LECTURE ONE

ROLE OF ACCOUNTING IN SOCIETY

Introduction
Accounting aims to provide financial information about an enterprise to various
interested groups for decision-making. As accounting communicates financial
information for decision-making to many parties outside the reporting business
entity, it is necessary that there is uniformity in the preparation of financial
statements of different enterprises at a given point of time. It also requires
consistency in the preparation of financial statements of an enterprise over a
period of time. If every business could follow its own notion about the accounting
terms like revenue, expenses, assets, liabilities, income etc., there will be complete
chaos. To have uniformity and consistency in the preparation of financial
statements, accounting operates within a framework of “Generally Accepted
Accounting Principles” (GAAP), follows a conceptual framework and adheres to the
Accounting Standards issued by the recognised regulatory body. This is referred to
as the theory base of accounting.
The term GAAP is used to describe rules or guidelines, variously called concepts,
conventions, axioms, assumptions, postulated principles, and modifying principles
etc., developed for the preparation of financial statements. Accounting principles
are a body of doctrines commonly associated with the theory and procedure of
accounting, serving as an explanation of current practices and as guide for the
selection of conventions and procedures where alternatives exist. It provides
explanation for accounting practices followed by an enterprise at a given point of
time. However, it should be clearly understood that accounting theory is not and
probably will never be in a completely stable state. Accounting principles are
constantly evolving and are influenced by the following:

• Changes in the social, legal and economic environment

• Professional bodies like the Institute of Chartered Accountants of England

and Wales, the American Institute of Certified Public Accountants,
International Accounting Standards Board.

• Needs of the users of financial information

Accounting, being a man made system, should evolve and adjust itself to the
changes needed by the mankind. As a result, accounting principles are not as
exact and rigid as the laws of natural sciences. Therefore, the emphasis is on
general instead of universal acceptability of accounting principles. GAAP is not the
building blocks of the accounting language. Rather, GAAP is the pillar on which the
structure of accounting rests. If we remove these principles, the entire structure of
accounting will come down. The GAAP should be understood by the makers and the
users of accounting information before analysing and interpreting financial
statements.
GAAP includes the following concepts:

• Accounting entity

• Stable money measurement

• Going concern

• Accounting period

• Cost

• Revenue recognition (or realisation)

• Expenses recognition

• Matching (or accrual)

• Full, fair and adequate disclosure

• Dual aspect (or duality)

• Verifiable objectivity (neutrality and reliability)

• Materiality

• Consistency

• Conservatism

• Timeliness

• Industry practices

• Substance over form

Of these, the first four concepts are the most basic assumption on which
accounting structure rests. The next six are the basic accounting principles which
help us in ascertaining the result of a business entity. However, we are essentially
operating in a social system which is bound to be inexact. Hence, we need to be
flexible in our approach. The basic knowledge needs to be modified due to
changing circumstances/situations to enhance the utility of the information
generated by the accounting system. The next six concepts serve the same
purpose.

All financial statements recognise the fundamental accounting concepts of going

concern, matching (or accrual) and consistency. Financial statements should
further emphasise prudence and substance over form and materiality as
considerations in the selection of accounting policies, where accounting policies are
defined as referring to the specific accounting principles and the method of
applying those principles adopted by the enterprise in the preparation and
presentation of financial statements. The end result of the application of these
accounting principles is the preparation of meaningful financial statements.
1. Accounting Entity

Accountants treat a business as distinct from the persons who own it. Then, it
becomes possible to record the transactions of the business without the proprietor
also. The concept of separate business entity is applicable for all types of
organizations like sole proprietorship, partnership etc. where the business affairs
are free from the private affairs of the proprietor or partner.

2. Money Measurement

Accounting records normally those transactions which are being expressed in

monetary terms. Measurement of business events in monetary terms helps in
understanding the state of affairs of the business in a much better way. For
example, if a business owns two factory buildings, five machines and £1,000,000
cash at bank, we cannot add these numbers so as to produce a meaningful result.
However, if we say the value of two factory buildings is £10,000,000, the value of
five machines is £500,000 and cash of £1,000,000; we can add these values and
say that the value of assets owned by the business is £11,500,000. This is
definitely informative and useful.

