You visit the shop of a person known to you and observe the activities he/she is doing. He/she is selling goods for cash and on credit, collecting payments, making payments to suppliers, instructing the worker to deliver the goods in time, making payments for telephone, carriage, etc. These are all business activities, but cash is not involved in all of them at the time of making transactions. Activities which are in cash terms are called business transactions. You will also find that for every transaction, he/she makes use of a document like bills, cash memos, receipts, etc. These are termed as vouchers. In this lesson, you will learn about business transactions, accounting vouchers, accounting equation and the basic mechanism of accounting


After studying this lesson, you will be able to

explain the meaning of source documents and accounting vouchers;

explain the preparation of accounting vouchers;

explain the meaning of accounting equation;

 explain the effect of business transactions on the accounting equation;

explain the rules of accounting;

explain the bases of accounting and

 explain the double entry mechanism.


accounting process begins with the origin of business transactions and it is followed by analysis of such transactions. A business transaction is a transaction, which involves exchange of values between two parties. Every transaction involves Give and Take aspect. The debit represents Take aspect and credit represents the Give aspect in a transaction. For example, when a computer is purchased for office use for cash, then the delivery of computer represents Take aspect and payment of cash represents Give aspect. Thus , business transactions are exchange of goods or services between two parties and effects of these transactions are recorded in two accounts.

Source Documents and vouchers

 All business transactions are based on documentary evidence. A Cash memo showing cash sale, an invoice showing sale of goods on credit, the receipt made out by the payee against cash payment, are all examples of source documents. A document which provides evidence of the transactions is called the Source Document or a voucher. It is the primary evidence in support of a business transaction. A source document is the first record prepared for a business transaction and is the basis for entries in the books of accounts. There are certain items, which have no documentary proof, such as petty expenses. In such case necessary voucher is prepared showing the necessary details. All such documents are kept in a separate file in chronological order and are serially numbered. All recording in books of accounts is done on the basis of accounting vouchers. A Voucher is documentary evidence in support of a transaction. It is a document to record the accounting transaction. A transaction with one debit and one credit is a simple transaction and voucher prepared for such transaction is known as transaction voucher. The format of transaction voucher is as follows:

Preparation of Accounting Vouchers

Accounting vouchers are the written documents containing the analysis of business transactions for accounting and recording purpose. These are prepared by the accountant and countersigned by authorised person. Features of Accounting vouchers are as :

  •  It is a written document.
  •  It is prepared on the basis of evidence of the transaction.
  • It contains an analysis of a transaction i.e. which account has to be debited and which has to be credited.
  • It is prepared by an accountant and countersigned by the authorised signatory.
  •  Accounting voucher may be classified as Cash voucher i.e., debit voucher, credit voucher, and non-cash voucher i.e., transfer voucher.

In all cash payments, one aspect is cash and the other is either the party to whom the payment is made, or an expense or an item of property for which the payment is made. A format of debit voucher is as follows:


Illustration 1

On September 21, 2014 M/s Mohit Chemicals paid `40,000 in Cash and balance amount of `1,60,000 by Banker’s Cheque to HT Chemicals Ltd., Prepare Debit Voucher.

Credit Vouchers

These vouchers are prepared for recording of transactions involving cash-receipts only. Cash receipts in the business are accepted on account of:

  •  Cash sales of goods
  • cash sales of assets
  • revenue income like interest, rent, etc. received in cash
  •  Cash receipts from debtors.
  • Loan taken
  •  Cash withdrawn from bank
  • receipts of advances, etc.

 In all cash receipts, one aspect is cash and the other is either person or party from whom cash is received or revenue on account of which cash is received or the property on sale of which cash is received. A format of credit voucher is as follows:

Transfer Vouchers

With the expansion of business, the role of credit transactions is increasing at a fast pace. For recording of these credit transactions, a voucher is prepared known as transfer voucher. These transfer vouchers are prepared to record non-cash transactions of the business involving:

  •  Credit purchases
  • Credit sales
  •  Return of goods sold
  •  Return of goods purchased on credit
  • Depreciation on Assets Bad Debts etc.
  •  These vouchers are prepared both in debit and credit forms simultaneously


 The recording of business transactions in the books of account is based on a fundamental equation called Accounting Equation. Whatever business possesses in the form of assets is financed by proprietor or by outsiders. This equation expresses the equality of assets on the one side and equity on the other side i.e., the claims of outsider [liabilities] and owners or proprietors funds on the other side. In mathematical form

Expenses and Revenue also affect the accounting equation. Their effect is always on the capital.

 A business concern has to meet some expenses in its normal course of operations such as payment of salary, rent, insurance premium, postage, wages, repairs etc. Payment of these expenses reduces the cash. These expenses reduce the net income of the business. All the income is the income of proprietor, which is added in the capital account, so all these expenses are deducted from the capital. Similarly, business concern receives some revenues during normal course of operations, such as rent received, commission received, etc. Revenue is added to the cash balance as it is received in terms of cash. Revenue increases the net income of the business and hence, it is added to the capital. Now, the accounting equation is represented by

Accounting equation is thus, affected by every business transaction. Any increase or decrease in assets, liabilities, and capital can be identified by preparing accounting equation. It shows that every business transaction satisfies the dual aspect concept of accounting. It also serves as the basis for preparing the Balance Sheet.

