Basic Terminology in Accounting

Basic Terms In Accounting

Understanding the fundamental terms used in accounting is essential for comprehending the process and interpreting financial information. This section defines key terms that form the vocabulary of accounting.

Entity

In accounting, an Entity refers to a specific economic unit that is accounted for separately. This means the business is considered distinct and separate from its owners. This principle is known as the Business Entity Principle. It is crucial because it ensures that the business's transactions are recorded and reported independently from the personal transactions of its owners.

Answer:

Entities can be sole proprietorships, partnerships, companies, cooperative societies, or even non-profit organisations.

Transaction

A Transaction is an economic event that involves the transfer of money or money's worth between two or more parties. It brings about a change in the financial position of the business. Accounting deals with recording only those events that qualify as transactions.

Transactions can be:

• External Transactions: Involve external parties (e.g., buying goods from a supplier, selling goods to a customer, paying rent to a landlord).
• Internal Transactions: Occur entirely within the entity (e.g., transfer of raw materials to finished goods in production, depreciation of assets).

Every transaction has a dual aspect (Debit and Credit, as per the double-entry system), affecting at least two accounts.

Answer:

Assets

Assets are economic resources owned or controlled by the business that are expected to provide future economic benefits. They represent the property or rights of the business.

Assets can be classified as:

• Non-Current Assets (Fixed Assets): Assets held for long-term use in the business, not intended for immediate resale. Their benefit extends beyond one accounting period. Examples: Land, Buildings, Machinery, Furniture, Vehicles.
• Current Assets: Assets held for short-term use, expected to be converted into cash or consumed within one accounting period (usually 12 months). Examples: Cash in Hand, Cash at Bank, Stock (Inventory), Debtors (Accounts Receivable), Bills Receivable, Short-term Investments.

Assets also include intangible assets (assets without physical substance but having value), like Goodwill, Patents, Trademarks.

Answer:

Liabilities

Liabilities are obligations or debts that the business owes to external parties (creditors). They represent claims of outsiders against the assets of the business. Liabilities are expected to be settled in the future, usually by giving up an economic benefit (like cash).

Liabilities can be classified as:

• Non-Current Liabilities (Long-term Liabilities): Obligations payable after a period of more than one accounting period. Examples: Long-term Loans from banks, Debentures.
• Current Liabilities: Obligations payable within one accounting period (usually 12 months). Examples: Creditors (Accounts Payable), Bills Payable, Outstanding Expenses (expenses incurred but not yet paid), Short-term Bank Overdraft.

Answer:

Capital

Capital, also known as Owner's Equity or Proprietor's Fund, refers to the amount invested by the owner(s) in the business. It represents the owner's claim on the assets of the business after all external liabilities have been paid.

Capital is treated as an internal liability of the business towards the owner, based on the Business Entity Principle. It is the amount that the business owes back to the owner.

Capital = Assets - Liabilities (This is the fundamental Accounting Equation or Balance Sheet Equation).

Answer:

Capital increases with profit earned and additional investments by the owner, and decreases with loss incurred and drawings made by the owner.

Sales

Sales refer to the total revenue earned by a business from selling goods or rendering services that constitute its primary operations. It is the main source of income for most businesses.

Sales can be:

• Cash Sales: Goods or services sold for immediate cash payment.
• Credit Sales: Goods or services sold on credit, where payment is received at a later date from the customer (Debtor).

Answer:

Sales Revenue is recorded when the sale occurs, regardless of when cash is received (following the Accrual Basis of Accounting, discussed later).

Revenues

Revenues are incomes earned by the business from its operating activities and other sources. While Sales are the primary form of revenue for businesses selling goods/services, revenues can also include income from other activities.

Revenues represent an increase in the owner's equity resulting from the operations of the business.

Examples of Revenues:

• Sales of goods/services
• Rent Received
• Interest Received
• Commission Received
• Dividend Received

Total Revenue is matched against total expenses to calculate Profit or Loss.

