Basic Accounting

What is accounting?

Simply speaking accounting is the language of business. Accounting is to record all the detail of any business.
It also sometime is called “basis for business decision”, as primary purpose of accounting is to provide
information that is useful for the decision making purposes whether the decision is made by owners,
management, creditors, government, partners or any other person or group that have an interest in the
financial performance of an enterprise.

Definition:

Accounting is the process of recording financial information of any business, and than to further
communicate this information with concerned persons (owner, managers, partners, investors, tax
authorities).

From this definition we can say accounting is satisfying two purposes, firstly to record the financial
information of any business and secondly to communicate this information with internal persons such as,
owner, managers etc, and external parties which include, investors, tax authorities.

When we talk about recording financial information, it is the information related to rupees, amount,
invested into business. And accountant is responsible to maintain the record of this information, from where
the cash is been brought in the business, for what this cash is been paid for, in short all the information
regarding the cash of any business is to be maintained in an appropriate way defined by accounting.

This process starts from transactions

Transactions are activities which changes the financial position of the business

Transaction is any dealing between two persons or two things. You go out to the book shop you pay cash to
buy a book is a dealing between you and the owner of the book shop, so is a transaction between you and
him. From your point of view its nothing but to purchase of book but from books shop’s point of view it is a
business dealing and they will record this as their sale. There are two types of transactions

Cash Transactions

Transactions which involve cash are cash transactions. Any purchase made for cash, any sale made for cash,
cash paid for office rent, cash paid for the purchase of office table, cash paid for salary of employee, cash
paid for any expense, cash received from the sale of asset etc.

Credit transactions

Transactions which do not involve cash are credit transactions (payable in future or receivable in future).
For example If someone purchases office furniture without paying any cash at that time and is to pay cash in
future when he will have enough cash to pay, this transaction is credit transaction. Purchased furniture from
Amir & sons, sold computer to Rashid & co. etc. there is a simple way to recognize any transaction on credit.
When in the transaction there is not mentioned the word “cash” and there is the name of any person, this
transaction is credit transaction.

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Here are some cash transactions which occurs in any business

Cash investment to start the business from the owner or outsiders:

Cash invested in business rs.10000 by the owner

Cash invested in business rs.10000, out of which 8000 from owner and remaining 2000 by outsider (loan)

Started business with cash rs.10000

Started business with cash rs.8000 by owner and rs.2000 by outsider (loan)

Cash borrowed by a friend Mr. raza rs.50000

Cash, furniture and building investment from owner or outsider:

Started business with cash rs.10000 furniture of value rs.5000 and building of value rs.20000 Total invested
value is rs.35000 (10000+5000+20000)

Purchases of any asset (furniture, office building, goods to sale purpose, motor vehicle for business use etc)

Purchased furniture (office table and chair or any other furniture for office) for cash rs.8000

Purchased building (office building, store room building) for cash rs.25000

Purchased goods for cash rs.30000 to resale

Purchased a van for office use rs.50000

Expenses paid by any business

Cash paid for office rent (rent expense) rs.8000

Cash paid for electricity bill (bill expense) for the month rs.5000

Cash paid for the salary (salary expense) rs.10000

Cash paid for telephone bill rs.3000

Cash paid for depreciation (depreciation expense) of furniture rs.2000

Sales by a business on cash

Sold goods for cash rs.20000

Sold 5 computer to Mr. Akbar for cash rs.40000

Here are some credit transactions:

Purchased office furniture from raza & company of value rs.9000

Purchased office building on installment for rs.50000 from Mr. Asim

Purchased goods from Mr. Raza of value rs.60000 to resale purpose

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Important Accounting Terms

Above stated transactions are recorded date wise in the register of general journal. But before starting to
record the transactions, before moving onto general journal entries we must understand some important
accounting terms.

