Introduction to Accounting

Accountancy (Class-XI) CHAPTER-1

Introduction to Accounting

 

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 thereof.

Attributes of Accounting

 (i) Accounting is the process of recording, classifying and summarizing the business transactions.

(ii) Business transactions are measured in monetary terms before being recorded.

(iii) Accounting consists of interpreting the results.

(iv) Accounting conveys economic information to various groups interested in them.

Process of Accounting

 (i)   Recording – Accounting consists of recording business transactions and events in a systematic way in Journal or primary/subsidiary books.

(ii)    Classifying – Classifying means grouping the transactions of same nature at one place. This is done by preparing appropriate accounts in Ledger. For example, all transactions relating to cash would be recorded in the Cash Account.

(iii)   Summarising – Summarising involves the preparation of financial statements i.e. Trial Balance; Profit and Loss Account (Statement of Profit and Loss in case of companies) Balance Sheet and Cash Flow Statement. Summarising helps in conveying economic information to various parties interested in them.

(iv)   Analysing – The term Analysis means methodical classification and establishment of relationship of the data given in the financial statements.

(v)    Interpreting – It is concerned with explaining the meaning and significance of the relationship as established by the analysis of accounting data.

(vi)   Communicating – It is concerned with the transmission of summarized analysed and interpreted information to the end users to enable them to make balanced decisions. This is done through accounting reports.

 

Objectives of Accounting

(1)  To keep systematic records – Accounting keeps a systematic record of financial transactions. There is a limit to human memory and therefore, a systematic record of all transactions is essential for every business.

(2)  To ascertain profit or loss – Accounting helps in ascertaining the net profit earned or loss suffered by the business. It is done by preparing Profit and Loss Account (Statement of Profit and Loss in case of companies).

(3)  To ascertain financial position of the business – Every business wants to know its financial position. This is served by the Balance Sheet, which is a statement of assets and liabilities of the business on a particular date.

(4)  To communicate results – Another objective of accounting is to communicate the results to interested groups viz investors, employees, creditors etc.

(5)  To facilitate rational decision-making – Accounting facilitates rational decision-making by providing relevant data.

(6)  To prevent frauds – Accounting serves the objective of presenting frauds as they got detected by accounting easily.

Functions of Accounting

1. Measurement: Accounting measures past performance of the business entity and depicts its current financial position.
2. Forecasting: Accounting helps in forecasting future performance and financial position of the enterprise using past data.
3. Decision-making: Accounting provides relevant information to the users of accounts ‘to aid rational decision-making.
4. Comparison and Evaluation: Accounting assesses performance achieved in relation to targets and discloses information regarding accounting policies and contingent liabilities which play an important role in predicting, comparing and evaluating the financial results.
5. Control: Accounting also identifies weaknesses of the operational system and provides feedbacks regarding effectiveness of measures adopted to check such weaknesses.
6. Government Regulation and Taxation: Accounting provides necessary information to the Government to exercise control on the entity as well as in collection of tax revenues.

 

Distinguish between Book-Keeping and Accounting

Basis of Distinction	Book-Keeping	Accounting
Scope	It involves recording of transaction of accounts. It does not cover preparation of final accounts.	It involves recording analysis and interpretation of business transactions. It covers preparation of final accounts.
Stage	It is the primary stage and it is done first.	It is the secondary stage and begins after book-keeping.
Knowledge	It does not require special knowledge and ability. It is done by clerical i.e. junior staff.	It requires special knowledge and ability. It is done by qualified and senior staff.
Interest	Outsiders do not have any interest in it.	Various groups including outsiders have interest in it.
Nature	It is complementary to accounting	It is not complementary to book- keeping.
Branch	There is no branch of Book-Keeping.	It has several branches like financial, cost, management accounting etc.
Financial Position	Financial position of the business cannot be ascertained.	Financial position of the business is ascertained on the basis of the accounting reports.
Base/language	It constitutes as a base for accounting.	It is considered as a language of the business.

Essential Characteristics of the Accounting

(1) Economic Events: Accounting requires events to be expressed in terms of money. Transactions should involve transfer or exchange of monetary value between the business entity and outsiders.

(2)  Identification, Measurement, Recording and Communication: Accounting is a process of identifying the transactions to be recorded, quantifying the transactions into financial terms, recording the transactions in a systematic manner and communicating the desired information to various interested groups.

(3)  Organisation: Accounting is applied by the entities performing business activities either for profit or not for profit motive.