3. Going Concern Concept

It is assumed that the business will exist for a long time and transactions are
recorded from this point of view. Based on this concept, the accountants, while
valuing assets, will not consider the forced sale value of assets (market value), but
the assets, normally, will be reflected at the cost of acquisition minus depreciation.
Similarly, depreciation is provided based on the expected life of the assets. The
concept, however, does not imply the permanent continuance of the business. The
underlying presumption is that the business will continue in operations long
enough to charge against income the cost of fixed assets over their economic lives
and to pay the liabilities when they fall due. This concept is applicable to the
business as a whole and not for a particular division or branch. Merely closing of a
branch or division may not adversely affect the ability of the enterprise to continue
other businesses normally. Once the business goes in to liquidation or becomes
insolvent, this concept does not apply. In other words, the going concern status of
the concern will stand terminated from the date of appointment of a receiver.

4. Accounting Period Concept

According to this concept, the life of a business is divided into appropriate

segments of time, say 12 months, for studying the results. While the life of a
business is considered to be indefinite, according to the going concern concept, the
measurement of income and studying the financial position of the business after a
very long time would not be helpful in taking corrective steps at the appropriate
time. Therefore, it is necessary that after each segment of time interval the
management should review the performance. The segment of time interval is
called accounting period, which is usually a year. At the end of each accounting
period, an income statement and a balance sheet is prepared. The income
statement discloses the profit or loss made by the business during an accounting
period. The balance sheet discloses the state of affairs of the business as on the
last date of the accounting period. The term “conventions” includes those customs
or traditions which guide the accountants while preparing the accounting
statements.
5. Cost Concept

Transactions are entered in the books of account at the amounts actually involved.
An asset is ordinarily recorded at a price at which it has been acquired. For
example, a plot of land purchased by a firm for £5,000,000 would be recorded at
this value irrespective of its current market price. Cost concept has the advantage
of bringing objectivity in the presentation of the financial statements. In the
absence of this concept, the figures shown in the accounting records would have to
depend on the subjective view of a person.

6. Realization Concept

Accounting is a historical record of transactions. It only records what has

happened. It does not anticipate events, though anticipated adverse effects of
events that have already occurred are usually recorded. For example, A places an
order on B for supply of certain goods. Upon receipt of the order, B procures raw
material, employs labour, and produces and delivers the goods to A. In this case,
the sale transaction will be recorded in the books of B only when the goods are
delivered and not upon the receipt of an enforceable purchase order from A.
There are certain exceptions to this concept which are as follows:

i) In the case of hire-purchase transaction, the ownership of the goods passes

on to the buyer only when the last instalment is paid, but sales are
presumed to have been made to the extent of instalments received and
instalments outstanding (instalments due but not received).

ii) In the case of contract accounts, though the contractor is liable to pay only
when the whole of contract is completed as per terms of the contract, the
profit at the end of accounting year is calculated on the basis of the work
completed and certified by a competent authority.

7. Expenses Recognition

Cost is the total outlay or expenditure on acquiring resources required for the
production of goods or rendering of services. Cost of resources utilized and lost
during a particular period is termed as the expired cost or expense and is charged
to the revenue of the period to obtain information about income. Costs of the
resources remaining unutilized or unexpired at the end of the period are carried
forward to the next accounting period and are termed as assets.

8. Accrual Concept

The accrual system is a method whereby revenue and expenses are identified with
specific period of time like a month, half year or a year. It implies recording of
revenue and expenses of a particular accounting period whether they are
received /paid in cash or not. Under the cash system of accounting, the revenue
and expenses are recorded only if they are actually received /paid in cash
irrespective of the accounting period to which they belong. But under accrual
method, the revenue and expenses relating to that particular accounting period
only are considered.