Assets Profit / Net Income

Liabilities Cost of Goods Sold
Owner’s Equity Purchase
Expenses Sales
Revenue Accounting Period and Accounting Cycle
Depreciation Accounting Equation
Account

Assets:

Assets are the things business own for the purpose to earn profit in future

Assets are economic resources business own to use them for the purpose of earning profit

Assets are things of value any business own

Assets are total worth of business. Lets assume that a business own two buildings, cash, and office furniture
and these buildings, cash and furniture are being used by the owner to earn profit by using them is what the
concept of assets. How can business earn profit from building or cash or furniture? Well the buildings
business own lets owner to use as the office or as the store room or for production, furniture for office lets
owner to manage its work by sitting on chair and by using the office table, cash owned by business lets
owner to pay bills, expenses, and to buy or purchases things (goods) to sale. As every asset somehow helps
owners, managers to generate profit in future by using them

There are two types of assets, current assets and long term or fixed assets

Current Assets

Current assets are the assets which have a life of less than or equal to one year. Or we can say the assets
which changes their value within one year, examples are (cash, stock, accounts receivable)

Cash

Cash amount in hand or owned by any business from which owner or manager can buy something of value
for business purpose. Whether owner keeps this cash in hand or deposits it in the bank to later use this for
business.

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Accounts receivable

Above I mentioned credit transactions “transactions which do not involve cash”. Accounts receivable is an
asset for business which occurs when any business sell goods on credit (amount of which is been collectable
in future).

Stock

Inventories are the goods in hand or stock in hand for the sale purpose. A company is in the business of
computers. It purchases computers and sale those computers to other parties (customers). Let’s say a
company had purchased 10 computers one month back. During the whole month 7 computers are been sold
and 3 computers are still in store room. These remaining 3 computers are inventory or stock in hand, which
still is available for sale.

Long term/Fixed Assets

These are the assets with the life of more than one year. Or we can say the assets which remain in the use of
the business for more than one year; examples are (building, land, furniture)

Buildings

Buildings which business use for office or store room or to keep machinery for the production is also an
asset which helps businesses to generate revenue by using them

Furniture

Office furniture is also the asset for the business. Office table and chairs business own facilitates owners to
use for the operation of their running businesses

Liabilities

Liabilities are the debts of business, or the amounts due on business

When business borrow loan or when business is to pay someone any amount of money which business owe

Liabilities are the claims of outsiders on the assets of the business

Simply speaking we can say liabilities are the amount of money business has to pay in future, even if it has to
go through the sale of the assets. Let’s say you are a businessman, and you might get in a position where
you have to borrow some loan from someone (bank, financing companies, and any other person) this is
what liability really is. The amount you will borrow is the amount of liability for your business. You have
borrowed a loan from National Bank of Pakistan for rs.10000; this amount (10000) is your liability which you
have to pay back to National Bank.

As assets, liabilities also have two types regarding to their life of usage

Current liabilities

Are the liabilities which have a life of less than one year, or liability business pay within one year are current
liabilities.

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Accounts Payable

Accounts payable occurs when you purchase any goods or any other thing for your business on credit.
Payment of which is due on you in some future time. Let’s say you purchase a table for your office use from
the shop, but you don’t have enough cash to pay right now. It turns into a liability name accounts payable,
the accounts you have to pay.

Expenses payable

You are in a business of computers, and you have hired 2 employees to facilitate your business. Due to some
reason you are not been able to pay them the salary of the current month, you have planned to pay them in
next month. This salary expense which is yet to be paid or is payable to employees is your liability. Same as
any other expense which is been occurred but is not been paid yet is your liability, mean you have to pay the
expense in future

Long term Liability

These are the liabilities which have the life of more than one year, or liabilities which remains in the business
for more than one year. If a business borrows a loan from bank with the condition of paying back in equal
installments in 5 years, this liability is long term liability because it will be paid out in 5 years

Owner’s Equity

From the name of this term, an idea might have come in your mind that it is about the owner of the
business. Simply speaking owner’s equity is the interest of owner in the business

It’s the right of owner on the assets of business

It’s the claim of owner on the assets of business

Assume you have started a business of computers, and you have invested rs.50000 cash in it. This 50000
from accounts point of view is the owner’s equity. It is your right on the business or on the assets of it.