(4)  Users of Information : Accounting is complete when information is communicated to various groups interested in the functioning of business entity.

Advantages of Accounting

(i)  Helps in ascertaining the profit and financial position – Accounting facilitates .the preparation of financial statements e.g. Profit and Loss Account (Statement of Profit and Loss in case of companies) and Balance Sheet which depict the profit and financial position of the business respectively.

(ii)  Assists in managing the business – Accounting helps the management in taking prompt decisions to run the· business efficiently.

(iii) Provides Ready Reference of Past Transactions – All past transactions can be referred anytime, so there is no need to remember them.

(iv) Proof in the court of law – If the accounts of business are kept properly and according to the principles of accounting, they can be presented in the court of law for giving necessary documentary evidence.

(v)  Correct payment of taxes – Accounting helps in ascertaining the tax liability of the business correctly. Taxation authorities insist that accounts should be maintained according to principles of accounting.

(vi) Comparative study – Accounting facilitates inter-firm and intra-firm comparisons to detect the strong and weak points of the business.

Limitations of Accounting

1. Only monetary transactions – Accounting records only those transactions which can be measured in terms of money. Transactions and events howsoever important they may be, do not find a place in the accounts if they cannot be measured in terms of money.
2. Assets at cost – Assets are recorded at their cost and not at their market price. Hence financial statements fail to show real worth of the business.
3. Personal Judgement – Adoption of various accounting policies depends on the personal judgement of the accountant. As a result, financial statements may not be objective and comparable.
4. Not Exact – Accounting information is sometimes based on estimates. Hence the financial statements do not reflect the true position of the business.
5. Not a good tool for management – Accounting records the historical transactions which does not help the management in decision-making. Accounting does not provide for evaluation of business policies and plans.
6. May Lead to Window Dressing – Window dressing means showing better financial position than the actual real position. Various policies like depreciation methods and inventory valuation methods can be manipulated to show better financial position.

Branches of accounting

1. Financial Accounting – Financial Accounting is the accounting for revenues, expenses, assets and liabilities that is commonly carried on in the general offices of a business. Financial accounting involves preparation of financial reports which provide summaries of a firm’s financial condition. The main task of financial accounting is to prepare the Profit and Loss Account (Income Statement) and· the Balance Sheet. These financial statements provide vital information to several groups of interested parties like shareholders, creditors, employee and financial analyst.
2. Cost Accounting – Cost accounting deals with the classification, recording, allocation, summarization and reporting of current and prospective costs involved. The main purpose of cost accounting is to ascertain the cost of production to enable the management fix the price of the product and to ensure cost reduction. Unlike financial accounting, cost accounting has to depend, to a great extent, on the estimation of costs. Cost accounting is generally adopted in the business engaged in manufacturing activities.
3. Management Accounting – According to the Chartered Institute of Management Accountants, London. “Management accounting is the application of professional information in such a way as to assist the management in the formation of policies and in the planning and control of the operations of the undertaking.” The main purpose of management accounting is, therefore, to provide all the relevant information that may be required by the management to take decisions in respect of various aspects of running the business enterprise. In a way, management accounting is like a tool in the hands of management for the purpose of making policy decisions.

The Qualitative Characteristics of Accounting Information

Following are the qualitative characteristics of accounting information:

(i)   Understandability – An accounting information should be readily understandable by the different users. Accounting Information should be presented in simple terms and form.

(ii) Relevance – An accounting information should be relevant for decision-making. To be relevant, information must be made available in time and must help in prediction and feedback.

(iii)       Reliability – An accounting information should be reliable in the sense that it would be free from error and bias and should represent what it should represent. An accounting information should be objective i.e. solidly supported by the facts.

(iv) Comparability – An accounting information will be useful and beneficial to the different users only when it is comparable overtime and with other enterprises. For this, there should be consistency i.e. use of common unit of measurement, common format of reporting and common accounting policies.

 

Accounting Information

Following are the groups of people interested in “accounting information”:

The users of accounting Information are broadly categorized into : Internal users and External users

1. Internal Users : Internal users means those persons who are directly connected with the operations and management of the business entity. Thus, they include management (i.e. directors, officers etc. and sole proprietors’ or partners).

(i)   Management : Management requires accounting information for the smooth and efficient functioning of the enterprise. They need frequent information with regard to cost price, selling price. They produce annual reports of the entity containing.

