1. INTRODUCTION TO ACCOUNTING
Accounting is the system a company uses to measure its financial performance by noting and classifying all the transactions like sales, purchases, assets, and liabilities in a manner that adheres to certain accepted standard formats. It helps to evaluate a Company’s past performance, present condition, and future prospects.
In all activities (whether business activities or non-business activities) and in
all organizations (whether business organizations like a manufacturing entity or
trading entity or non-business organizations like schools, colleges, hospitals, libraries, clubs, temples, political parties) which require money and other economic resources, accounting is required to account for these resources. In other words, wherever money is involved, accounting is required to account for it. Accounting is often called the language of business. The basic function of any language is to serve as a means of communication. Accounting also serves this function.
Meaning of Accounting
Accounting, as an information system is the process of identifying, measuring
and communicating the economic information of an organization to its users who need the information for decision making. It identifies transactions and events of a specific entity. A transaction is an exchange in which each participant receives or sacrifices value (e.g. purchase of raw material). An event (whether internal or external) is a happening of consequence to an entity (e.g. use of raw material for production). An entity means an economic unit that performs economic activities.
Definition of Accounting
American Institute of Certified Public Accountants (AICPA) which defines
accounting as “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events, which are, in part at least, of a financial character and interpreting the results thereof”.
Features of Accounting
· Accounting is an art
· Accounting is a science
· Accounting is the art of recording the transaction in the book
- Accounting is the art of recording transactions in terms of money
- Accounting classifies the recorded transactions
- Accounting summarise the classified data
- Accounting analyses and interprets the summarised data
- Accounting provides information to users
Accountancy, Accounting and Book-keeping
Accountancy refers to a systematic knowledge of accounting. It explains “why to do” and “how to do” of various aspects of accounting. It tells us why and how to prepare the books of accounts and how to summarize the accounting information and communicate it to the interested parties.
Accounting refers to the actual process of preparing and presenting the accounts. In other words, it is the art of putting the academic knowledge of accountancy into practice.
Book-keeping is a part of accounting and is concerned with record keeping or maintenance of books of accounts. It is often routine and clerical in nature.
Book-keeping provides the basis for accounting and it is complementary to accounting process. Accounting begins where book-keeping ends. Accountancy includes accounting and book-keeping. The terms Accounting and Accountancy are used synonymously.
Objective of Accounting
Objective of accounting may differ from business to business depending upon
their specific requirements. However, the following are the general objectives of accounting.
i) To keeping systematic record
ii) To ascertain the results of the operation: Accounting helps in
iii) To ascertain the financial position of the business
iv) To portray the liquidity position
v) To protect business properties
vi) To facilitate rational decision – making
vii) To satisfy the requirements of law
Importance of Accounting(Advantage)
i) It helps in having complete record of business transactions.
ii) Accounting is to supply meaningful information about the financial activities of the business to the owners and the managers.
iii) It gives information about the profit or loss made by the business at the close of a year and its financial conditions.
iv) Accounting records can be produced as evidence in court proceedings.
v) It provides useful information form making economic decisions,
vi) When a business is likely to be sold to someone else we can ascertain the purchase price with the help of accounting records.
vii) It facilitates comparative study of current year’s profit, sales, expenses etc., with those of the previous years.
viii) It supplies information useful in judging the management’s ability to utilise enterprise resources effectively in achieving primary enterprise goals.
ix) It provides users with factual and interpretive information about transactions and other events which are useful for predicting, comparing and evaluation the enterprise’s earning power.
x) It helps in complying with certain legal formalities like filing of income-tax and sales-tax returns. If the accounts are properly maintained, the assessment of taxes is greatly facilitated.