Expenses

Expenses are the payments you pay in order to receive or already received benefit. We will take the same
example of the employees of any business. Businesses hire managers to get profit by operating the business.
For this business pay salary to those managers who are running it. This salary is an expense for business
which is been occurred to earn profit.

Revenue

It is the price of goods sold in case of goods business, and price of services rendered in case of services
business. You are the owner of a computer shop, in the end of month you sale 10 computers for 5000 each,
total rs.50, 000. This 50,000 is the revenue which is been generated by sales. But this revenue is not your
profit or net income. Revenue becomes profit when you subtract all of your expenses from it, which were
been occurred or paid to earn this revenue.

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Depreciation

Basically it is an expense but a non cash expense. Depreciation is a technique to allocate the cost of any
fixed asset (furniture, building, machinery) over its life. Simply speaking depreciation is the method to
decrease the value of the assets like building and furniture time by time. As is a normal practice, when you
purchase furniture for your office use and time by time it reduces its value. This is what depreciation is, a
charge of the portion of the cost to the asset. We will take an example here. You have purchased an office
table for rs.10000 and you know after a year or two this table will reduces its value, mean you cannot sale it
for 10,000 but less then its original cost you have paid.

So you will spread this whole cost over the useful life (the life or the time period this table will have or will
remain good for use) of this office table. Assume the useful life of this table is 10 years, mean for 10 years
this table will be usable for you and will expire after that. So you will spread the whole 10,000 cost over 10
years (10000/10) 1000 each year. You will charge 1000 each year as depreciation expense till 10 years. Note
I have mentioned depreciation is the non cash expense (does not involve any cash payment). You have
already paid the total amount of furniture this is a method to charge a portion of cost every year.

Profit or Net Income

Above I have described revenue. Revenue becomes profit when it exceeds total expenses of an accounting
period. I will use the same example, sale of 10 computers for 5000 each total rs.50000. This 50,000 is the
revenue from sales but yet is not the profit. It will become profit when you will subtract any expenses you
have paid to generate this revenue. Assume you had purchased these 10 computers for 3000 each total
rs.30000, and you have paid salary to your employee rs.5000 and you have also paid telephone bill rs.2000.
In above stated example your profit is

Sales revenue 50000

Less your cost of computers 30000

Gross Profit 20000

Less salary expense 5000

Less telephone bill expense 2000

Profit or Net Income 13000

From this example we can see what profit is. It’s the amount after all the expenses and cost you have paid to
earn the revenue or benefit. Gross profit is the profit which comes after subtracting cost of purchases from
the sales of the same purchases.

Cost of Goods Sold

Cost of goods sold is quite same what we just explained up there. Simply speaking it is the statement to
calculate the cost of goods which businesses sell. In above example we can say cost of goods sold for the 10
computers was 30,000. It is the total cost you have paid to purchase the goods you have just sold.

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Purchases

Purchases have a special meaning in accounting. It is the acquisition of revenue asset, simply speaking it is
the cost you pay for a good to buy for sale purpose to generate revenue from selling it.

Sales

To sale the purchases we stated above in order to earn revenue.

Accounting period

It is a time span in which any business measure its position its financial strength its operating results. It can
be of 6 months or a year. Most companies measure the performance mentioned above after one year.

Accounting Cycle

It is the sequence of procedures used to record, classify and summarize accounting information in financial
reports (General Journal, General Ledger, Trial Balance, Income Statement, Balance Sheet), on a regular
basis.

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Accounting Equation
It the basic accounting methodology, accounting equation is

Assets are equal to liabilities plus owner’s equity

Asset = liabilities + Owner’s Equity

I have explained assets liabilities and owner’s equity above. In this section I will define the equality concept
of this equation. Every transaction effects business in a two sided manner or an equal manner for example
when we say we have purchased an office table for cash rs.5000, two things are happening in this
transaction. First new asset (office table) comes in the business and what goes out is cash which we have
paid to purchase the table. Let’s briefly describe this concept of equality through the equation.

