INTRODUCTION TO ACCOUNTING

CHAPTER 1

INTRODUCTION TO ACCOUNTING

Eldhose Poulose

Need for accounting

              We know that every businessman has a limited memory where as the number of transactions which take place in the business are increasing tremendously because of globalization i.e. because of the increasing scope of business-both nationally as well as internationally. Thus, there is a need for recording of transactions is done through a process which is known as ‘Accounting’ which it is also known as the language of business. In the modern age of Industrial advancement, recording of business transactions is not only necessary from an owners’ point of view, but are the creditors, the investors, the government and the society at large.

Meaning of Accounting

“Accounting is a service activity. Its function is to provide quantitative information primarily financial in nature about economic activities that is intended to be useful in making economic decisions.”

Definition of Accounting

“Accounting is 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 there of.”- American Institute of Certified Public Accountants, 1941.

 “Accounting system is a means of collecting, summarizing, analyzing and reporting in monitory terms, information about the business.”- Robert N. Antony                                                                                   

Features or functions of Accounting

An analysis of the above definition brings out the following functions of Accounting:

1.      Recording

It is the basic function of Accounting. It is concerned with ensuring that all the transactions of financial nature are recorded in orderly manner in the proper books of account. Recording is done in the book ‘Journal’ in chronological manner and various other ‘Special Subsidiary books.’

2.      Classifying

It is concerned with classification of recorded transactions so as to group the similar transactions at one place. It is done in the book termed as ‘Ledger’ in which different accounts are opened and all financial transactions of similar nature are recorded at one place under individual accounts heads.

3.      Summarizing

It involves presenting the classified transactions in a manner useful to its users (both internal and external). It involves the preparation of Trial Balance, Income Statement, Balance Sheet, Statement of Changes in Financial Position, Cash Flow Statement, etc.

4.      Analyzing

The recorded, financial information is analyzed to make useful interpretations. The term ‘Analyze’ means methodological classification of the data given in financial statements. The figures given tin financial statements need to be put in a simplified manner. For example, all items relating to ‘Current Assets’ are put at one place while all items relating to ‘Current Liabilities’ are put at another place. It provides the basis for interpretation.

5.      Interpreting

It means explaining the meaning and significance of the date so simplified. The accountants should interpret the statements in a manner useful to the users. Interpretation requires analysis and analysis is useless without interpretation. It aims at drawing meaningful conclusions from the information.

6.      Communicating

The Accounting information has to be communicated in a proper from and manner to the concerned persons. It is done by preparation and distribution of accounting reports for the users of financial statements to make decisions. It involves preparation of Income Statement, Balance Sheet, Funds Flow Statement, Cash Flow Statement, etc.

BOOK-KEEPING AND ACCOUNTING

Book-keeping is made of two words-Book and Keeping where Book means all types of books which are used to record the business transactions in business and keeping means recording all the entries and business transactions in the account books in a systematic manner as per rules and principles of accounts. Hence, Bookkeeping means “An art of recording the business transactions in the books of accounts in a proper form.”

Spicer and Pegler: “Bookkeeping is an art of recording business transactions in terms of money.”

A.H. Rosen Kampf: “Bookkeeping is the art of recording business transactions in systematic manners.”

ACCOUNTS:-

 An account is a summarized record of the transactions affecting one person, one kind of property or one class of gains or losses. An account is each head of expense or source of income. Every business transaction has a two-fold effect and that it affects two accounts in opposite directions, and if a complete record were to be made of each such transaction, it would be necessary to debit one account and credit another account. It is this recording of the two-fold effect of every transaction that has given rise to the term “Double Entry.”

TYPES OF ACCOUNTS

In order to decide which account is to be debited and which credited for the purpose of recording any particular transaction, the first important point is to see which class of accounts are affected by that transaction. Having ascertained that, the following rules of debit and credit will have to be followed. There are two types of classification:

1.      Traditional classification and

2.      Classification of Accounts based on accounting equation. It is also known as Modern classification

1.      Traditional Classification

As per traditional classification, account is classified into 3 categories, namely:

a) Property or Real Accounts

b) Personal Accounts

c) Nominal or Fictitious Accounts

Property or Real Accounts: These accounts record dealings in or with property, assets or possessions. A separate account is kept for each class of property, such as, cash, stock, plant, machinery, furniture, etc., so that by recording therein particulars of each such assets received or given away the trader can ascertain the value of each asset on hand on any particular date.

Rules for Debit and Credit:

                 “Debit what comes in, and credit what goes out.”