Limitations Of Accounting
Accounting has high importance and it is useful to the business in different ways at the same time it has some demerits. In this section, we discuss the limitations of accounting.
i) Accounting is historical in nature: It does not reflect the price level changes.
ii) Accounting is limited to monetary transactions only. It cannot record those
transactions which cannot be expressed in terms of money, and also it excludes qualitativeelements like management, reputation, employee morale, labour strike etc.
iii) Facts recorded in financial statements are greatly influenced by accounting
conventions and personal judgments of the Accountant of Management. Valuation of inventory, provision for doubtful debts, and assumption about useful life of an asset may, therefore, differ from one business house to another.
iv) Accounting principles are not static or unchanging-alternative accounting
procedures are often equally acceptable. Therefore, accounting statements do not always present comparable. Therefore, accounting statements do not always present comparable data.
v) The accounting statements do not reflect those increase in net asset values that are not considered realized.
Users of Accounting Information
The basic objective of accounting is to provide information which is useful for persons and groups inside and outside the organisation.
I. Internal users: Internal users are those individuals or groups who are within the organisation like owners, management, employees and trade unions.
II. External users: External users are those individuals or groups who are outside the organisation like creditors, investors, banks and other lending institutions, present and potential investors, Government, tax authorities, regulatory agencies and researchers.
Ø Internal
i. Owners To know the profitability and financial soundness of the business.
ii. Management To take prompt decisions to manage the business efficiently.
iii. Employees and Trade unions To form judgement about the earning capacity of the business since their remuneration and bonus depend on it.
Ø External
i. Creditors, banks and other To determine whether the principal and lending institutions the interest thereof will be paid in when due.
ii. Present investors To know the position, progress and prosperity of the business in order to ensure the safety of their investment.
iii. Potential investors To decide whether to invest in the business or not.
iv. Government and Tax To know the earnings in order to assess authorities the tax liabilities of the business.
v. Regulatory agencies To evaluate the business operation under the regulatory legislation.
vi. Researchers To use in their research work.
Accounting as an Information System
Input > Process > out put
Branches of Accounting
1 Financial Accounting
2 Cost Accounting
3 Management Accounting
Financial accounting
It is concerned with recording the transactions of financial character,
summarising and interpreting them and communicating the results to the
users. It ascertains profit earned or loss incurred during a period (usually
one year as accounting year) and the financial position as on the date when
the accounting period ends. It can provide financial information required
by the management and other parties. The word accounting and financial
accounting are used interchangeably. At present we are concerned with
financial accounting only.
Objectives and Functions of financial accounting
The main objectives of financial accounting are as under :
- Finding out various balances
Systematic recording of business transactions provides vital information
about various balances like cash balance, bank balance, etc.
- Providing knowledge of transactions
Systematic maintenance of books provides the details of every transactions.
- Ascertaining net profit or loss
Summarisation in form of Profit and Loss Account provides business
income over a period of time.
- Depicting financial position
Balance sheet is prepared to depict financial position of business means
what the business owns and what owes to others.
- Information to all interested users
After analysis and interpretation, business performance and position are
communicated to the interested users.
- Fulfilling legal obligations
Vital accounting information helps in fulfilling legal obligations e.g. sales
tax, income tax etc.
Limitations of Financial Accounting
One of the major limitations of financial accounting is that it does not take into
account the non-monetary facts of the business like the competition in the market, change in the value for money etc.
Following are the limitations of financial accounting :-
- No clear idea of operating efficiency
- Weakness not spotted out by collective results
- Not helpful in price fixation
- No classification of expenses and accounts
- No data for comparison and decision-making
- No control on cost
- No standards to assess the performance
- Provides only historical information
- No analysis of losses
Scope of Financial Accounting
1. Book-keeping: - “The art of keeping a permanent record of business transactions is book keeping”.
2. Financial statement:-To know profit or loss and financial position of the firm
3. Analysis and interpretation of financial statements: - To analysis and interpret some additional statements like, fund flow and cash flow statement.
4. Financial reporting:- It is the important part of financial accounting and it helps to decision making and to provide information to internal and external users.
5. Segment reporting :- It means the reports of financial information in relation to different business activities of the firm. These are classified as business segment or geographical segment.
6. Accounting principles :- Financial accounting follows a set of principles. These help in the preparation of financial statement and the choice of methods.