On January 1 2009 Mr. raza started a business with an investment of cash rs.50000

Journal entry to record this transaction is

date detail debit credit

1/1/2009 cash 50000
capital 50000
cash invested in business by owner
We will put the same entry in Accounting Equation

Assets = Liabilities Owner's equity

1/1/09 Cash Capital
50000 50000

On January 2, 2009 purchases office table for business use for cash rs.10000

Journal entry to record this transaction is

date detail debit credit

1/2/2009 furniture 10000
cash 10000
purchased office table for business use
Effect on accounting equation

assets = liabilities owner's equity

1/1/09 cash furniture capital
2/1/09 50000 10000 50000
balance 40000 10000 50000

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Look at the effect of this transaction. It decreases cash balance which we paid to purchase furniture and it
increases a new asset named furniture in the business.

On January 3, 09 purchased 5computer to sale purpose for cash rs.30000

Journal entry

date detail debit credit

3/1/2009 purchases (computer) 30000
cash 30000
purchased computer to sale
Effect on accounting equation

assets = liabilities owner's equity

1/1/09 cash furniture computer capital
2/1/09 50000 10000 50000
balance 40000 10000 50000
3/1/09 30000
balance 10000 10000 30000 50000

As you can see this transaction has changed the cash balance again and have added a new asset in business

On January 4, 09 sold 3 computers for cash rs.50000

Journal entry

date detail debit credit

4/1/2009 cash 50000
sales 50000
sold 5 computers on 20,000 profit
Effect on accounting equation

assets = liabilities owner's equity

1/1/09 cash furniture computer capital
2/1/09 50000 10000 50000
balance 40000 10000 50000
3/1/09 30000
balance 10000 10000 30000 50000
4/1/09 60000 10000 0 50000
balance 60000 10000 0 70000
Closely look at the effect of the transaction, as the 5 computers which were been purchased for 30000 are
sold for rs.50000 with 20000 profit. Profit is always adjusted with capital (profit goes to owner) so 20000 is
added in owner’s investment capital 50000 (50000+20000) 70000. Second effect on cash, as cash is
increased by 50000.

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Account

An account may be defined as a record of the increases, decreases, and balances in an individual item of
asset, liability, capital, income (revenue), or expense.

The simplest form of the account is known as the “T” account because it resembles the letter “T.” The
account has three parts:

1. The name of the account and the account number

2. The debit side (left side), and

3. The credit side (right side).

The increases are entered on one side, the decreases on the other. The balance (the excess of the total of
one side over the total of the other) is inserted near the last figure on the side with the larger amount.

Debit and Credit

Simply speaking Debit is the left side of an account and Credit is the right side of account. But this
explanation for debit and credit is not enough. Let’s go in detail

Every transaction is been recorded in the books of accounts as an entry called, general entry. These entries
are recorded in two ways debit and credit. Debit is the benefit receiving side and credit is the benefit giving
side or the side through which the benefit is been received.

Account
Debit Credit

Benefit receiving side Benefit giving side

Who provided this benefit?

Will further describe it with an example of transaction “cash invested in business rs.5000 by owner’

To record this entry as I have said above I need two parts one is debit and other is credit. So in this
transaction benefit receiving side of the business is cash (as cash comes in the business when owner invest it
for the business use) so the cash is debit side and benefit giving side or from where this benefit comes is the
owner who invested this cash. So credit side is capital (owner).

Entry will be: Debit Credit

Cash 5000

Capital 5000

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Another transaction: purchased computer to sale purpose for cash rs.2000

Benefit received from the business is computer which comes in the business and who provided this
computer or benefit is the cash you pay. So

Entry will be: Debit Credit

Computer 2000

Cash 2000

We can say, what comes in the business is debit and who provided it is credit or what goes out of the
business is credit. Things (cash, purchases, furniture, building) you receive or you will in future, is debit. On
the other hand things you pay out or you will pay out in future is credit.

