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Definition of Accounting
Accounting is concerned with the processes of recording, sorting and summarizing data resulting from the business operations and events. The definition given by the American Institute of Certified Public Accountants clearly brings out the meaning and functions of accounting. According to it, 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 result thereof.”
Meaning of Accounting
1. Accounting is an Art
Accounting classifies as an art as it helps in attaining the goal of ascertaining the financial results. Analysis and interpretation of the financial data is the art of accounting, requiring special knowledge, experience and judgment.
2. Involves Recording, Classifying and Summarizing
Recording means systematically writing down the transactions and events in account books soon after their occurrence. Classifying is the process of grouping transactions or entries of similar nature at a place. This is done by opening accounts in a book called ledger. Summarizing involves the preparation of reports and statements from the classified data (ledger), understandable and useful to management and other interested parties. This involves preparation of final accounts.
3. Records Transaction in Terms of Money
Recording business transaction in terms of money is the common measure of recording and helps in better understanding of the state of affairs of the business.
4. Deals with Financial Transactions
Accounting records only those transactions and events which are of financial character. If a transaction has no financial character, it will not be measured in terms of money and hence will not be recorded.
Interpretation is the art of interpreting the results of operations to determine the financial position of an enterprise, the progress it has made and how well it is getting along.
6. Accounting involves Communication
The results of analysis and interpretation are communicated to management and to other interested parties.
Accounting-- A Means and Not an End
After analyzing properly the information supplied by the accounting statements, the users of the same take decisions for future activities. Since accounting supplies the necessary information, it performs a service function and simultaneously represents the economic position of an entity. Therefore, it is clear that keeping accounts is not the primary objective of a person or an entity. On the contrary, the primary objective is to take decision on the basis of the financial facts given by the accounting statements. Thus, the understanding of accounts is not the basic objective. It only helps to realize a specific objective. As such, accounting is not an end in itself but a means to an end.
Accounting is essentially a service function designed to provide relevant information concerning an entity to those who are interested in interpreting and using that information.
Objectives and Functions
The primary or basic objective of accounting is to supply the necessary information to the users and analysts for taking futuristic decisions. Let us now look at its other objectives and functions. These are as follows:
• Provides necessary information about the financial activities to the interested parties
• Provides necessary information about the efficiency or otherwise of management with regard to the proper utilization of scarce resources
• Provides necessary information for making predictions (financial forecasting)
• Facilitates to evaluate the earning capacity of a firm by supplying the statement of financial position, the statement of periodical earning, together with the statement of financial activities to various interested parties
• Facilitates in decision-making with regard to the changes in the manner of acquisition, utilization, preservation and distribution of scarce resources
• Facilitates in decision-making with regard to the replacement of fixed assets and expansion of the firm
• Provides necessary data to the government to enable it to take proper decisions concerning to duties, taxes, price control etc.
• Devices remedial measures for the deviations of the actual from the budgeted performance
• Provides necessary data and information to managers for internal reporting and formulation of overall policies
Branches of Accounting
1. Financial Accounting
Accounting deals with recording, classifying and summarizing the business events that have already occurred. It is, therefore, historical in nature. That is why it is called historical accounting or postmortem accounting or more popularly financial accounting. Its aim is to collate the information about income and financial position on the basis of business events that have taken place during a particular period of time.
Information provided by the financial accounting system about financial results and financial position on historical basis is though significant yet inadequate for smooth, orderly and efficient running of business. Management needs more information for planning and control of the business activities. The answer lies in two more forms of accounting viz. cost accounting and management accounting.
2. Cost Accounting
Cost accounting deals with the detailed study of cost pertaining to cost ascertainment, cost reduction and cost control. The emphasis is on historical costs as well as future decision-making costs.
3. Management Accounting
Management accounting provides information to management not only about cost but also about revenue, profits, investments etc. to enable managers to discharge their duties more efficiently and effectively. Thus, it provides required database to managers to plan and control the activities of business.
4. Social Responsibility Accounting
Social responsibility accounting involves accounting of social costs incurred by an enterprise and reporting of social benefits created by it.