Personal Accounts: These accounts record a trader’s dealings with other persons, firms or companies. A separate account is kept of each such person, firm or company from whom, goods may have been purchased or to whom goods may have been sold on credit, so that the amounts owing to and by the trader can be readily ascertained at any time.

Rules for Debit and Credit:

                “Debit the receiver, and credit the giver.”

Nominal or Fictitious: - These accounts record a trader’s expenses or gains. A separate account is opened for each head of expenditure or income, such as, rent, salaried, wages, printing, stationary, cartage, interest, discount, commission, etc., so that the trader can see the amount expended, lost or gained under each heading.

Rules for Debit and Credit:

                “Debit expenses and losses, and credit  incomes and gains.”

       It should be borne in mind that these rules never vary and will have to be rigidly followed       under all conceivable conditions.

2.      Classification of accounts based on Accounting equation, also known as Modern Classification

This classification is based on the nature of accounts. Broadly speaking the following will be the types of accounts:

a)      Assets

b)      Liabilities

c)      Capital

Let us discuss the above types of accounts one by one.

a)      Assets: These accounts are related to all types of assets whether tangible or intangible. Example- Land and Building, Plants and Machinery, furniture and fixture, all current assets – such as Cash, Bank, Stock Debtors bills receivable, Goodwill, Patents a/c etc.

b)      Liabilities: These refer to such accounts, which create obligations for the business from the outsiders. Such as creditors, Bills payable long-term loans in the form of Debentures and outstanding liabilities, etc.

c)      Capital: These refers to such accounts which are for the properties of the business, example is Cash/Goods brought in as capital and drawings etc.

ACCOUNTING EQUATIONS

Mainly there are two sources from which fiancé can be arranged to purchase assets. Firstly, the businessman himself provides money or money’s worth from his private estate which is called capital. Secondly he can borrow from other person which is known as Liabilities. Therefore, at any point of time, total of business assets is always equal to aggregate of personal contributions of the businessman (i.e., capital) and money borrowed from others (i.e., liabilities). This relation when expressed in the form of equation is called “Accounting Equation.”Accounting equation is another form of dual aspects concept. The dual aspect concept will be expressed in the following manner. 

Assets = Total Equity

Or

Assets = Creditor’s Equity + Owner’s Equity

Or

Assets = Liabilities + Capital

Or

Liabilities = Assets – Capital

Capital = Assets – Liabilities

Or

Capital + Liabilities = Assets

Accounting equation is also known as Balance Sheet equation. Balance Sheet is the mirror through which a businessman is bale to know the position of its Assets, Liabilities and Capital.

Accounting Principles

Meaning of Accounting Principles

The term ‘Principles’ refers to fundamental belief or a general truth which once established does not change. AICPA defined the term ‘Principles’ as a guide to action, a settled ground or basis of conduct or practice.

Accounting principles can be classified into two categories:

i)                    Accounting concepts, and

ii)                  Accounting conventions

Accounting Concepts or Accounting postulates

Accounting concepts may be considered as postulates i.e., basic assumptions or conditions upon which the science of accounting is based.

i)                    Business Entity Concept

This concept implies that a business unit is separate and distinct from the person who supplies capital to it. The accounting equation (i.e. Assets = Liabilities + Capital) is an expression of the entity concept because it shows that the business itself owns the assets and in term owns the various claimants. Business is kept separate from the proprietor so that transactions of the business may also be recorded with him. Thus, in the books of sole trader, a firm or a limited company, only business transactions are recorded and no note is taken of the personal transactions of a sole proprietor, the partners of the firms and the shareholders of the company. But their transactions with the business, (e.g., capital provided to the business, goods and amount withdrawn from the business for the personal use of the sole trader and the partners of the firm, income tax or life insurance premium paid from the business on the taxable income or life of the proprietor etc.) are recorded so that true financial position and profitability of the business may be disclosed. The non business expenses, incomes, assets and liabilities of a sole proprietor are excluded from the business accounts.

ii)                  Money Measurement Concept

Money is the only practical unit of measurement that can be employed to achieve homogeneity of financial data, so accounting records only those transactions which can be expressed in terms of money though quantitative records are also kept. The advantages of expressing business transactions in terms of money is that money serves a common denominator by means of which heterogeneous facts about a business can be expressed in terms of money which are capable of additions and subtractions. The money measurement concept restricts the scope of accounting as it does not record the fact that there is a strike in the factory or the sales manager is not on speaking terms with the production manager.