7. Accounting Standards :- The preparation, presentation and reporting of financial accounts have to be done according to certain standards and it will helps to keep uniformity of accounting information and reporting.
ACCOUNTING PRINCIPLES
Accounting Postulates:
1. Business entity postulates - According to this assumption, business is treated as a unit or entity apart from its owners, creditors and others. In other words, the proprietor of a business concern is always considered to be separate and distinct from the business which he controls. All the business transactions are recorded in the books of accounts from the view point of the business. Even the proprietor is treated as a creditor to the extent of his capital.
2. Money measurement postulates - In accounting, only those business transactions and events which are of financial nature are recorded. For example, when Sales Manager is not on good terms with Production Manager, the business is bound to suffer. This fact will not be recorded, because it cannot be measured in terms of money.
3. Going concern postulates - As per this assumption, the business will exist for a long period and transactions are recorded from this point of view. There is neither the intention nor the necessity to wind up the business in the foreseeable future.
4. Accounting period postulates - The users of financial statements need periodical reports to know the operational result and the financial position of the business concern. Hence it becomes necessary to close the accounts at regular intervals. Usually a period of 365 days or 52 weeks or 1 year is considered as the accounting period.
5. Property rights postulates – it means the right of accounting entities to possess and alienate property value and the things of value to an entity can be transferred from one to another
Accounting Concepts:
1. Cost concept - Under this concept, assets are recorded at the price paid to acquire them and this cost is the basis for all subsequent accounting for the asset. For example, if a piece of land is purchased for Rs.5,00,000 and its market value is Rs.8,00,000 at the time of preparing final accounts the land value is recorded only for Rs.5,00,000. Thus, the balance sheet does not indicate the price at which the asset could be sold for.
2. Dual aspect concept - Dual aspect principle is the basis for Double Entry System of book-keeping. All business transactions recorded in accounts have two aspects - receiving benefit and giving benefit. For example, when a business acquires an asset (receiving of benefit) it must pay cash (giving of benefit).
3. Realisation concept - According to this concept, revenue is considered as the income earned on the date when it is realised. Unearned or unrealised revenue should not be taken into account. The realisation concept is vital for determining income pertaining to an accounting period. It avoids the possibility of inflating incomes and profits.
4. Matching concept - Matching the revenues earned during an accounting period with the cost associated with the period to ascertain the result of the business concern is called the matching concept. It is the basis for finding accurate profit for a period which can be safely distributed to the owners.
5. Objectivity concept - It means the accounting data should be verifiable and free from personal bias of the accountant and each transaction should have an adequate evidence to support with vouchers, receipts, invoices etc.
Accounting Conventions:
1. Convention of consistency - The aim of consistency principle is to preserve the comparability of financial statements. The rules, practices, concepts and principles used in accounting should be continuously observed and applied year after year. Comparisons of financial results of the business among different accounting period can be significant and meaningful only when consistent practices were followed in ascertaining them. For example, depreciation of assets can be provided under different methods, whichever method is followed, it should be followed regularly.
2. Convention of conservatism - Prudence principle takes into consideration all prospective losses but leaves all prospective profits. The essence of this principle is “anticipate no profit and provide for all possible losses”. For example, while valuing stock in trade, market price or cost price whichever is less is considered.
3. Convention of materiality - The materiality principle requires all relatively relevant information should be disclosed in the financial statements. Unimportant and immaterial information are either left out or merged with other items.
4. Convention of full disclosure - Accounting statements should disclose fully and completely all the significant information. Based on this, decisions can be taken by various interested parties. It involves proper classification and explanations of accounting information which are published in the financial statements.
Generally accepted accounting principles (GAAP)
Generally accepted accounting principles (GAAP) are those accounting principles that have substantial authoritative support. Substantial authoritative support is a question of fact and a matter of judgment. The power to establish GAAP actually rests with the Securities and Exchange Commission (SEC); however, except for rare instances, it has essentially allowed the accounting profession itself to establish GAAP and self-regulate. Three bodies of the accounting profession have determined GAAP since 1939.