Expenses

Expenses are costs incurred by a business in the process of earning revenues. They represent a decrease in the owner's equity resulting from operations. Expenses are consumed or expired costs.

Expenses are matched against revenues for a specific accounting period to determine the profit or loss for that period (following the Matching Principle).

Examples of Expenses:

• Salaries and Wages
• Rent Paid
• Electricity Charges
• Advertising Costs
• Depreciation
• Repairs and Maintenance (if routine)

Answer:

Expenditure

Expenditure refers to the spending of money or incurring a liability for receiving a benefit. It is a broader term than expense. When an expenditure is incurred, the benefit received may extend over several accounting periods or be consumed within the current period.

Expenditure can be classified as:

• Capital Expenditure: An expenditure the benefit of which is received for more than one accounting period. Such expenditure results in the acquisition of an asset or increases the earning capacity or reduces the operating costs of the business. Capital expenditures are recorded as assets on the Balance Sheet.

  Example 8. Capital Expenditure.

  Purchasing a delivery van for a business for ₹8,00,000.

  Answer:

  This is Capital Expenditure. The benefit of the van (transportation) will be received over several years. The van is recorded as a Fixed Asset on the Balance Sheet.
• Revenue Expenditure: An expenditure the benefit of which is received within the current accounting period. Revenue expenditures are treated as expenses and matched against revenue in the Profit and Loss Account.

  Example 9. Revenue Expenditure.

  Paying ₹5,000 for petrol for the delivery van for the month.

  Answer:

  This is Revenue Expenditure. The benefit of the petrol is consumed within the month. It is recorded as a Vehicle Running Expense (an expense) in the Profit and Loss Account.

All expenses are expenditures, but not all expenditures are expenses. Only revenue expenditures are treated as expenses of the current period.

Profit

Profit is the excess of revenues over expenses for an accounting period. It represents the earning capacity of the business and results in an increase in the owner's equity.

Profit = Total Revenue - Total Expenses (for a period)

Profit can be categorised:

• Gross Profit: The excess of revenue from sales over the direct costs of goods sold (Cost of Goods Sold). It shows the profitability of buying/producing and selling goods.
• Net Profit: The profit remaining after deducting all operating and non-operating expenses from Gross Profit (or total revenues). It is the final profit figure transferred to the owner's capital account.

Earning profit is a primary objective for most businesses.

Gain

Gain is a profit that arises from events or transactions which are incidental to the main operations of the business. Gains are not from the regular day-to-day activities of buying and selling goods/services.

Examples of Gains:

• Profit on the sale of a fixed asset (e.g., selling an old building for more than its book value).
• Gain from winning a court case.
• Gain from appreciation in the value of investments.

Gains are usually shown separately from the regular profit from operations in the Profit and Loss Account.

Loss

Loss is the excess of expenses over revenues for an accounting period. It results in a decrease in the owner's equity.

Loss = Total Expenses - Total Revenue (for a period)

A loss indicates that the business's operations were not financially successful during the period. The term loss is also used to describe:

• Loss by fire, theft, or accident (destruction of assets).
• Loss on the sale of a fixed asset (selling below book value).

These specific losses are usually reported separately.

Discount

Discount is a reduction in the price of goods or services. Discounts are offered to encourage prompt payment or bulk purchases.

There are two main types of discounts:

• Trade Discount: A reduction in the list price (catalogue price) of goods offered by the seller to the buyer, usually for bulk purchases or as per trade practice. Trade discount is deducted from the list price to arrive at the net price, and only the net price is recorded in the books of accounts. Trade discount is NOT recorded in the books.

  Example 10. Trade Discount.

  A wholesaler in Delhi sells goods with a list price of ₹10,000 to a retailer, offering a 10% trade discount.

  Answer:

  Trade Discount = 10% of ₹10,000 = ₹1,000.
  Net Price = ₹10,000 - ₹1,000 = ₹9,000.
  The sale will be recorded at ₹9,000. The ₹1,000 trade discount is not explicitly recorded.
• Cash Discount: A reduction in the amount payable, offered by the seller to the buyer to encourage prompt payment of a credit transaction within a specified period. Cash discount is recorded in the books of accounts.

