Accounting basics: meaning, process and basic terms

Accounting is the language a business uses to tell its own story in numbers. Learn the words first and every later chapter becomes easier.

What accounting is

A shopkeeper buys, sells, pays rent, takes loans and gives credit all day long. Memory cannot hold all of it, and memory cannot prove anything to a bank or a tax officer. Accounting is the orderly way of recording these money events, classifying them under heads, summarising them into statements and interpreting the result, so that the owner and others can take decisions.

Book-keeping is the first part of this work: the routine recording and posting. Accounting is wider: it includes preparing the final statements and reading what they mean.

The accounting process, step by step

Identify the transaction. Only events measurable in money are recorded. A manager's skill is valuable but is not a transaction.
Record it in the book of original entry, the journal, from a source document such as a bill or receipt.
Classify by posting to accounts in the ledger, so that all entries about one person or thing are in one place.
Summarise: balance the accounts, draw up a trial balance, then the final accounts.
Analyse and interpret the statements, for example with ratios.
Communicate the result to those who need it.

Who uses accounting information

User	What they want to know
Owners and partners	Profit earned and whether their capital is safe
Managers	Costs, sales and cash position, for day to day decisions
Lenders and banks	Whether loan and interest will be repaid on time
Suppliers (creditors)	Whether bills will be paid when due
Investors	Whether to buy, hold or sell their investment
Employees	Stability of the business and its ability to pay wages
Government and tax authorities	Correct tax and compliance with law
Customers and the public	Whether the business will continue to supply and serve

Basic terms, each with an example

The example business is Meera Stores, a stationery shop owned by Meera.

Term	Meaning	At Meera Stores
Capital	Money or goods the owner puts into the business. The business owes it to the owner.	Meera brings in ₹5,00,000 to start the shop.
Drawings	Cash or goods the owner takes out for personal use.	Meera takes ₹5,000 from the till for a family function.
Assets	Things of value the business owns. Non-current (fixed) assets are for long use; current assets turn into cash within a year.	Furniture is a fixed asset. Stock, debtors and cash are current assets.
Liabilities	Amounts the business owes to outsiders. Non-current are due after a year; current are due within a year.	A five year bank loan is non-current. An unpaid supplier bill is current.
Goods	Things bought to sell again.	Notebooks and pens are goods. The shop counter is not.
Purchases	Goods bought for resale, for cash or on credit.	Notebooks bought from Gupta Traders for ₹80,000.
Sales	Goods sold, for cash or on credit.	Notebooks sold to a school for ₹70,000.
Stock (inventory)	Goods lying unsold on a given date.	Unsold pens on 31 March are closing stock.
Debtor	A person who owes money to the business for goods sold on credit.	The school, until it pays its bill.
Creditor	A person to whom the business owes money for goods bought on credit.	Gupta Traders, until Meera pays them.
Revenue	Income from the normal activity of the business.	Sales, and commission received.
Expense	Cost incurred to earn revenue.	Rent, wages, electricity.
Expenditure	Amount spent or liability incurred. Revenue expenditure gives benefit within the year; capital expenditure gives benefit over many years.	Rent is revenue expenditure. Buying a computer is capital expenditure.
Profit and loss	Revenue more than expenses is profit; less is loss.	Sales ₹70,000 less cost and expenses ₹60,000 gives profit ₹10,000.
Discount	Trade discount reduces the list price and is not recorded. Cash discount is allowed for quick payment and is recorded.	10% off the catalogue price is trade discount. ₹500 off for paying within a week is cash discount.
Voucher	The written evidence of a transaction.	A cash memo, an invoice, a receipt.

Branches and limits

Financial accounting records transactions and reports profit and financial position. Cost accounting finds the cost of a product or service. Management accounting prepares information for decisions inside the business.

Accounting has limits. It records only what can be measured in money. It mostly shows assets at what they cost, not what they are worth today. And it depends on estimates, such as the life of a machine, so two honest accountants can show slightly different profits.

Basic assumptions and principles

Business entity: the business is separate from its owner. That is why capital is shown as a liability of the business.
Money measurement: only transactions expressed in money are recorded.
Going concern: the business is assumed to continue for the foreseeable future.
Accounting period: the life of the business is cut into periods, usually a year from 1 April to 31 March in India.
Cost: assets are recorded at the price paid for them.
Dual aspect: every transaction has two sides of equal value. This gives the accounting equation.
Matching: expenses of a period are set against the revenue of the same period.
Accrual: income and expenses are recorded when earned or incurred, not when cash moves.
Consistency and prudence: use the same methods year after year; provide for likely losses but do not count gains before they are earned.

Questions students ask

What is the difference between book-keeping and accounting?

Book-keeping is the routine recording of transactions in the journal and ledger. Accounting includes book-keeping and goes further: summarising, preparing final accounts and interpreting them.

Is capital an asset or a liability?

For the business, capital is a liability, because the business owes that amount to the owner. This follows from the business entity assumption.

What is the difference between a debtor and a creditor?

A debtor owes money to the business. A creditor is owed money by the business. Debtors are an asset; creditors are a liability.