Accounting Standards
To promote world-wide uniformity in published accounts, the International Accounting Standards Committee (IASC) has been set up in June 1973 with nine nations as founder members. The purpose of this committee is to formulate and publish in public interest, standards to be observed in the presentation of audited financial statements and to promote their world-wide acceptance and observance. IASC exist to reduce the differences between different countries’ accounting practices. This process of harmonisation will make it easier for the users and preparers of financial statement to operate across international boundaries. In our country, the Institute of Chartered Accountants of India has constituted Accounting Standard Board (ASB) in 1977. The ASB has been empowered to formulate and issue accounting standards, that should be followed by all business concerns in India.
Functions of Accounting Standards Board
i) The main function of ASB is to formulate accounting standards so that such standards may be established by the Council of the Institute in India. While formulating the accounting standards, ASB will take into consideration the applicable laws, customs, usages and business environment. ii) The Institute is one of the Members of International Accounting Standards Committee (IASC) and has agreed to support the objectives of IASC. While formulating the Accounting Standards, ASB will give due consideration to International Accounting Standards, issued by IASC and try to integrate them, to the extent possible, in the light of the conditions and practices prevailing in India. iii) The Accounting Standards will be issued under the authority of the council. ASB has also been entrusted with the responsibility of propagating the Accounting Standards and persuading the concerned parties to adopt them in the preparation and presentation of financial statements. ASB will issue guidance notes on the Accounting Standards and give clarifications on issue arising there from. ASB will also review the Accounting Standards at periodical intervals.
Accounting Standards are the defined accounting policies issued by Government or expert institute. These standards are issued to bring harmonization in follow up of accounting policies.
Presently, Institute of Chartered Accountants of India has issued 32 Accounting Standards as listed below:-
AS 01. Disclosure of Accounting Policies
AS 02. Valuation of Inventories
AS 03. Cash Flow Statements
AS 04. Contingencies and Events Occurring After the Balance Sheet Date
AS 05. Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies
AS 06. Depreciation Accounting
AS 07. Construction Contracts
AS 08. Accounting for Research and Development (Not Applicable now)
AS 09. Revenue Recognition
AS 10. Accounting for Fixed Assets
AS 11. Accounting for the Effects of Changes in Foreign Exchange Rates
AS 12. Accounting for Government Grants
AS 13. Accounting for Investments
AS 14. Accounting for Amalgamation
AS 15. Accounting for Retirement Benefits in the financial Statements of Employers
AS 16. Borrowing Costs
AS 17. Segment Reporting
AS 18. Related Party Disclosure
AS 19. Leases
AS 20. Earning Per Share
AS 21. Consolidated Financial Statements
AS 22. Accounting for Taxes on Income
AS 23. Accounting for Investments in Associates in Consolidated Financial Statements
AS 24. Discontinuing Operations
AS 25. Interim Financial Reporting
AS 26. Intangible Assets
AS 27. Financial Reporting of Interests in Joint Ventures
AS 28. Impairment of Assets
AS 29. Provisions, Contingent Liabilities & Contingent Assets
AS 30.Financial Instruments- Recognition and management
AS 31.Financial Instruments- Presentation
AS 32.Financial Instruments- Disclosures
Accounting System:
There are three bases of accounting in common usage. Any one of the
following bases may be used to finalise accounts.
1. Cash basis :- Under cash basis accounting, entries are recorded only when cash is received or paid. No entry is passed when a payment or receipt becomes due. Income under cash basis of accounting, therefore, represents excess of receipts over payments during an accounting period. Government system of accounting is mostly on cash basis.
2. Accrual or Mercantile basis :- Under accrual basis of accounting, accounting entries are made on the basis of amounts having become due for payment or receipt. Incomes are credited to the period in which they are earned whether cash is received or not. Similarly, expenses and losses ere detailed to the period in which, they arc incurred, whether cash is paid or not.
3. Mixed or Hybrid basis :- When certain items of revenue or expenditure are recorded in the books of account on cash basis and certain items on mercantile basis, the basis of accounting so employed is called ‘hybrid basis of accounting’.
