Principles of Accounting

PRINCIPLES OF ACCOUNTING
1. Introduction & Scope of Accounting
Students’ Notes: This area covers the Meaning of “Accounting” and an overview of the Accounting Process and related fields.

1.1 Definition of Accounting:

i. As per the American Institute of Certified Public Accountants (AICPA) – Accounting is an art of
recording, classifying and summarizing transactions and events which are in part at least of financial
character, in a significant manner and in terms of money, and interpreting the results thereof.
ii. Accounting also involves analyzing and interpreting the financial transactions and communicating
the results to the persons interested in such information.
iii. Accounting is considered as an ‘Information System’, as the function of Accounting is to provide
quantitative information, primarily financial in nature about the business organization.

1.2 Origin & Growth of Accounting:

Accounting is as old as money itself. However, the act of accounting was not as developed as it is today
because in the early stages of civilization, the number of transactions to be recorded were so small that
each businessman was able to record and check for himself all his transactions.
However, the modern system of accounting based on the principles of double entry system owes it origin
to Luco Pacioli who first published the principles of Double Entry System in 1494 at Venice in Italy. Thus,
the art of accounting has been practiced for centuries but it is only in the late thirties that the study of the
subject 'accounting' has been taken up seriously.

1.3 Nature and Scope of Financial Accounting:

The nature and scope of accounting is described in the traditional definition of amounting given 1961 by
the AICPA as Accounting is the art of recording, classifying and summarizing significant manner and in
terms of money transactions and event to interoperate financial information & results.
i ) Accounting as a service activity
Accounting is a service activity. That accounting collects financial information for the various users for
taking decisions and tackling business issues. Accounting in itself cannot create wealth though, if it
produces information which is useful to others, it may assist in wealth creation and maintenance.
(ii) Accounting as a profession
Accounting is very much a profession. A profession is a career that involve the acquiring of a specialized
formal education before rendering any service. Accounting is a systematized body of knowledge
developed with the development of trade and business over the past century. In a way, accountancy as a
profession has attained the stature comparable with that of lawyer, medicine or architecture.
(iii) Accounting as a social force
The society is composed of people as customer, shareholders, creditors and investors. The accounting
information/data is to be used to solve the problems of the public at large such as determination and
controlling of prices. Therefore, safeguarding of public interest can better be facilitated with the help of
proper, adequate and reliable accounting information and as a result of it the society at large is benefited.
(iv) Accounting as a language
Accounting is rightly referred the "language of business". It is one means of reporting and communicating

Instructor: Farhan Bajwa

 Principles of Accounting

information about a business. As one has to learn a new language to converse and communicate, so also
accounting is to be learned and practiced to communicate business events.

(v) Accounting as an information system

Accounting generally does not generate the basic information (raw financial data), rather the raw financial
data result from the day to day transactions of the business. As an information system, accounting links
an information source or transmitter (generally the accountant), a channel of communication (generally
the financial statements) and a set of receivers (external users).

1.4 Different Types of Business Organizations:

There are 4 main types of business organization: sole proprietorship, partnership, corporation, and
Limited Liability Company, or LLC. Below, we give an explanation of each of these and how they are used
in the scope of business law.

Sole Proprietorship
The simplest and most common form of business ownership, sole proprietorship is a business owned and
run by someone for their own benefit. The business’ existence is entirely dependent on the owner’s
decisions, so when the owner dies, so does the business.
Advantages of sole proprietorship:
 All profits are subject to the owner
 There is very little regulation for proprietorships
 Owners have total flexibility when running the business
 Very few requirements for starting—often only a business license
Disadvantages of sole proprietorship:
 Owner is 100% liable for business debts
 Equity is limited to the owner’s personal resources
 Ownership of proprietorship is difficult to transfer
 No distinction between personal and business income

Partnership
These come in two types: general and limited. In general partnerships, both owners invest their money,
property, labor, etc. to the business and are both 100% liable for business debts. In other words, even if
you invest a little into a general partnership, you are still potentially responsible for all its debt. General
partnerships do not require a formal agreement—partnerships can be verbal or even implied between
the two business owners.
Limited partnerships require a formal agreement between the partners. They must also file a certificate
of partnership with the state. Limited partnerships allow partners to limit their own liability for business
debts according to their portion of ownership or investment.
Advantages of partnerships:
 Shared resources provides more capital for the business
 Each partner shares the total profits of the company
 Similar flexibility and simple design of a proprietorship
 Inexpensive to establish a business partnership, formal or informal
Disadvantages of partnerships:
 Each partner is 100% responsible for debts and losses
 Selling the business is difficult—requires finding new partner
 Partnership ends when any partner decides to end it