Distinction between Bookkeeping and Accounting
Bookkeeping differs from accounting in the following respects:
Basis of Distinction Bookkeeping Accounting
1. Scope Bookkeeping involves the following functions:
• Identifying the transactions
• Measuring the identified transactions
• Recording the measured transactions
• Classifying the recorded transactions
Accounting, in addition to bookkeeping, involves the following functions:
• Summarizing the classified transactions
• Analyzing the summarized results
• Interpreting the analyzed results
• Communicating the interpreted information to the interested parties
2. Stage Bookkeeping is a primary stage. Accounting is the secondary stage. It starts where bookkeeping ends.
3. Basic The basic objective of bookkeeping is to maintain systematic records of financial transactions. The basic objectives of accounting are as follows:
• To ascertain the net results of operations and financial position
• To communicate information to the interested parties
4. Who performs Junior staff performs bookkeeping work. Senior staff performs accounting work.
5. Knowledge level A bookkeeper is not required to have a higher level of knowledge than that of an accountant. An accountant is required to have a higher level of knowledge than that of a bookkeeper.
6. Analytical skills A bookkeeper may or may not possess analytical skills. An accountant should possess analytical skills.
7. Nature of job The job of a bookkeeper is often routine and clerical in nature. The job of an accountant is analytical in nature.
8. Designing of accounting system Bookkeeping does not cover designing of accounts system. Accounting covers designing of accounting system.
9. Supervision and checking A bookkeeper does not supervise and check the work of an accountant. An accountant supervises and checks the work of a bookkeeper.
Users of Accounting Information
Owner(s) refers to a person or a group of persons who has provided capital for running the business. It refers to an individual in case of proprietor, partners in case of partnership firm and shareholders in case of a joint stock company. The information needs of shareholders have assumed a greater significance in the corporate business world because of the separation of ownership and management in the case of joint stock companies. Usually, an owner is interested in the financial information to know about the safety of amount invested and the return on investment.
For managing business profitably, management requires adequate information about financial results and financial position. By providing this information, accounting helps managers in efficient and smooth running of the business.
Prospective investors would be keen to know about the past performance of business before making investment in that concern. By analyzing historical information provided by accounting records, they can arrive at a decision about the expected return and the risk involved in investing in a particular business.
4. Creditors and Financial Institutions
Whosoever is extending credit or loan to a business enterprise would like to have information about its repaying capacity, credit worthiness etc. Analyzing and interpreting the financial statements of an enterprise can help in obtaining the required information.
Employees are concerned about job security and future prospects. Both of these are intimately related with the performance of business. Thus, by analyzing the financial statements, they can draw conclusions about their job security and future prospects.
Government policies relating to taxation, providing subsidies etc. are guided by the relevance of industries in the economic development of the country. The policies also consider the past performance of industries. Information about past performance is provided by the accounting system. Collection of taxes is also based on accounting records.
Researchers need financial information for testing hypothesis and development of theories and models. The required information is provided by accounting system.
The customers who have developed loyalties toward a business are those who are certainly interested in the continuance of the business. They certainly want to know about the future directions of the enterprise with which they are associating themselves. The way to information about the enterprise is through their financial statements.
An enterprise affects the public at large in many ways as it acts as a provider of employment to a number of persons, a customer to many suppliers, a provider of amenities in the locality or a cause of concern to the public due to pollution. Hence, public at large is always interested in knowing the future directions of an enterprise and the only window to peep inside an enterprise is through their financial statements.
The above-mentioned list of group of users of accounting information is not exhaustive. Anyone having interest in an enterprise can use the information for decision-making.
Advantages of Accounting
1. Facilitates to Replace Memory
Accounting facilitates to replace human memory by maintaining a complete record of financial transactions. Human memory is limited by its very nature. Accounting helps to overcome this limitation.
2. Facilitates to Comply with Legal Requirements
Accounting facilitates to comply with legal requirements of an enterprise to maintain books of accounts. For example, Section 209 of the Companies Act, 1956 requires a company to maintain proper books of accounts on accrual basis, Section 44AA of the Income Tax Act, 1961 requires certain persons to maintain specified books of accounts etc.
3. Facilitates to Ascertain Net Result of Operations
Accounting facilitates to ascertain net results of operations by preparing income statement.
4. Facilitates to Ascertain Financial Position
Accounting facilitates to ascertain financial position by preparing the position statement.
5. Facilitates the Users to take Decisions
Accounting facilitates the users to take decisions by communicating accounting information to them. The users include the following:
• Short-term creditors
• Long-term creditors
• Present investors
• Potential investors
• Employees’ groups
• General public
• Tax authorities
6. Facilitates a Comparative Study
Accounting facilitates a comparative study in the following four ways:
a. Comparison of actual figures with standard or budgeted figures for the same period and for the same firm.
b. Comparison of actual figures of a period with those of another period for the same firm, i.e. intra-firm comparison.
c. Comparison of actual figures of a firm with those of another standard firm belonging to the same industry, i.e. inter-firm comparison.
d. Comparison of actual figures of a firm with those of industry to which the firm belongs, i.e. pattern comparison.