  Example 11. Cash Discount.

  In the previous example, the wholesaler offers a further 2% cash discount if the retailer pays within 7 days. The retailer pays within 7 days.

  Answer:

  The retailer owes ₹9,000. Cash Discount = 2% of ₹9,000 = ₹180.
  The retailer pays ₹9,000 - ₹180 = ₹8,820.
  The wholesaler records Cash Received ₹8,820 and Discount Allowed ₹180 (as an expense/reduction in revenue). The retailer records Cash Paid ₹8,820 and Discount Received ₹180 (as an income/reduction in expense).

Voucher

A Voucher is a documentary evidence in support of a transaction. It is the primary source document from which transactions are recorded in the books of accounts. Vouchers provide proof that a transaction has occurred and contain essential details like the date, amount, parties involved, and nature of the transaction.

Examples of Vouchers/Source Documents:

• Cash Memo / Bill / Invoice (for cash sales or purchases)
• Receipt (for cash received)
• Pay-in-slip (for cash deposited in bank)
• Cheque (for payment from bank)
• Payment Voucher (documenting cash/bank payment)
• Receipt Voucher (documenting cash/bank receipt)
• Journal Voucher (documenting non-cash transactions like depreciation)

Vouchers are crucial for maintaining accuracy and for auditing purposes. Auditors rely heavily on vouchers to verify the authenticity of recorded transactions.

Goods

Goods refer to the items that are purchased, produced, or manufactured by a business for the purpose of resale or for use in the production of other goods. These are the items the business deals in regularly.

Examples of Goods:

• For a bookseller: Books
• For a garment retailer: Clothes
• For a furniture manufacturer: Wood, fabric (raw materials), finished furniture (if also sold directly).
• For a car dealership: Cars

The terms 'Purchases' and 'Sales' typically refer to transactions involving 'Goods'.

Drawings

Drawings refer to any money or goods withdrawn by the owner(s) from the business for their personal use. This reduces the owner's investment in the business.

Drawings decrease the Capital (Owner's Equity) of the business. They are recorded separately and usually deducted from Capital at the end of the accounting period.

Answer:

Purchases

Purchases refer to the total amount of goods procured by a business for resale or for use in the production of goods for sale. This term is generally used for the acquisition of 'Goods', not for assets like machinery or furniture.

Purchases can be:

• Cash Purchases: Goods purchased for immediate cash payment.
• Credit Purchases: Goods purchased on credit, where payment is made at a later date to the supplier (Creditor).

Answer:

The term 'Purchases Return' refers to goods returned to suppliers. Net Purchases = Gross Purchases - Purchases Return.

Stock

Stock, also known as Inventory, refers to the goods lying unsold with the business at the end of an accounting period. These are the goods that were purchased or produced but have not yet been sold.

Stock represents a Current Asset for the business because it is expected to be sold and converted into cash within the next accounting period.

Key terms related to stock:

• Opening Stock: Value of goods lying unsold at the beginning of the accounting period. This is the closing stock of the previous period.
• Closing Stock: Value of goods lying unsold at the end of the accounting period. This is determined by physical count and valuation.

Answer:

Debtors

Debtors, also known as Accounts Receivable, are persons or entities who owe money to the business because the business has sold goods or rendered services to them on credit. They represent amounts that the business expects to receive in the future.

Debtors are considered Current Assets as the amounts are expected to be realised in cash within one accounting period.

Answer:

The total amount due from all debtors is shown as Debtors on the Balance Sheet.

Creditors

Creditors, also known as Accounts Payable, are persons or entities to whom the business owes money because the business has purchased goods or received services from them on credit. They represent amounts that the business has to pay in the future.

Creditors are considered Current Liabilities as the amounts are expected to be paid within one accounting period.

Answer:

The total amount owed to all creditors is shown as Creditors on the Balance Sheet.