Accounting therefore, does not give a complete account of the happenings in a business unit. Thus, money measurement concept of accounting and reporting the activities of an enterprise has two major limitations.

a) It restricts the scope of accounting because it is not capable of recordings transactions which cannot be expressed in terms of money.

b) It does not take care of the effects of inflation because it assumes a stability of the money measurement unit.

Generally business entity concept and money measurement concept are called fundamental accounting concepts.

iii)                Going Concern Concept

It is assumed that a business unit has a reasonable expectation of continuing business at a profit for an indefinite period of time. A business unit is deemed to be a going concern and not a gone concern. It will continue to operate in the future. Transactions are recorded in the books keeping in view the going concern aspect of the business unit. This assumption provides much of the justification for recording fixed assets at original cost (i.e. acquisition cost) and depreciating them in a systematic manner without reference to their current realizable value. Fixed assets are acquired for use in the business for earning revenues and are not meant for resale, so they are shown at their book values.

iv)                Cost Concept

A fundamental concept of accounting closely related to the going concern concept, is that an asset is recorded in the books at the price paid to acquire it and that this cost is the basis for all subsequent accounting for the asset. Asset is recorded at cost at the time of its purchase but is systematically reduced in its value by charging depreciation. The cost concept has the advantages of bringing objectively in the accounts. Information given in the financial statements is not influenced by the personal bias or judgment of those who furnish such statement. To overcome the drawback of cost concept, inflation accounting is advocated which makes a provision for recording all items regularly in the financial statements at their current values. The cost concept raises another problem. The major asset of a highly succeessful firm is the knowledge and skill created as a result of team work and good organisation . This asset will not appear in the accounts , since the firm has paid nothing for it.

      v)        Dual aspect concept

According to this concept, every financial transaction involves a two-fold aspect, (a) yielding of a benefit and (b) the giving of that benefit. There must be a double entry to have a complete record of each business transaction, an entry being made in the receiving account and an entry of the same amount in the giving account. The receiving account is termed as debtor and the given account is called creditor. Thus every debit must have a corresponding credit and vice versa and upon this dual aspect has been raised the whole superstructure of Double Entry System of Accounting.

vi)  Accounting Period Concept

Truly speaking, the measurement of income or loss of a business entity is relatively simple on a whole-life basis. A complete and accurate picture of the degree of success achieved by a business unit cannot be obtained until it is liquidated, converts its assets into cash pays off its debts. But the owners, the investors and overall the Government, all the impatient and do not want to wait, until the dissolution of the concern, to know what has been the results of the business activities. This means that the final accounts must be prepared on a periodic basis rather than waiting till the business is terminated. Under the going concern concept it is assumed that a business entity has a reasonable expectation of containing business for an indefinite period of time. This assumption provides much of the justification that the business will not be terminated so it is reasonable to divide the life of the business into accounting, periods so as to be able to know the profit or loss of each such period and the financial position at the end of such a period .Normally accounting period adopted is one year as it helps to take any corrective action, to pay income tax, to absorb the seasonal fluctuations and for reporting to the outsiders. A period of more than one year reduces the utility of accounting data.

vii) Matching concept

This concept is based on the accounting period concept. The determination of profit of a particular accounting period is essentially a process of matching the revenue recognized during the period and the costs to be allocated to the period to obtain the revenue. Revenue is considered to be earned on the date at which it is realized i.e. on the date when the goods are delivered or services rendered to the customer even though payment may be received at some future data. Expenses paid in advance are excluded from the total costs and expenses outstanding are added to the total costs to arrive at the costs attached to the period. Application of matching concept in practice, however, is beset with certain difficulties. There are some expenses like preliminary expenses, share issue expenses, advertisement expenses etc. which are not readily identifiable against the revenue of a particular period.

viii) Realization Concept

According to this concept associated with recognition of revenue is considered as being earned on the date at which it is realized i.e. on the data when the property in goods passes to the buyer and he becomes legally liable to pay. A customer at Ranchi places an order with a manufacturer at Delhi on 1^st January. On receipt of order, the manufacturer manufacturers goods and delivers them to the customer at Ranchi on 1^st February who makes payment of goods on March ` after enjoying the credit period of one month. In this case, revenue was realized not on January 1, when order was received nor on March 1, when cash was realized but on February 1, when goods were delivered to the customer. In case of hire-purchase sales, the ownership of goods sold on hire-purchase does not pass to the purchaser when the goods are delivered but it passes when the last installment is paid.  