7. Assist Management
Accounting assists management in planning and controlling business activities and in taking decisions. For example, projected cash flow statement facilitates management to know future receipts and payments and to take decision regarding anticipated surplus or shortage of funds.
8. Facilitates Control over Assets
Accounting facilitates control over assets by providing information regarding cash balance, bank balance, debtors, fixed assets, stock etc.
9. Facilitates the Settlement of Tax Liability
Accounting facilitates the settlement of tax liability with the authorities by maintaining proper books of accounts in a systematic manner.
10. Facilitates the Ascertainment of Value of Business
Accounting facilitates the ascertainment of value of business in case of transfer of business to another entity.
11. Facilitates Raising Loans
Accounting facilitates raising loans from lenders by proving them historical and projected financial statements.
12. Acts as Legal Evidence
Proper books of accounts maintained in a systematic manner act as legal evidence in case of disputes.
Limitations of Accounting
The financial accounting is mainly concerned with the preparation of final accounts, i.e. profit and loss account and balance sheet. Today, the scenario in which business has become so complex that mere final accounts information is not sufficient in meeting information needs. Management needs information for planning, controlling and coordinating business activities. It is because of the limitations of financial accounting that cost accounting and management accounting have developed. Some of the limitations of financial accounting are discussed below:
1. Historical Nature
Financial accounting is historical in nature in the sense that it keeps a record of all those transactions that have taken place in the business during a particular period of time. The impact of future uncertainties has no place in financial accounting. As management needs information for future planning, financial accounting can only give information about what has happened and not about what will happen. It does not suggest what should be done to increase the efficiency of the concern.
2. Provides Information about the Concern as a Whole
In financial accounting, information is recorded for the whole concern. One can find information about total expenses and total receipts only. The information is not recorded product-wise, process-wise, department-wise or any other line of activity, but activity-wise so that it could be helpful for cost determination and cost control purposes.
3. Unhelpful in Price Fixation
Financial accounting is unhelpful in fixing the price of a product. The cost of a product can be obtained only when all expenses have been incurred. It is not possible to determine the price in advance. The concern may be required to quote a price for the supply of goods in the near future (for submitting tenders etc.). Financial accounting cannot supply all these information, so it is unhelpful in price determination. Price fixation requires information about both variable and fixed costs as well as direct and indirect costs. Indirect expenses are estimated on the basis of previous records for price determination purposes.
4. Cost Control not Possible
Cost control is impossible in financial accounting. The cost figures are known only at the end of a financial period. When the cost has already been incurred, nothing can be done to control it. There is no technique in financial accounting which can help to ascertain whether the cost is more or less while the expenses are being incurred. There is no procedure to assign responsibility for higher costs, if any. The costing process requires a constant review of actual costs from time to time and this thing is not possible in financial accounting.
5. Appraisal of Policies not Possible
It is not possible to evaluate various policies and programs in financial accounting. There is no technique for comparing actual performance with budgeted targets. It is also difficult to determine whether the work is going on as per schedule. The only criterion for determining efficiency is to see profits at the end of a financial period. The profitability is the only yardstick for evaluating managerial performance. A number of outside factors influence profits of an enterprise. So, it is not a reliable test for ascertaining efficiency of management.
6. Only Actual Costs Recorded
Financial accounting records only actual cost figures. The amount paid for purchasing materials, property or other assets is recorded in the account books. The prices of goods and assets vary from time to time. The current prices of assets may be absolutely different from the recorded costs. Financial accounts do not record price level changes. The recorded costs cannot provide correct information or exact value of assets.
7. Not Helpful in taking Strategic Decisions
Management has to take strategic decisions like replacement of labor by machinery, introduction of a new product, discontinuation of an existing line of production, expansion of capacity etc. The impact of these decisions and cost involved will have to be ascertained in anticipation. Various alternative suggestions are to be studied before taking a final decision. This is because information is recorded for the whole concern and is available only when the event has taken place.
8. Technical Subject
Financial accounting is a technical subject. The recording of transactions and their use require knowledge of accounting principles and conventions. A person who is not conversant with accounting subject has a little utility of financial accounts.
