Business entity, transaction, capital and drawings
An entity is a unit with its own identity. For accounts, the business is an entity separate from its owner. A transaction is an event involving money value between two parties, for example buying goods for ₹10,000 (cash or credit).
Capital is the money or assets the owner puts into the business. The business owes it to the owner, so capital is a kind of liability to the owner. Drawings are money or goods the owner takes out for personal use; they reduce capital.
Capital = Assets − Liabilities (towards outsiders).
Current and non-current assets and liabilities
Assets are resources owned by the business with money value that will give future benefit.
- Non-current assets: held for long-term use, not for sale — land, building, machinery, furniture (tangible); goodwill, patents, trademarks (intangible); long-term investments.
- Current assets: expected to turn into cash or be used within one year (or one operating cycle) — cash, bank, stock, debtors, bills receivable, prepaid expenses.
Liabilities are amounts the business owes to outsiders.
- Non-current liabilities: payable after more than one year — long-term bank loan, debentures.
- Current liabilities: payable within one year — creditors, bills payable, outstanding expenses, short-term loans.
Capital expenditure and revenue expenditure
Expenditure is money spent (or a promise to pay) to get something.
- Capital expenditure: benefit lasts more than one year; buys or improves a non-current asset. Example: buying a machine, paying for its installation, building a new floor. It is shown in the balance sheet as an asset.
- Revenue expenditure: benefit is used up within the year; keeps the business running. Example: wages, rent, electricity, repairs. It goes to the trading or profit and loss account.
Income, revenue, expense, profit, gain and loss
- Revenue: amount earned from normal business — sales, commission received, rent received, interest received.
- Expense: cost used up to earn revenue — cost of goods, salary, rent.
- Income: increase in wealth; in simple words, Income = Revenue − Expenses for the period.
- Profit: revenue more than expenses. Gross profit = sales − cost of goods sold; net profit = gross profit + other incomes − all other expenses.
- Gain: profit of an irregular, non-trading kind — selling a fixed asset above its book value.
- Loss: expenses more than revenue, or money lost with no benefit, like goods destroyed by fire or theft.
Stock, debtor, creditor and voucher
- Stock (inventory): goods on hand for sale, plus raw materials and half-made goods. Closing stock is valued at cost or net realisable value, whichever is lower.
- Debtor: a person who owes money to the business, usually because of credit sales. Debtors are a current asset.
- Creditor: a person to whom the business owes money, usually for credit purchases. Creditors are a current liability.
- Voucher: the written proof (bill, receipt, cash memo) that supports a transaction.
Other terms you will meet: goods (what the business buys and sells), purchases and sales of goods, and purchases/sales returns.
Trade discount and cash discount
Trade discount is a reduction in the list price given at the time of sale to encourage bulk buying. It is shown on the invoice and not recorded in the books; entries are made at the invoice value.
Cash discount is given for quick payment. It is recorded: for the payer it is "discount received" (income); for the receiver it is "discount allowed" (expense).
Order of calculation: first trade discount on list price, then cash discount on the amount due (after trade discount).
Key formulas and definitions
- Capital = Assets − Outside liabilities
- Profit = Revenue − Expenses
- Invoice value = List price − Trade discount
- Cash paid = Invoice value − Cash discount
- Closing capital = Opening capital + Additional capital + Profit − Drawings
Worked examples
1. Aman starts a business with ₹1,00,000 cash and a ₹50,000 car. How much is his capital?
Capital = everything he brings in = ₹1,00,000 + ₹50,000 = ₹1,50,000.
2. Classify: machinery, bank loan (5 years), stock, creditors, patents, prepaid rent.
Non-current assets: machinery, patents. Current assets: stock, prepaid rent. Non-current liability: 5-year bank loan. Current liability: creditors.
3. Classify as capital or revenue expenditure: (a) ₹30,000 for a new AC in the office, (b) ₹2,000 to repair it later, (c) ₹5,000 installation charges of a new machine.
(a) Capital (lasts years). (b) Revenue (keeps it working). (c) Capital — installation is part of the cost of getting the machine ready.
4. Goods with list price ₹40,000 are sold at 10% trade discount and 2% cash discount; the buyer pays at once. Find the amount received.
Trade discount = 10% × 40,000 = ₹4,000 → invoice value ₹36,000. Cash discount = 2% × 36,000 = ₹720. Cash received = 36,000 − 720 = ₹35,280. Books record sales ₹36,000 and discount allowed ₹720.
5. Furniture with book value ₹18,000 is sold for ₹15,000. Is this a gain or a loss? How much?
Sold below book value, so loss = 18,000 − 15,000 = ₹3,000. It is a non-trading (capital) loss.
6. Opening capital ₹2,00,000, further capital ₹30,000, profit ₹45,000, drawings ₹25,000. Find closing capital.
Closing capital = 2,00,000 + 30,000 + 45,000 − 25,000 = ₹2,50,000.
Common mistakes
- Recording trade discount in the books. Only the invoice value is recorded; trade discount never appears.
- Calculating cash discount on the list price. It is calculated on the amount due after trade discount.
- Treating drawings as a business expense. Drawings reduce capital; they are not charged to profit and loss.
- Calling installation charges of a new machine revenue expenditure. They are capital expenditure.