Some more transactions to clear debit and credit

Transaction: rent exp payable rs.7000

Entry will be: Debit Credit

Rent expense 7000

Rent payable 7000

I have explained expenses in earlier pages. Expenses are the benefits already been taken to earn profit. Now
this entry tells that an amount of rs.7000 is due. This entry is just to record it not to pay it. As it is a liability
which will be paid in future, now in this entry debit is rent expense as benefit comes in business is that
business has used the facility for rent and rent payable is credit as amount will go out of rs.7000 from
business

Every transaction is recorded in general journal entry book in the same way of debit and credit. Proper
format of general journal entry register is

Date Detail/particulars/accounts P.R Debit Credit

1/1/2009 Cash 1 5000
Capital 5000
Narration: Cash invested in business

This is how every transaction is been recorded. “P.R” stands for post reference number, as entries are
recorded on vouchers when in practical businesses so this section is for the voucher number or reference
number for the transaction.

Narration is a short detail of the transaction for users

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General Ledger
Ledger is the second step for recording every transaction after journal entry. Ledger gives a complete
balance of every account individually after one or more transactions of same account.

Here are some transactions to understand ledger

1-7-2004: Started business with an investment of cash rs.50000

1-7-2004: Purchases office table for cash rs.10000

3-7-2004: Purchases 3 computers to sale purpose from MR Amir for rs.3000 each for total 9000

5-7-2004: Sold 3 computers for cash rs.5000 each total rs.15000

5-7-2004: Telephone bill expense paid for the month cash rs.1000

First I will put these transactions in general journal entries and then in general ledger

General Journal Entries

Date Detail P.R Debit credit

1-7-2004 Cash 50000
Capital 50000
Cash invested in business.
1-7-2004 Office table 10000
Cash 10000
Purchased office table for cash
3-7-2004 Purchases (computers)
Accounts payable (Mr. Amir ) 9000
Purchased computer from Mr. Amir on credit 9000
5-7-2004
cash
15000
Sales
15000
Sold computers for cash
5-7-2004 Telephone bill expense 1000
cash 1000
paid cash for telephone bill exp

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Now I will put these entries in general ledger

Simply speaking general ledger is a “T” account

Cash Account

Debit Credit

Cash comes in (capital) 50000

10000 cash paid for furniture

Cash comes in (sales) 15000

1000 cash paid for bill exp.

Debit Balance 54000

Explanation:

As I have said ledger is the balance of every account individually. Above is the cash account which get
involved in four transactions, all of these are summarized in one cash account to get the ending balance of
cash (54000). In first transaction started business with cash rs.50000 which tells that cash comes in business.
Second cash paid for furniture rs.10000 which makes the balance of cash 40000 (50000-10000). Third
transaction of sales in which cash comes in business and makes the balance 55000 (40000+15000), fourth
entry of telephone bill expense shows that cash goes out of business as is been paid for bill and it makes the
balance 54000 (55000-1000). And ending balance of cash account as you can see is 54000

This is what ledger account is, to calculate the ending balance of every single account which comes in
general journal. Now I will put all of remaining accounts in ledgers

Capital Account

Debit Credit

50000 cash invested by owner

50000 credit balance

Explanation

Capital account is credited for one time only this is why we will simply write it down in credit side of ledger

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Office Table Account

Debit Credit

Office table purchased 10000

Debit Balance 10000

Office table account is only been debited for once, no other entry is been made for office table, this is why
we will simply write it down at debit side of ledger

Purchases (Computer)

Debit Credit

Purchased computers 9000

Debit Balance 9000

Purchases (computer) account is only been debited for once, no other entry is been made for office table,
this is why we will simply write it down at debit side of ledger

Accounts Payable (amir)

Debit Credit

9000 purchased computers on credit

9000 credit balance

Accounts payable account is credited for one time only this is why we will simply write it down in credit side
of ledger

Sales Account

Debit Credit

15000 sold computers for cash

15000 credit balance

Sales account is credited for one time only this is why we will simply write it down in credit side of ledger

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Bill Expense

Debit Credit

Office table purchased 1000

Debit Balance 1000

This is how all the accounts will be summarized in ledger account separately to get an ending balance of
every account.