ix)  Objective Evidence Concept

Entries in accounting records and data reported in financial statement must be based on objectively determined evidence. Invoices and vouchers for purchases and sales, bank, statements for amount of cash at bank, physical checking of stock in hand etc. are examples, of objective evidence which are capable of verification. As far as possible, every entry in accounting records should be supported by some objective evidence. Evidence should be such which will minimize the possibility of error and intentional bias or fraud. Evidence is not always conclusively objective for there are numerous occasions in accounting where judgements and other subjective factors play part. In such situation, it should be seen that most objective evidence available should be used. For, example, the Provision for Doubtful Debts Account is an estimate of the losses expected from failure to collect sales made on credit. Estimation of this account should be made on such objective factors as past experience in collecting debtors and reliable forecasts of future business activities.

x) Accrual Concept

The essence of the accrual concept is that revenue is recognized when it is realized, that is when sale is complete or services are given and it is immaterial whether cash is received or not. Similarly, according to this concept, expenses are recognized in the accounting period in which they help in earning the revenue whether cash is paid or not. Thus, to ascertain correct profit or loss for an accounting period and to show the true and fair financial position of the business at the end of the accounting period, we make record of all expenses and incomes relating to the accounting period whether actual cash has been paid or received or not. Therefore, as a result of the accrual concept, outstanding expenses and outstanding incomes are  taken into consideration while preparing final accounts of a business entity.

ACCOUNTING CONVENTIONS

i) Convention of Consistency

Accounting rules, practices and conventions should be continuously observed and applied i.e. these should not change from one year to another. The result of different years will be comparable only when accounting rules are continuously adhered to from year to year. Consistency serves to eliminate personal bias because the accountant will have to follow consistent rules, practices and conventions year after year. This convention does not completely prohibit changes. It does not debar from introducing improved accounting techniques. However, if a change becomes desirable, the change and its effect on profits and financial position as compared to the previous year should be clearly stated in the financial statement.Eg various methods for charging depreciation- straight line ,diminishing balance, sinking fund, etc

ii) Convention of Full Disclosure

According to this convention, all accounting statements should be honestly prepared to that end full disclosure of all significant information should be made. All information which is of material interest to proprietors, creditors and investors should be disclosed in accounting statements. The companies Act, 1956 has prescribed the forms in which financial statements are to be prepared. The act makes ample provisions for the disclosure of essential information that there is no chance of any material information being left out. For example, the basis of valuation of fixed assets, investments and stock should be clearly stated in the Balance Sheet because it is of material interest to the proprietors, creditors and prospective investors.

iii) Convention of Conservatism or Prudence

 Conservatism is a policy caution or a safeguard against possible losses. It compels the businessman to wear a “risk-proof’ jacked, for the working rule is : anticipate no-profits but provide for all losses. For example, higher than the cost, the higher amount is ignored in the accounts and closing stock will be valued at cost which is lower than the market price. But if the market price is lower than the cost, the higher amount of cost will be ignored and stock will be valued at market price which is lower than the cost.

iv) Convention of Materiality

Whether something should be disclosed or not in the financial statements will depend on whether it is material or not. Materiality depends on the amount involved in the transaction. For example, minor expenditure of Rs.10 for the purchase of waste basket may be treated as an expense of the period rather than an asset. Customs also influence materiality. For example, only round figures (to the nearest rupee) may be shown in the financial statements to make the figures manageable without affecting the accounting data. Similarly, for income tax purpose the income has to be rounded to nearest ten rupees. The term ‘materiality’ is a subjective term. The accountant should record an item as material even though it is of small amount if its knowledge seems to influence the decision of the proprietors or auditors or investors.

PERSONS INTERESTED IN ACCOUNTING

Accounting information is very useful to all parties; their interest in the institution may be individually, jointly or in any other manner. All parties, internal or external are able to take correct and right decision on the basis of separate or collective information of accounts at right time. The following is the classification of persons interested in the accounts of an organization.

1.      Owners: The owners have special interest in the accounting information. Based on accounting information, he can get the information of profit earned and the financial position of the organization in a specific period. He can prepare the future plans by determining the efficiency of various departments on the basis of accounting information.

2.      Management: The management needs information from accounting for successful efficient and smooth running of business operations. The management can evaluate the progress and future plans on based on accounting information. The short-term plans can be prepared based on the basis of financial information.

3.      Employees: The employees are always interested in the accounting information of the business as their future well-being are tied to the business. They can bargain on matter related to salary determination, bonus fringe benefit working conditions, etc. on the basis of accounting information.

4.      Suppliers: The suppliers are always interested in getting accounting information. They decide to supply goods to the organization on the basis of accounting information. The regular supply of goods is possible only when the activities of the concerns are regulated systematically and regularly otherwise supply is affected when there is obstacle in the activities of the concern.

