Lesson-1

Introduction to Accounting

Learning Objectives

To understand the meaning of accounting
To understand the scope and objectives of financial accounting
To know about the branches of accounting
To understand the importance and limitations of financial accounting
To know more about accountancy, accounting and bookkeeping
To understand the systems of bookkeeping and accounting
To know more about the users of accounting information

Introduction

In this lesson, our objective is to get acquainted with the basic need, development and
definition of basic terms. The accounting records that have been maintained help various
interested parties in a variety of manner. For some persons, these records are informative
whereas others may take crucial investment decisions based on the information.

Accounting is the language of the business, the basic function of which is to serve as a
means of communication. If you ask to whom does it communicate the results of
business operations, the various interested parties are owners, creditors, investors,
governments and other agencies.

A language has following three important jobs to perform:

To act as a medium of communication
To help in understanding the existing literature
To make additions to the already existing literature

Accounting has been performing all these roles. As a language, it is responsible for
preparing financial statements with its own syntax. The syntax of accounting language
comprises the following:

Total system of recording and analyzing business transactions called the double
entry system of bookkeeping
The basic principles on which it is based like Accounting Standards or Generally
Accepted Accounting Principles (GAAP)

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.

5. Interpretation

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

1. Owner(s)

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.

2. Managers

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.

3. Investors

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.

5. Employees

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.

6. Government

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.

7. Researchers

Researchers need financial information for testing hypothesis and development of
theories and models. The required information is provided by accounting system.

8. Customers

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.

9. Public

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
Management
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
companys 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

Accrual 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.

Illustration

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.

Solution

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:

1. Capital

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.

2. Assets

Assets refer to the tangible objects or intangible rights owned by an enterprise and
carrying probable future benefits.

3. Liability

Liability is the financial obligation of an enterprise other than owners funds.

4. Revenue

Revenue is the gross inflow of cash, receivables or other considerations arising in the
course of ordinary activities of an enterprises 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.

6. Profit

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.

7. Expenditure

Expenditure includes incurring a liability, disbursement of cash or transfer of property
for the purpose of obtaining assets, goods or services.

8. Expenses

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.

11. Inventory

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 companys 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.

21. Goodwill

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.

Summary

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.

Questions

1. Define the term accounting. State its functions. Explain how accounting is different
from bookkeeping?
2. Who are the interested persons in the accounting information?