Actually ledger, as defined earlier is the step further from journal entries. At the end of a time period
businesses might need to know the ending balances of every running account , ledger gives the right
balances of every account in use or been used in general journal entries.

Third step in accounting is of “trial balance”

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Trial Balance
Trial balance is the third step in accounting when you are recording the transactions after ledger and general
journal entries.

A trial balance is a list of all the accounts for a period, to test that the Debits agree with the Credits

Trial balance is a check statement to see that the ledgers you have posted are accurate or misbalance, this
statement is just to check the balances of all the accounts at one place. If the balance is equal than ledgers
are accurately posted if balance is not equal than there might be an error in ledgers

How to prepare trial balance?

Trial balance statement is very simple to continue, all you have to do is to put all the debit balances of ledger
accounts in debit side of trial balance and all the credit balances of ledger in credit side of trial balance
statement.

As in above ledger accounts, balance of cash account is debit balance and will be posted in debit side of trial
balance. And capital account in ledger got a credit balance so will be posted in credit side of trial balance

Accounts Detail Debit amount Accounts Detail Credit

amount

Cash 54000 Accounts Payable 9000

Office table 10000 Capital 50000

Purchases (computers) 9000 Sales 15000

Bills Expense 1000

Balance 74000 Balance 74000

As you can see the balance of every account from ledger in trial balance is equal as I said it’s a check
statement for the purpose to check that the ledgers are in balance or not

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Income Statement
A financial document that shows how much money (revenues) came in and how much money (expenses)
was paid out. Subtracting the expenses from the revenue gives the net profit.

A report that indicates how much profit or loss a company generates over a period of time—a month, a
quarter, or a year

Simply speaking income statement is the statement to check or calculate the profit of the business

When you are to calculate the profit there you have to put all the costs and expenses you have occurred to
earn profit from your business

Here you will minus all the operating expenses (bill expenses, and all other expenses you have paid to earn
profit) and you will also minus the “cost of goods sold”

I have explained cost of goods sold and expenses earlier so I will just make the income statement for above
transactions

Income statement starts from sales revenue

Sales Revenue 15000

Less: Cost of Goods Sold

Opening Inventory 0

Add: Purchases (computers) 9000

Less: Ending Inventory 0

Total Cost of Goods Sold 9000

Gross Profit 6000

Less: Operating Expenses

Bill expense 1000

Net Profit 5000

This is how income statement is been made. As you can see first I started with sales revenue after that cost
of goods sold, now in cost of goods sold there comes opening inventory and ending inventory. As I have
explained what inventory is.

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Balance Sheet
A record of the financial situation of an institution on a particular date by listing its assets and the claims
against those assets

In financial accounting, a balance sheet or statement of financial position is a summary of a person's or

organization's balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the
end of its financial year.

Statement showing the financial position at a particular point in time (eg, at the end of the financial year),
listing all assets and liabilities at that time

A balance sheet is part of the financial statements. The balance sheet reports the amounts of assets,
liabilities, and owners' equity at a specific date. The total of all assets is always equal to the total of liabilities
plus owners' equity. This is a function of the double-entry accounting system

A summary of a company's assets and liabilities

Financial statement that presents a "snapshot" of what the business owns, what it owes, and what equity is
has on a given date

See all of these definitions are telling the same thing that balance sheet is a snapshot of your business which
include (assets, liabilities and owner’s equity)

Here is the format of balance sheet

Assets amount Liabilities Credit

amount

Cash 54000 Accounts Payable 9000

Office table 10000

Owner’s Equity

Capital 50000

Net Income/Profit 5000

Balance 64000 Balance 64000

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This is how balance sheet is been prepared which shows assets liabilities and equity section separately

Now from the balance sheet we can see that bill expense and purchases (computer) account is not recorded
in here, reason is bill expense and purchases (computer) account is already been recorded in income
statement and been subtracted from sales revenue to calculate profit. Means these accounts no more exist
in business

Another thing that net profit is been add in equity section of amount rs.5000, it is the profit we have
calculated from income statement and will be added in owner’s capital investment as profit goes to owner
of the business

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