• Profit and Loss Account (Statement of Profit and Loss, in case of Companies)
• Balance Sheet
• Cash Flow Statement
• Employees : The employees of a firm are also interested in the accounting information to assess the ability of the entity to pay higher and regular wages payments, payment of bonus, regularity in depositing amount of provident fund of workers. If the firm is earning high profits, there are chances of opening a new branchs. Thus, possibility of promotion of worker is also there.

These published informations are used by the external end users of the accounting service. However, management requires both published and unpublished informations for making future plans and for controlling the business entity. Management also exercises corrective actions on the basis of accounting informations.

1. External Users : All other users of accounting service except the management fall under the category of external end users. The management provides published information to all the external end users. The management provides published information to all the external end users while it uses both published and unpublished information for the efficient conduct of managerial decisions. Thus, analysis of the management is more detailed in extensive. External end users include.

• Shareholders/Proprietors : The owners of Company e. share holders are interested in knowing about regularity of adequate return on their invested capital in the short run and safety of their capital in the long run. To meet these objectives, they require accounting information. They are also interested in knowing whether the profits are increasing or decreasing, probable reason for this change. Should they continue to remain with their investment? If they are not satisfied with the performance of the company, they may sell their shares and buy the shares of a company where prospects are better.
• Potential Investors : Making investment involves risk. The investors have no control on the preparation of accounting information so they rely on the information provided to them in the form of published information. They should try to evaluate the earning prospects of the company and safety of their investment.
• Bankers and Financial Institution : They provide long term need and term loan (medium term loan) need of the business entity so they make financial appraisal of the entity to know the repayment capacity of loan of the entity and regularity of interest payment of loan. Thus, they need accounting information to meet their objectives.
• Creditors : They provide goods on credit to the business entity so they would like to ensure creditworthiness of the firm. Accounting information helps to provide information about the financial soundness of the firm. Thus, they can decide whether goods be provided to firm on credit or not and if yes, to what extent.
• Government : The Government collects taxes in the form of sales tax, VAT, excise duty, income tax, corporate tax etc. so government agencies need accounting information to assess the tax liability of the business entity.
• Researchers : Researchers also require accounting information for their research work to make inter-firm and intra-firm (comparisons of same firm with the past), to know the operating performance and financial soundness of the business entity.
• Public : Public is interested in knowing the growth potential of business entity. Only prosperous entity will provide job employment opportunities to the public. Public also uses the products manufactured by the firm. Financial accounting provides such information to the public. Public is also interested in knowing about the corporate social responsibilities. All this information is derived from the accounting information.

Accounting as a source of information

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

—Accounting Principles Board

As an information system, accounting collects data and communicates economic information about the organisation to a number of users whose decisions and actions are related to its performance. Accounting begins with the identification of transactions of financial nature and ends with the preparation of financial statements (i.e., Income Statement and Balance Sheet). Each step in the process of accounting generates information. Generation of information is not an end in itself, it is a way to facilitate the dissemination of information among users of accounting information. Accounting information is used for predicting comparing and evaluating the earning power and financial position of a business enterprise. Therefore, dissemination of information is an essential function of accounting. To be useful, the accounting information should:

• provide information for taking economic decisions;
• serve the needs of the users who rely on financial statements as their principle source of information for decision making;
• provide information useful for predicting, comparing and evaluating earning power and financial position of a business firm. Besides, it should provide information about cash flows;
• provide information for judging managerial efficiency to utilise resources effectively in achieving goals;
• provide factual and interpretative information regarding assumptions taken of interpretation, evaluation, prediction or estimation; and
• provide information on activities affecting the society.

As an information system, accounting may be explained as below:

It is universally accepted that making available the qualitative accounting information is an important objective of accounting because it is the basis for decision making by its users. Accounting Information is a mean by which we measure and communicate accounting information.

Accounting information thus refers to the financial statements generated through the process of book keeping, use of which enables the users to arrive at the correct decision. The financial statements so generated are the Income Statement, i.e., Profit and Loss Account and ‘the Position Statement, i.e., Balance Sheet. The information made available by these statements can be categorized into the following:

1. Information Relating to Profit;
2. Information Relating to Financial Position; and
3. Cash Flow Statement.

Let us now discuss them in detail:

1. Information Relating to Profit: The Income Statement, i.e., Profit and Loss Account makes available the accounting information about the profit earned or loss suffered as a result of business operations or otherwise during an accounting period. Trading Account, a part of the Profit and Loss Account provides information about Gross Profit and Profit and Loss Account provides information about the net profit.
2. Information Relating to Financial Position: The Position Statement, i.e., the Balance Sheet makes available the information about the financial health of the enterprise. The Position Statement provides information about the assets owned by the enterprise, amounts receivable and the cash and bank balance held by it. These are represented in the liabilities by the amounts owed by the enterprise towards loans, creditors and amounts payable. The difference between the two is represented by capital, i.e., amount due to owners.
3. Cash Flow Statement: Cash Flow Statement is a statement that shows flow, both inflow and outflow, of cash during a specific period. It is of immense use as many decisions such as payment of liabilities, payment of dividend and expansion of business, etc., are based on availability of cash.

