;
A loan obtained from a bank

The business is bound to repay these liabilities in future. Therefore, these are
considered as current obligations. When these liabilities are settled, the resources
which generate future economic benefits (assets) will flow out from the business.
Further, in order to show a liability in the accounts, its amount should be able to be
measured reliably.
 Example :
In settling a bank loan, it requires to pay cash and cash outfiows
from the business.

Accordingly.
following characteristics are observed of a liability
*Arose as a result of a past transaction
* Outfiow of economic resources when settlement is made
* Having a current obligation

Examples :
Bank loans, Trade creditors

Liabilities also can be categorised into two types as follows.

* Current Liabilities
Non-current Liabilities

Current Liabilities

The liabilities that should be settled within a short period of time as within 12
months are classified as current liabilities. These are also termed as short-term
liabilities.

Examples :
Trade creditors that arise when goods are purchased on credit for
resale, accrued electricity expense.
Non-current Liabilities

Allof the liabilities that cannot be considered as current liabilities are

classified as non-current liabilities.

Example ;
The portion of a bank loan that needs to be settled after one year.
Equity
If the business has liabilities, a part of its assets has to be used to settle those
liabilities. After the settlement of such liabilities the assets that remain belongs to
the owners of the business.

The value of assets that belongs to owners of the business is termed as equity.
Example :
Let us assume that a business has RS. 500 000 worth of assets and a
bank loan amounting to Rs. 200 000. RS. 200 000 out of Rs. 500 000
of assets has to be used to settle the bank loan and therefore, the
remaining of assets worth of RS. 300 000 belongs to the owners.
Equity Assets Liabilities
Rs 500000 Rs 200 000
Rs 300 000

In a sole proprietorship, the capital invested represents the equity.

Income and Expenses
Profit of a business is the difference between income and expenses.
Accordingly.
Profit = Income - Expenses

Profit belongs to the owners of the business. Therefore, profit must be added to the
equity. Profit can be calculated separately and thereby it can be added to the equity.
Alternatively, income could be added to the equity and expenses could be deducted
from the equity. In other words, equity is increased by income and decreased by
expenses.

As mentioned above, income belongs to the owners. Therefore, it should be added

to the equity. As a result, equity increase. However, an increase of equity does not
occur only from receipt of income. When owners bring additional capital to the
business it causes to increase the equity. This increase in equity is not considered
as income.

Therefore, income can be defined as an increase in equity except due to the increases
from capital introductions by owners.
 Examples :
Sales
t Interest received
*Rent received
* Commission received

As income belongs to the owners, expenses should also be born by the owners.
Therefore, expenses should be deducted from the equity and it causes to reduce the
equity. However, a decrease of equity does not occur only from expenses. When
owners take goods or cash out of the business for their private use (which is termed
as drawings), equity decreases.
Therefore, expenses can be defined as a reduction in equity except due to
drawings.
Examples -
* Salaries and wages
* Insurance expenses
*Cost of goods sold
*Interest expenses

The difference between income and expenses is identified as the profit or loss. If
it is a profit, it belongs to owners and if it is a loss, owners have to bear that as
well. Therefore, profit or loss should be ultimately adjusted to the equity. Then,
what remain are assets, liabilities and equity. The relationship among these assets,
liabilities and equity could be shown in an equation. This equation is named as
the Accounting Equation. You can learn about the accounting equation in the next
chapter.
 Activity 01

Following are somne items of Yeshika's business who carries out a canteen.

Electricity expense
Investments
Commission received
Sales
Advertising expense
Bank loans

Capital
Creditors
Commission paid
Vehicles
Vehicle repair expense
Investment interest income
Debtors
Interest paid on bank loan

Using a tabular format categorise each of the above items under the columns of
assets, liabilities, equity, income and expenses.