Business Transactions (Transaction = Action + money)
Transactions are those activities of a business, which involve transfer of money or goods or services between two persons or two accounts. For example, purchase of goods, sale of goods, borrowing from bank, lending of money, salaries paid, rent paid, commission received and dividend received. Transactions are of two types, namely,
cash and credit transactions.
Cash Transaction is one where cash receipt or payment is involved in the transaction. For example, When Ram buys goods from Kannan paying the price of goods by cash immediately, it is a cash transaction.
Credit Transaction is one where cash is not involved immediately but will be paid or received later. In the above example, if Ram, does not pay cash immediately but promises to pay later, it is credit transaction.
Double Entry System
There are numerous transactions in a business concern. Each transaction, when closely analysed, reveals two aspects. One aspect will be “receiving aspect” or “incoming aspect” or “expenses/loss aspect”. This is termed as the “Debit aspect”. The other aspect will be “giving aspect” or “outgoing aspect” or “income/gain aspect”. This is termed as the “Credit aspect”. These two aspects namely “Debit aspect” and “Credit aspect” form the basis of Double Entry System. The double entry system is so named since it records both the aspects of a transaction. In short, the basic principle of this system is, for every debit, there must be a corresponding credit of equal amount and for every credit, there must be a corresponding debit of equal amount.
Advantages of Double Entry System
i) Scientific system: This system is the only scientific system of recording
business transactions in a set of accounting records. It helps to attain the objectives of
accounting.
ii) Complete record of transactions: This system maintains a complete
record of all business transactions.
iii) A check on the accuracy of accounts: By use of this system the accuracy
of accounting book can be established through the device called a Trail balance.
iv) Ascertainment of profit or loss: The profit earned or loss suffered during
a period can be ascertained together with details by the preparation of Profit and Loss Account.
v) Knowledge of the financial position of the business: The financial
position of the firm can be ascertained at the end of each period, through the
preparation of balance sheet.
vi) Full details for purposes of control: This system permits accounts to be
prepared or kept in as much detail as necessary and, therefore, affords significant
information for purposes of control etc.
vii) Comparative study is possible: Results of one year may be compared
with those of the precious year and reasons for the change may be ascertained.
viii) Helps management in decision making: The management may be also
to obtain good information for its work, specially for making decisions.
ix) No scope for fraud: The firm is saved from frauds and misappropriations
since full information about all assets and liabilities will be available.
Accounting Equation
The source document is the origin of a transaction and it initiates the accounting process, whose starting point is the accounting equation. Accounting equation is based on dual aspect concept (Debit and Credit). It emphasizes on the fact that every transaction has a two sided effect i.e., on the assets and claims on assets. Always the total claims (those of outsiders and of the proprietors) will be equal to the total assets of the business concern. The claims are also known as equities, are of two types: i.) Owners equity (Capital); ii.) Outsiders’ equity (Liabilities).
Assets = Equities
Assets = Capital + Liabilities (A = C+L)
Capital = Assets – Liabilities (C = A–L)
Liabilities = Assets – Capital (L = A–C)
Effect of Transactions on Accounting Equation :
Illustration 1
If the capital of a business is Rs.3,00,000 and other liabilities are Rs.2,00,000, calculate the total assets of the business.
Solution
Assets = Capital + Liabilities
Capital + Liabilities = Assets
Rs. 3,00,000 + Rs.2,00,000 = Rs.5,00,000
Illustration 2
If the total assets of a business are Rs.3,60,000 and capital is Rs.2,00,000, calculate liabilities.
Solution
Assets = Capital + Liabilities
Liabilities = Assets – Capital
Assets – Capital = Liabilities
Rs. 3,60,000 – Rs. 2,00,000 = Rs. 1,60,000
Illustration 3
If the total assets of a business are Rs.4,50,000 and outside liabilities are Rs.2,50,000, calculate the capital.
Solution:
Capital = Assets – Liabilities
Assets – Liabilities = Capital
Rs. 4,50,000 – Rs. 2,50,000 = Rs.2,00,000
Illustration - 4
Murugan started business with Rs.50,000 as capital.