Effect of Transactions on the Accounting Equation

 You have learnt that assets, liabilities and capital are the three basic elements of every business transaction, and their relationship is expressed in the form of accounting equation which always remains equal. At any point of time, there can be a change in the individual asset, liability or capital, but the two sides of the accounting equation always remain equal. Let us verify this fact by taking up some transactions and see how these transactions affect the accounting equation :


 Using Debit and Credit

In Double Entry accounting both the aspects of the transaction are recorded. Every transaction has two aspects and according to this system, both the aspects are recorded. If the business acquires something, it must have been acquired by giving something. While recording each transaction, the total amount debited must be equal to the total amount credited. The terms ‘Debit’ and ‘Credit’ indicate whether the transaction is to be recorded on the left hand side or right hand side of the account. In its simplest form, an account looks like the English Language Letter ‘T’. Because of its shape, this simple form of account is called T-account (refer figure 4.5) . Have you observed that

the ‘T’ format has a left side and a right side for recording increases and decreases in the item? This helps in ascertaining the ultimate position of each item at the end of an accounting period. For example, if it is an account of a supplier all goods/materials supplied shall appear on the right (Credit) side of the Supplier’s account and all payments made on the left (debit) side.

 In a‘T’ account, the left side is called debit (usually abbreviated as Dr.) and the right side is known as credit (as usually abbreviated Cr.)

Analysis of Transaction: In this transaction, the two accounts affected are salary account and Cash account. Salary account is an expense and has increased. Cash is an asset and has decreased. Rule regarding expenses/losses is that if it increases the account is debited

Analysis of Transaction: In this transaction, the two accounts affected are Interest and Cash. Interest is an item of Income and Cash an item of asset. Rule regarding Revenue/profit is, increase in revenue is credited. Cash is an asset and rule for assets is increase in assets is debited.


As we are aware that one of the most significant functions of accounting is to make us know true and fair amount of profit earned by the business entity in a particular period. This Profit or income figure can be ascertained by following

Cash Basis of accounting

(ii) Accrual Basis of accounting

 (iii) Hybrid Basis of accounting

 I. Cash Basis of accounting

This is a system in which accounting entries are recorded only when cash is received or paid. Revenue is recognized only on receipt of cash. Similarly, expenses are recorded as incurred when they are paid. The difference between the total revenues and total expenses represents profit or loss of an enterprise for a particular accounting period. Outstanding and prepaid expenses and income received in advance or accrued incomes are not considered.


 Following are the advantages of adopting cash basis of accounting:

 It is very simple as no adjustment entries are required.

It appears more objective as very few estimates and personal judgments are required.

 It is more suitable to those entities which have most of the transactions on cash basis.


 Following are the disadvantages of adopting cash basis of accounting:

It does not give a true and fair view of profit and loss and the financial position of the business unit as it ignores outstanding and prepaid expenses.

 It does not follow the matching concept of accounting.

Illustration 7

 During the financial year 2013-14, Mela Ram had cash sales of `580000 and credit sales of `265000. His expenses for the year were `.460000 out of which `60000 are still to be paid. Find out Mela Ram’s Income for the year 2013-14 following the cash basis of accounting.

Accrual Basis of accounting

 Revenue and expense are taken into consideration for the purpose of income determination on the basis of accounting period to which they relate. The accrual basis makes a distinction between actual receipts of cash and the right to receive cash for revenues and the actual payment of cash and the legal obligation to pay expenses. It means the income accrued in the current year becomes the income of the current year whether the cash for that item is received in the current year or it was received in the previous year or it will be received in the next year. The same is true of expense items. Expense item is recorded if it becomes payable in the current year whether it is paid in the current year or it was paid in the previous year or it will be paid in the next year. For example, credit sales are included in the total sales of the period irrespective of the fact when cash on account is received. Similarly, in case the firm has taken benefit of a certain service, but has not paid within that period, the expense will relate to the period in which the service has been utilized and not the period in which the payment for it is made

Outstanding Expenses are those expenses which have become due during the accounting period but which have yet not been paid off. Prepaid Expenses are those expenses which have been paid in advance. Accrued Income means income which has been earned by the business during the accounting period but has not yet become due for payment and therefore has not yet been received. Income received in advance means income which has been received by the business before being earned. Costs incurred during a particular period should be set out against the revenue of the period to ascertain profit or loss.

Following are the advantages :

  •  It is based on all business transactions of the year and discloses correct profit or loss.
  •  This method is used in all types of of business units.
  • It is more scientific and rational in application.

Following are the disadvantages:

  • It is not simple one and requires the use of estimates and personal judgment.
  • It fails to disclose the actual cash flows.

 Illustration 8 Taking the data given in the Illustration 7, find out the net income of Mela Ram as per accrual basis of accounting.