5.      Creditors: Suppliers of goods and services to organization are known as Creditors. The creditors evaluate the economic and profitability conditions of the concern before supplying goods or services to the concern. Accounting gives them information easily.

6.      Investors: Investors provide risk capital to the business. Shareholders and Debenture holders who provide long-term loans to the company are the investors of the company. They are interested to know the survival, prosperity, profitability and ability to pay dividend. They also want to know about the safety of their invited. They need information to assess whether to buy, hold sell the investments.

7.      Taxing Department: The tax department determines the taxable income of the concern with the help of financial information. They make suitable adjustments as per rules in the profit shown by the accounts and then determine the taxable income. Various plans of taxation are implemented by the government on the basis of information.

8.      Consumers: Consumers are interested in buying goods at the reasonable price. Based and accounting information the consumers can know that how the cost is controlled and prices are fixed. The consumers have continuous interest on the financial status and result of the concern.

9.      Local Community: Industrial affects the local environment and economic structure therefore local communities also have interest in accounting information. Based on accounting information the contribution of concern towards the community can be ascertained like how many local persons are getting jobs, what is the role in the supply of goods, protection of society interest, etc.

10.  Government: Central and State Government have special interest in the reports and information of the concerns. Legal control can be on based on accounting information.

11.  Financial Analysis: Accounting information is useful to researchers regarding industries and trading concern. They can analyses the financial positions of various concerns based on such information.

12.  Stock Exchange: The shares of companies can be purchased and sold through the help of stock exchanges if they are listed. Stock exchanges have interest on the financial information by accounting information.

13.  Trade Associations: Trade Associations are established to safeguard the interest of its members. They prepare future plans for the member trading concerns based on accounting information.

14.  Labour Unions: Labour unions always fight for the interest of the workers and they succeed to get their demand fulfilled basis of profitability and economic status of the organization. They try to bargain their demands like increment in salary, labour welfare, improvements in working conditions, etc. on the basis of accounting information and records.

BRANCHES OF ACCOUNTING

Many branches of accounting came into existence to center and fulfil the needs of various parties like Owner, creditors, Management, Taxing Department, etc. The main branches of accounting are as under:

1.      Financial Accounting: It is the oldest branch accounting. It is concerned with recording and summarizing financial transactions in the books of accounting in such a manner that on a particular date the profit or loss as well as financial position of the organization may be known. Under it Journal, Ledger, Trial balance, Trading and Profit and Loss Accounting and Balance sheet is the prepared. Financial Accounts can be prepared on Double Entry system, Single Entry System, Maharani System, Cash System, etc.

2.      Cost Accounting: Cost Accounting is concerned with the determination of costs of goods and services produced or offered by the concerns and to have control over it and under it, cost/expenses of production is classified scientifically and regularly in such a manner that the total cost and cost per unit of article or service can be determined. It provides information on the basis of quality and monetary terms. Cost account is a supplement to financial account. Financial accounts and cost accounts, both systems are used in concern engaged in large scale production.

3.      Management Accounting: The object of management accounting is to provide information to the management for planning policy formation and cost is made. Cost accounting helps the management in their operation.

4.      Tax Accounting: The accounting made by keeping in mind various taxes like income tax, gift tax, property tax, sales tax, etc. is known as Tex Accounting. It is helpful in tax planning and in setting the disputes relating to taxation.

5.      Government Accounting: The accounting made by Central Government, state Government or Local Bodies is known as Government Accounting.

6.      Inflation Accounting: The Accounting made by keeping in view expansion of money is known as Inflation Accounting. In this effects of expansion of money is concerned as nil and then actual result are calculated. Final account is adjusted with the help of index or revolution. At present two methods of inflation accountings are: (a) Current Cost Accounting (b) Current Purchasing Power Accounting.

7.      Human Resource Accounting: The measurement of cost and price human resources and the accounts relating to investments and changes made in human resources are known as Human Resource Accounting. Under it, the human force evaluated and entered into accounts and financial result are displayed. According to America Accounting Association, Human Resource Accounting Committee, “Human Resource Accounting is a process of judging human resources measuring them unto date and giving information to related parties.”

8.      Social Responsibility Accounting: It is a new form of accounting. The accounts are made keeping in mind the social responsibility. The taxes received form trade, factors of production and local sources affect the environments. Hence, accounting contribution of trade, towards society, employment in services products, taxes and fees, environment safety, etc. are kept into consideration while presenting final accounts.