The business unit has received assets totalling Rs.50,000 in the form of cash and the claims against the firm are also Rs.50,000 in the form of capital. The transaction can be expressed in the form of an accounting equation as follows:
Assets = Capital + Liabilities
Cash = Capital + Liabilities
Rs. 50,000 = Rs. 50,000 + 0
Types of Accounts
The object of book-keeping is to keep a complete record of all the transactions
that place in the business. To achieve this object, business transactions have been classified into three categories:
(i) Transactions relating to persons.
(ii) Transactions relating to properties and assets
(iii) Transactions relating to incomes and expenses.
The accounts falling under the first heading are known as ‘personal Accounts’.
The accounts falling under the second heading are known as ‘Real Accounts’, The accounts falling under the third heading are called ‘Nominal Accounts’.
Personal Accounts: Accounts recording transactions with a person or group of persons are known as personal accounts. These accounts are necessary, in particular,
to record credit transactions. Personal accounts are of the following types:
(a) Natural persons: An account recording transactions with an individual
human being is termed as a natural persons’ personal account. eg., Kamal’s account,
Mala’s account, Sharma’s accounts. Both males and females are included in it
(b) Artificial or legal persons: An account recording financial transactions
with an artificial person created by law or otherwise is termed as an artificial person,
personal account, e.g. Firms’ accounts, limited companies’ accounts, educational
institutions’ accounts, Co-operative society account.
(c) Groups/Representative personal Accounts: An account indirectly
representing a person or persons is known as representative personal account. When
accounts are of a similar nature and their number is large, it is better tot group them
under one head and open a representative personal accounts. e.g., prepaid insurance,
outstanding salaries, rent, wages etc,
Real Accounts: Accounts relating to properties or assets are known as ‘Real Accounts’, A separate account is maintained for each asset e.g., Cash Machinery, Building, etc., Real accounts can be further classified into tangible and intangible.
(a) Tangible Real Accounts: These accounts represent assets and properties
which can be seen, touched, felt, measured, purchased and sold. e.g. Machinery
account Cash account, Furniture account, stock account etc.
(b) Intangible Real Accounts: These accounts represent assets and properties
which cannot be seen, touched or felt but they can be measured in terms of money. e.g., Goodwill accounts, patents account, Trademarks account, Copyrights account,
Nominal Accounts: Accounts relating to income, revenue, gain expenses and losses are termed as nominal accounts. These accounts are also known as fictitious accounts as they do not represent any tangible asset. A separate account is maintained for each head or expense or loss and gain or income. Wages account, Rent account Commission account, Interest received account are some examples of nominal account.
Rules for Debit and Credit:(English Approach)
All the accounts are classified into the following three types.
o Personal Accounts
o Real Accounts
o Nominal Accounts
1. Personal Accounts – a) Debit the receiver
b) Credit the giver
2. Real Accounts – a) Debit what comes in
b) Credit what goes out
3. Nominal Accounts – a) Debit all expenses and losses
b) Credit all incomes and gains
Rules for Debit and Credit:(American Approach)
All the accounts are classified into the following types
o Assets Accounts
o Liabilities Accounts
o Revenues or Incomes Accounts
o Expenses or Losses Accounts
1. Increases in assets are Debits;
decreases in assets are Credits.
2. Increases in liabilities are Credits;
decreases in liabilities are Debits.
3. Increases in incomes and gains are Credits;
decreases in incomes and gains are Debits.
4. Increases in expenses and losses are Debits;
decreases in expenses and losses are Credits.
1. Transactions
Started business with Rs.10,000
2.Accounts involved
Cash a/c and Capital a/c
3.Classification of Accounts
Real account and Personal account
4.Rules for debit and credit
Debit what comes in
Credit the giver
5. Explanation
Cash comes in the business
Proprietor is giver of cash
6. Account to be debited
Cash a/c– Rs.10,000
7.Account to be credited
Capital a/c Rs 10,000
