Elements of Accountancy · Ch 1 — Introduction to Accounting
Basic Terms in Accounting
Basic Terms in Accounting
The Language of Business: Basic Terms in Accounting
Before you can record a single transaction, you must speak the language that accounting uses. Every business conversation — every journal entry, every ledger account, every financial statement — is built from a small set of fundamental terms. These are not optional vocabulary; they are the tools you will use for the rest of your study of Accountancy.
Entity
An entity is any economic unit that exists independently for accounting purposes. It could be a sole proprietorship, a partnership firm, a company, a cooperative society, a trust, or even a government department. The key idea is that the entity is treated as a person separate from its owners. When you record a transaction, you record it from the entity's point of view, not the owner's personal point of view.
The Business Entity Concept is the foundation: the business is distinct from its owner. The owner is a creditor of the business for the capital contributed.
Transaction
A transaction is an event involving a transfer of money or money's worth between the entity and an outside party (or between two accounts within the entity, in the case of adjustments). Every transaction has two aspects — a give and a take — which is why we use double-entry bookkeeping. A transaction must be supported by a source document (a bill, a receipt, a cash memo, a cheque, etc.) before it can be recorded.
Transactions are of two types:
- Cash transaction: Payment or receipt happens immediately (cash or cheque).
- Credit transaction: Payment is deferred to a future date.
Assets
An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. In simpler terms, it is anything of value that the business owns.
Assets are broadly classified as:
| Type | Definition | Examples |
|---|---|---|
| Non-current Assets (Fixed Assets) | Held for use in the business for more than one accounting period, not for resale | Land, Building, Plant & Machinery, Furniture, Patents, Goodwill |
| Current Assets | Held for conversion into cash or for sale/consumption within one accounting period | Cash in hand, Cash at bank, Debtors, Stock (Inventory), Prepaid expenses |
Debtors are persons who owe money to the business for goods sold on credit. They are an asset because the business has a legal right to receive that money.
Liabilities
A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits. In simple terms, it is what the business owes to others.
Liabilities are classified as:
| Type | Definition | Examples |
|---|---|---|
| Non-current Liabilities (Long-term) | Payable after more than one accounting period | Long-term loans, Debentures, Bank loan (repayable after 1 year) |
| Current Liabilities | Payable within one accounting period | Creditors, Bills payable, Outstanding expenses, Bank overdraft, Short-term loans |
Creditors are persons to whom the business owes money for goods purchased on credit. They are a liability. Do not confuse creditors with debtors — they are opposite sides of the same coin.
Capital
Capital is the amount invested by the owner(s) into the business. From the entity's point of view, the owner is a creditor — the business owes this amount back to the owner. Therefore, capital is a liability of the business to the owner. However, it is shown on the liabilities side of the Balance Sheet under "Owner's Equity" or "Capital", separate from external liabilities.
The fundamental accounting equation is:
Assets = Liabilities + Capital
This equation must always hold true. If you rearrange it:
- Capital = Assets – Liabilities (this is also called Net Worth or Owner's Equity)
Drawings
Drawings are the amount of cash or value of goods that the owner withdraws from the business for personal use. Drawings reduce the capital of the business. They are not an expense of the business; they are a reduction in the owner's claim.
Revenue (Income)
Revenue is the amount earned by the business from its normal operating activities. For most businesses, the main source of revenue is the sale of goods (Sales) or the provision of services. Other revenues include interest received, commission earned, rent received, and dividends received.
Revenue increases the capital of the business (because it increases the net assets).
Expenses
An expense is the cost incurred by the business to earn revenue. It is the outflow of assets (or increase in liabilities) that occurs during the process of generating revenue. Examples: purchase of goods (cost of goods sold), salaries, rent, wages, electricity charges, depreciation, interest paid.
Expenses decrease the capital of the business (because they reduce net assets).
The difference between Revenue and Expenses is Profit (if Revenue > Expenses) or Loss (if Expenses > Revenue). Profit increases capital; Loss decreases capital.
Purchases
Purchases refer to the total amount of goods (raw materials or finished goods) bought by the business for resale or for use in production. It does not include the purchase of fixed assets (like a machine or a building). Purchases may be:
- Cash purchases: Paid for immediately.
- Credit purchases: Payment to be made later.
Purchases Return (Return Outwards)
When goods previously purchased on credit are returned to the supplier (due to defects, damage, or not as per order), it is called Purchases Return or Return Outwards. It reduces the total purchases.
Sales
Sales refer to the total amount of goods sold by the business. It is the primary source of revenue for a trading business. Sales may be:
- Cash sales: Payment received immediately.
- Credit sales: Payment to be received later.
Sales Return (Return Inwards)
When goods previously sold on credit are returned by the customer (due to defects, damage, or not as per order), it is called Sales Return or Return Inwards. It reduces the total sales.
Stock (Inventory)
Stock (also called Inventory) is the quantity of goods held by the business at a given point in time. It includes:
- Opening Stock: The stock at the beginning of the accounting period.
- Closing Stock: The stock at the end of the accounting period.
Stock is valued at cost price or net realisable value, whichever is lower (the principle of conservatism).
Debtors (Accounts Receivable)
Debtors are persons or entities who owe money to the business because they have purchased goods or services on credit. They are a current asset. The total amount due from all debtors is shown as "Sundry Debtors" on the assets side of the Balance Sheet.
Creditors (Accounts Payable)
Creditors are persons or entities to whom the business owes money because it has purchased goods or services on credit. They are a current liability. The total amount payable to all creditors is shown as "Sundry Creditors" on the liabilities side of the Balance Sheet.
Voucher
A voucher is a written document that provides evidence of a transaction. It is the basis for recording the transaction in the books of accounts. Examples: cash memo, invoice, receipt, pay-in-slip, cheque, debit note, credit note.
Discount
Discount is a reduction in the price of goods or services. There are two types:
| Type | Purpose | Accounting Treatment |
|---|---|---|
| Trade Discount | Given at the time of purchase/sale to encourage bulk buying or as a special offer. It is not recorded in the books. | Deducted from the list price before recording the transaction. The entry is made for the net amount. |
| Cash Discount | Given to encourage prompt payment. It is recorded in the books. | Allowed to debtors for early payment (reduces the amount received). Received from creditors for early payment (reduces the amount paid). |
Trade discount is never shown in the journal or ledger. Cash discount is always recorded — it is an expense for the giver and an income for the receiver.
Bad Debts
Bad debts are amounts owed by debtors that are no longer recoverable. When a debtor fails to pay, the amount becomes a loss for the business. Bad debts are treated as an expense and are written off from the books.
Insolvency
Insolvency is the state where a person or entity is unable to pay its debts as they fall due. When a debtor is declared insolvent by a court, the business can only recover a portion of the amount due (if anything at all). The unrecovered portion is treated as a bad debt.
Cost
Cost is the amount spent to acquire an asset or to produce goods. It includes all expenses incurred to bring the asset to its present location and condition (e.g., purchase price, freight, installation charges). Cost is the basis for recording an asset in the books.
Gain
A gain is a profit that arises from transactions that are not part of the normal operating activities of the business. For example, profit on sale of a fixed asset (like an old machine) is a gain, not revenue. Gains increase the capital of the business.
Loss
A loss is a reduction in the owner's equity that arises from transactions that are not part of the normal operating activities. For example, loss on sale of a fixed asset, or loss due to fire or theft. Losses decrease the capital of the business.
Goods
Goods are the physical items that a business buys and sells in its normal course of operations. For a furniture shop, furniture is goods. For a car dealer, cars are goods. Goods are distinct from fixed assets — a car is goods for a car dealer but a fixed asset for a transport company.