9. Quantitative Information
Financial accounting records only that information which can be quantitatively measured. Anything that cannot be quantitatively measured will not form a part of financial accounting, no matter how much is it important for the business. The policies and plans of the government have a direct bearing on the working of business. It is essential to determine the impact of government decisions on the entrepreneurial
policies. Financial accounts will avoid qualitative factors because they cannot be quantitatively measured.
10. Lack of Unanimity about Accounting Principles
Different accountants apply accounting principles differently. In spite of the efforts of International Accounting Standards Committee, there is a lack of unanimity on the use of accounting principles and procedures. The methods of valuing inventory and charging depreciation are the most controversial issues on which unanimity has not been possible. The preference for the use of different accounting principles brings in an element of subjectivity and human biasedness. The use of different accounting methods reduces the usefulness and reliability of accounts.
11. Chances of Manipulation
Financial accounting can be used to suit the whims of management. The over valuation or under valuation of inventory may change the figures of profits. More profits may be shown to get more remuneration, issue more dividends or to raise the prices of company’s shares. Less profit may be shown to save taxes for not paying bonus to workers etc. The possibility of manipulating financial accounts reduces their reliability.
Basis of Accounting
The income of business belongs to the owner and is a direct result of matching of revenue and expenses of a period. It is always calculated at the end of a period and hence is an ex-post or actual income. The matching of revenue and expenses of a period can be done on the basis of accounting. The basis of accounting comprises the following three bases:
• Accrual basis
• Pure cash basis
• Modified cash basis or hybrid basis
Under this base, incomes as well as expenses are considered on the basis of their occurrence in an accounting period and not on the basis of their actual receipts/ payments. Hence, revenue are recognized if they belong to a period, irrespective of the fact whether received in cash or not. Expenses are recognized in an accounting period in the following cases:
a. A cause-effect relationship can be established with the revenue earned. For example, purchases, wages, salaries etc.
b. It amounts to some kind of systematic allocation of an already incurred cost in the past. For example, depreciation, writing off of deferred revenue expenditure etc.
c. It amounts to expenses related to the period. For example, rent paid, salaries paid etc.
d. The amount represents something which is permanently lost. For example, loss of material by fire or theft etc.
It is immaterial whether expenses are paid in cash or not. Hence, in accrual basis, we match the revenue earned and expenses incurred during a particular period. This matching is in line with the GAAP of realization (or revenue recognition), expense recognition and matching. In fact, the matching concept and accrual concept are used interchangeably.
Pure Cash Basis
Under this method, revenue are not recognized and recorded unless they are received in cash. Similarly, expenses are recognized only when they are paid in cash. Hence, income of a period is calculated by setting off expenses paid in cash against revenue received during a period. The application of pure cash basis of accounting is without sound logic. It would mean that inventories, when purchased and paid for in cash, will be treated as expense. Logically, inventories should be treated as expense when they are sold. The acquisition of fixed assets will have to be treated as expense of the period in which they are paid instead of periods in which benefits are derived from them. The practice of GAAP does not permit application of cash basis of accounting for any kind of business entity.
Modified Cash Basis or Hybrid System
The system is a mixture of both the basis of accounting discussed above. In this, accrual basis are followed normally for expenses and cash basis are followed normally for revenue. Professionals who term their income statement as receipt and expenditure account normally follow such system.
The most genuine and authentic system, i.e. the one having widespread applicability, is accrual system and the other two systems are quite infrequently used. The practical utility of these two systems is minimal.
A business generates sales of Rs. 2,00,000 (including Rs. 40,000 as credit sales) and expenses amount to Rs. 1,40,000 (including Rs. 25,000 still payable) during the accounting period. Compute the profit of the business as per the above-mentioned bases of accounting for the accounting period.
Under Accrual Basis
Income = Revenue Earned – Expenses Incurred
= Rs. 2,00,000 – Rs. 1,40,000
= Rs. 60,000
Under Pure Cash Basis
Income = Revenue Received – Expenses Paid
= Rs. 1,60,000 – Rs. 1,15,000
= Rs. 45,000
Basic Terms in Accounting
For the proper understating of accounting system, it is necessary to understand some important terms which are used in the business world. The Institute of Chartered Accountants of India (ICAI) has done an excellent compilation of the various terms used in the business under “Guidance Note on Terms Used in Financial Statements.” Some important terms explained in the guidance note are reproduced below:
Capital generally refers to the amount invested in an enterprise by its owners. For example, paid up share capital in a corporate enterprise. Capital also refers to the interest of owners in the assets of an enterprise.