9. Disclosure

Apart from the statutory obligations, good accounting practice also demands that
all significant information should be disclosed fully and fairly. The financial
statements have to be prepared honestly and should disclose the information
which is of material interest to the owners, present and potential creditors, and
investors. Whether information should be disclosed or not will depend on whether it
is material. Materiality depends on the amounts involved in relation to the assets
group involved or profits. In the case of financial statements of a limited company,
the practice followed is to append the notes to the accounts and disclose
significant accounting policies. This is in pursuance of the convention of full
disclosure.

10. Dual Aspect Concept

Each transaction has two aspects. With every increase in the money owned to
others, there should be an increase in assets or loss. Thus, at any time the
accounting equations is as follows:
Assets = Liabilities + Capital, or alternatively
Capital = Assets - Liabilities
For example, a proprietor brings in £100,000 in cash as capital to start a small
business.
£100,000 is the capital and corresponding amount of £100,000 will appear as cash
in hand (assets).

11. Verifiable Objectivity

According to this concept, all accounting transactions should be evidenced and

supported by objective documents. These documents include invoices, contracts,
correspondence, vouchers, and bills, pass books, cheque books etc. Such
supporting documents provide the basis for making accounting entries and for
verification by the auditors later on. This concept also has its limitations. For
example, it is difficult to verify internal allocation of costs to accounting periods.

12. Materiality

According to this convention, the accountant should attach importance to material

details and ignore insignificant details. This is because otherwise accounting will be
unnecessarily overburdened with minute details. The question “what constitutes
material details” is left to the discretion of the accountant. Moreover, an item may
be material for one purpose while immaterial for another. The term materiality is a
subjective term. The accountant should regard an item as material if there is a
reason to believe that knowledge of it would influence decision of the informed
investor. According to Kohler, “Materiality means characteristic attaching to a
statement, fact or item whereby its disclosure or method of giving it expression
would be likely to influence the judgment of a reasonable person.”

13. Consistency
The accounting practices should remain the same from one year to another. For
example, consistency in valuing stock in trade or in the method of charging
depreciation. If the stock has been valued by adopting the principle of cost or
market value, whichever is less, the same principle has to be consistently followed
year after year. Similarly, the method of charging depreciation, either straight line
or written down value method, has to be consistently followed. This is necessary
for the comparison of results. However, consistency does not mean inflexibility.
In the case of change in law or from the point of view of improved reporting, this
convention is broken and then adequate disclosure, as to the impact on the profit
due to such change, has to be mentioned in the notes appended to the accounts.

14. Conservatism

Financial statements are usually drawn up on a conservative basis, especially in

the initial stages when the anticipated profits, which were accounted, did not
materialize. This results in less acceptability of accounting figures by the end-users.
Therefore, accountants follow the rule “anticipate no profits but provide for all
possible losses.” Similarly, based on this convention, the inventory is valued at
lower of cost or market price. Necessary provision for bad and doubtful debts is
made in the books of account. Window-dressing, i.e. showing a position better than
what it is, is not permitted. It is also not proper to show a position substantially
worse than what it is. In other words, secret reserves are not permitted. Therefore,
this convention has to be applied with reasonable caution and care.

15. Timeliness

Financial reports should be timely to have any usefulness for decision makers.
Timeliness in financial reporting requires estimation of depreciation, provision for
bad and doubtful debts, provision for discount etc. to prepare the financial
statements of different accounting periods.

16. Industry Practice

Sometimes, practice prevailing in a particular industry is given precedence over

generally accepted accounting principles. For example, valuation of gold on the
basis of market price, agriculture products on the basis of minimum support price
determined by the government etc.

17. Substance over Form

The accounting treatment and presentation in the financial statements of

transactions and events should be governed by their substance and not merely by
their legal form. Hence, when goods are purchased on hire-purchase basis, the
property in goods is transferred to the buyer on the payment of the last instalment
only. However, the buyer for all practical purpose uses the goods as if he is the
owner of the goods in question from the date of acquisition. This aspect is reflected
in the books of the buyer, normally by recording the asset at its cash price at the
time of payment of initial amount (down payment). Hence, substance should
always override the legal form – always choose substance over form.