System of Accounting

The systems of recording transactions in the books of accounts are classified into two types:

1. Double Entry System; and
2. Single Entry System.
3. Double Entry System

The Double Entry System of accounting was developed in the 15th Century in Italy by Lucas Pacioli. Under the system, every transaction has two aspects-Debit and Credit and at the time of recording a transaction, it is recorded once on the debit side and again on the credit side. For example, at the time of cash purchases, goods are acquired and in return cash is paid. In the transaction, two aspects are involved, i.e., receiving goods and paying cash and under the Double Entry System, both these aspects are recorded. One part, i.e., the receipt of goods is debited and the second part, i.e., payment of cash is credited. Thus, on any day, total amount debited is equal to the total amount credited.

Thus, we can define Double Entry System as: “The system which recognizes and records both aspects of the transaction. The Double Entry System has proved to be a scientific and complete system of accounting followed by every enterprise and Organization.”

Features of the Double Entry System

1. It maintains a complete record of each transaction.
2. It recognises the two-fold aspect of every transaction, viz., the aspect of receiving (value in) and the aspect of giving (value out).
3. In this system, one aspect is debited and other aspect is credited following the rules of debit and credit.
4. Since, one aspect of a transaction is debited and the other is credited, the total of all debits is always equal to total of all credits. It helps in establishing arithmetical accuracy by preparing a Trial Balance.

Advantages of the Double Entry System

Double Entry System being a systematic and scientific system bears several advantages. Some of the important advantages are given here:

(i)       Scientific System: As a matter of fact, this system is the only scientific system of recording business transactions as compared to other systems of book keeping. It helps attain the objectives of accounting.

(ii)      Complete Record of Transactions: This system maintains a complete record of all business transactions. Hence, it is a complete system.

(iii)     A Check on the Accuracy of Accounts: By the use of this system the accuracy of the accounting work can be established through Trial Balance. Besides, both aspects are recorded.

(iv)     Ascertainment of Profit or Loss: The profit earned or loss suffered during a period can be ascertained together with details by preparation of the Profit and Loss Account.

(v)      Knowledge of Financial Position of the Firm: The financial position of the firm or the institution concerned can be ascertained at the end of each period, through preparation of the Balance Sheet.

(vi)     Full Details for Purposes of Control: This system permits accounts to be 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 previous years and reasons for the change may be ascertained.

(viii)   Helps Management in Decision Making: The management may be able to obtain good information for its work, specially in making decisions.

(ix)     No Scope of Fraud: The firm is saved from frauds and misappropriations since full information about all assets and liabilities will be available.

It is because of these advantages that the Double Entry System has been used extensively in all countries.

 

Disadvantages of the Double Entry System

(i)       Adequate Knowledge of Book Keeping: Maintenance of books of accounts requires adequate knowledge of principles of accounting and the procedure for maintaining them.

(ii)      Complicated Method: This system involves recording both the aspects of a transaction. It also involves application of principles of accounting. The process thus, becomes complicated besides being lengthy.

(iii)     Costly: Maintaining the books of accounts involves specialised knowledge. It thus, requires trained and experienced staff. Such a staff commands higher salaries which makes book keeping under the Double Entry System costly.

(iv)     Not Suitable for Small Business: Double Entry System of book keeping is not suitable for small businesses with few transactions.

The above disadvantages to a greater extent are resolved through computerized

accounting.

2. Single Entry System

Single Entry System of recording transactions in the books of accounts, may be defined as a system, which is an incomplete double entry system. In this system, all transactions are not recorded on the double entry basis. As regards some transactions, both aspects of the transactions are recorded, as regards others, either one aspect is recorded or not recorded at all. Instead of maintaining all the accounts, only personal accounts and cash book are maintained under this system. The accounts maintained under this system are incomplete and unsystematic and therefore, not reliable. The Single Entry System is also known as Accounts from Incomplete Records.