Assets refer to the tangible objects or intangible rights owned by an enterprise and carrying probable future benefits.
Liability is the financial obligation of an enterprise other than owners’ funds.
Revenue is the gross inflow of cash, receivables or other considerations arising in the course of ordinary activities of an enterprise’s resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. It excludes amounts collected on behalf of third parties such as certain taxes. In an agency relationship, revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.
5. Cost of Goods Sold
It is the cost of goods sold during an accounting period. In manufacturing operations, it includes the following:
• Cost of materials
• Labor and factory overheads
Selling and administrative expenses are normally excluded.
Profit is a general term for the excess of revenue over related cost. When the result of this computation is negative, it is referred to as loss.
Expenditure includes incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods or services.
Expense is the cost relating to the operation of an accounting period, or the revenue eared during the period, or the benefit of which do not extend that period.
9. Deferred Expenditure
Deferred expenditure is the expenditure for which payment has been made or a liability incurred but which is carried forward on the presumption that it will be a benefit over a subsequent period or periods. This is also referred to as deferred revenue expenditure.
10. Sales Turnover
Sales turnover includes the total amount for which sales are affected or services rendered by an enterprise. The terms gross turnover and net turnover (or gross sales and net sales) are sometimes used to distinguish the sales aggregate before and after deduction of returns and trade discounts.
Inventory includes tangible property held for sale in the ordinary course of business, or in the process of the production for such sale, or the consumption in the production of goods or services for sale, including maintenance supplies and consumables other than machinery spares.
12. Accumulated Depreciation
Accumulated depreciation includes the total up-to-date of the periodic depreciation charges on depreciable assets.
13. Profit and Loss Statement
Profit and loss statement is a financial statement which presents the revenue and expenses of an enterprise for an accounting period and shows the excess of revenue over expenses (or vice versa). It is also known as profit and loss account.
14. Appropriation Account
Appropriation account is an account, sometimes included as a separate section of the profit and loss statement, showing application of profits toward dividends, reserves etc.
15. Prior Period Item
Prior period item is a material change or credit that arises in the current period as a result of errors or omissions in the preparation of financial statements of one or more prior periods.
16. Accounting Policies
Accounting policies include the specific accounting principles and methods of applying those principles adopted by an enterprise in the preparation and presentation of financial statements.
17. Cash Basis of Accounting
Cash basis of accounting is the method of recording transactions by which revenue, costs, assets and liabilities are reflected in the accounts in the period in which actual receipts or actual payments are made.
18. Accrual Basis of Accounting
Accrual basis of accounting is the method of recording transactions by which revenue, costs, assets and liabilities are reflected in the accounts in the period in which they accrue. The accrual basis of accounting includes considerations relating to deferrals, allocations, depreciation and amortization. This basis is also referred to as mercantile basis of accounting.
19. Balance Sheet
Balance sheet is a statement of financial position of an enterprise at a given date. It exhibits a company’s assets, liabilities, capital, reserves and other account balances at their respective book value.
20. Book Value
Book value is the amount at which an item appears in the books of account or financial statement. It does not refer to any particular basis on which the amount is determined. For example, cost, replacement value etc.
Goodwill is an intangible asset arising from business connection or trade name or reputation of an enterprise.
22. Sundry Creditor
Sundry creditor is the amount owed by an enterprise on account of goods purchased or services received, or in respect of contractual obligations. It is also termed as trade creditor or account payable.
23. Sundry Debtor
Sundry debtors are persons from whom amounts are due for goods sold or services rendered, or in respect of contractual obligations. These are also termed as debtor, trade debtor and account receivable.
24. Contingent Asset
Contingent asset is an asset, the existence, ownership or value of which may be known or determined only on the occurrence or non-occurrence of one or more uncertain future events.
25. Contingent Liability
Contingent liability is an obligation relating to an existing condition or situation which may arise in future depending on the occurrence or non-occurrence of one or more uncertain future events.
Accounting is that language of business through which a business house communicates with the outside world. Over a period, the nature of the functions of accounting has changed. Initially, more thrust was on bookkeeping, i.e. maintenance of records manually. However, today, where computerized accounting software are used, the role of accountants is more inclined toward analysis and interpretation than mere maintenance of the data.
The accounting information is useful not only for the owners and management but also for the creditors, employees, government and prospective investors. The main objective of accounting is to reflect the true and fair picture of profitability and financial position which helps management to take corrective actions and future decisions.