Accounting Standards or Financial Reporting Standards

Accounting communicates the financial results of business to various parties by
means of financial statements which have to exhibit a “true and fair” view of the
state of affairs. Like any other language, accounting also has complex set of rules.
However, these rules have to be used with a reasonable degree of flexibility in
response to specific circumstances of the business and also in line with the
changes in the economic environment, social needs, legal requirement and
technological developments. Thus, these rules, though not rigid, cannot be applied
arbitrarily. They normally operate within the boundary of rationality.
Accounting standards are defined as the policy documents issued by a recognized
expert accounting body relating to various aspects of measurement, treatment and
disclosure of accounting transactions and events.

Systems of Bookkeeping
Bookkeeping, as explained earlier, is an art of recording pecuniary or business
transactions
in a regular and systematic manner. The recording of transactions may be done
according
to any of the following two systems:

1. Single Entry System

This is a system of bookkeeping in which, as a rule, only records of cash and

personal accounts are maintained. It is always incomplete, varying with
circumstances. Since all records are not kept, it is not reliable and can only be
suitable for small business firms.

2. Double Entry System

Every transaction in accounting is considered as having two aspects. Double entry

system is the name given for recognising both the aspect of any business
transaction as per prescribed set of rules. For example, £1,000 in cash received
from Gerrard. This is a transaction having the following two aspects:
(i) Business Receiving Cash £1,000
(ii) Gerrard Giving Cash £1,000

As per the prescribed rules followed for accounting, one aspect is given a DEBIT
effect and other aspect is given a CREDIT effect of equivalent amount.

The above system of accounting is known as double entry system. The system
implies that a transaction is entered twice to account for the two fold aspect of a
transaction.

Both the aspects are equal in monetary terms in opposite directions. If one is debit,
the other one will be credit. If one is credit, then the other one will be debit. Both
debit and credit aspects should be equal in monetary terms.
Thus, double entry system is a system of accounting which gives the two fold
aspects of any monetary business transaction, according to certain prescribed
rules.

Main Features of Double Entry System

1. Both the aspects of the transaction, i.e. debit as well as credit are to be

recorded.

2. Since one aspect is debited with equal amount and the other aspect is credited,
the total of debit effects should agree with total of the credit effects. This is done
by preparing a trial balance to test the arithmetical accuracy.
Stages of Double Entry System of Accounting
1st stage Recording transactions in journal and subsidiary books
2nd stage Posting in ledger (classified group)
3rd stage Preparation of trial balance
4th stage Preparation of final accounts
5th stage Management accounting
Summary
Accounting is the language of business. Accounting is the art of recording,
classifying and summarising meaningfully the transactions and events which are
of financial character and interpreting the results thereof.
Basic accounting concepts are the ground rules for financial accounting. These
concepts are vital for the understanding of the process of accounting.
A financial statement comprises a balance sheet, a profit and loss statement and
the schedule and notes forming part thereof.
The accounting equation shows the relationship of different elements of a balance
sheet.

Questions

1. Write short notes on the following:

• Fundamental accounting assumptions

• Going concern concept
• Periodicity concept

2. Accounting period assumption is made to provide timely information to the user

of accounting information. Explain it clearly, stating the nature of information
provided by financial statements of an accounting period.
3. State whether the following statements are true or false:

a. Accounting entity is recognised by law.

b. Accounting records changes in the level of prices and non-monetary events.

c. Full disclosure requires disclosure of insignificant information.

d. Revenue increases capital.

e. Revenue is recognised when it is earned, irrespective of cash inflow.

f. Assets are always equal to liabilities plus capital.

g. Purchasing power of money and level of prices are inversely related.

h. Income statement reports income on historical cost basis.

i. Cost of fixed assets becomes expense over the period of its use.

j. Income is excess of revenue over cost.

k. Cost is expense over the period of its use.

l. Income is excess of revenue over cost.

m. Cost and expense are same.

n. Recognition of an expense is related to outflow of cash.