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 Principles of Accounting

Corporation
Corporations are, for tax purposes, separate entities and are considered a legal person. This means,
among other things, that the profits generated by a corporation are taxed as the “personal income” of
the company. Then, any income distributed to the shareholders as dividends or profits are taxed again as
the personal income of the owners.
Advantages of a corporation:
 Limits liability of the owner to debts or losses
 Profits and losses belong to the corporation
 Can be transferred to new owners fairly easily
 Personal assets cannot be seized to pay for business debts
Disadvantages of a corporation:
 Corporate operations are costly
 Establishing a corporation is costly
 Start a corporate business requires complex paperwork
 With some exceptions, corporate income is taxed twice

Limited Liability Company (LLC)

Similar to a limited partnership, an LLC provides owners with limited liability while providing some of the
income advantages of a partnership. Essentially, the advantages of partnerships and corporations are
combined in an LLC, mitigating some of the disadvantages of each.
Advantages of an LLC:
 Limits liability to the company owners for debts or losses
 The profits of the LLC are shared by the owners without double-taxation
Disadvantages of an LLC:
 Ownership is limited by certain state laws
 Agreements must be comprehensive and complex
 Beginning an LLC has high costs due to legal and filing fees

1.5 Types of Accounting:

As a result of economic, industrial, and technological developments, different specialized fields in
accounting have emerged.
The famous branches or types of accounting include: financial accounting, managerial accounting, cost
accounting, auditing, taxation, AIS, fiduciary, and forensic accounting.

1. Financial Accounting
Financial accounting involves recording and classifying business transactions, and preparing and
presenting financial statements to be used by internal and external users.
In the preparation of financial statements, strict compliance with generally accepted accounting principles
or GAAP is observed. Financial accounting is primarily concerned in processing historical data.

2. Managerial Accounting
Managerial or management accounting focuses on providing information for use by internal users, the
management. This branch deals with the needs of the management rather than strict compliance with
generally accepted accounting principles.
Managerial accounting involves financial analysis, budgeting and forecasting, cost analysis, evaluation of
business decisions, and similar areas.

Instructor: Farhan Bajwa

 Principles of Accounting

3. Cost Accounting
Often times considered as a subset of management accounting, cost accounting refers to the recording,
presentation, and analysis of manufacturing costs. Cost accounting is very useful in manufacturing
businesses since they have the most complicated costing process.
Cost accountants also analyze actual costs versus budgets or standards to help determine future courses
of action regarding the company's cost management.

4. Auditing
External auditing refers to the examination of financial statements by an independent party with the
purpose of expressing an opinion as to fairness of presentation and compliance with GAAP. Internal
auditing focuses on evaluating the adequacy of a company's internal control structure by testing
segregation of duties, policies and procedures, degrees of authorization, and other controls implemented
by management.

5. Tax Accounting
Tax accounting helps clients follow rules set by tax authorities. It includes tax planning and preparation of
tax returns. It also involves determination of income tax and other taxes, tax advisory services such as
ways to minimize taxes legally, evaluation of the consequences of tax decisions, and other tax-related
matters.

6. Accounting Information Systems

Accounting information systems (AIS) involves the development, installation, implementation, and
monitoring of accounting procedures and systems used in the accounting process. It includes the
employment of business forms, accounting personnel direction, and software management.

7. Fiduciary Accounting
Fiduciary accounting involves handling of accounts managed by a person entrusted with the custody and
management of property of or for the benefit of another person. Examples of fiduciary accounting include
trust accounting, receivership, and estate accounting.

8. Forensic Accounting
Forensic accounting involves court and litigation cases, fraud investigation, claims and dispute
resolution, and other areas that involve legal matters. This is one of the popular trends in accounting
today.

1.6 Role of Accounting:

Besides, accounting is also useful in the following respects:
(i) Increased volume of business results in large number of transactions and no businessman can
remember everything. Accounting records obviate the necessity of remembering various transactions.
(ii) Accounting records, prepared on the basis of uniform practices, will enable a business to compare
results of one period with another period.
(iii) Taxation authorities (both income tax and sales tax) are likely to believe the facts contained in the set
of accounting books if maintained according to generally accepted accounting principles.
(iv) Accounting records, backed up by proper and authenticated vouchers, are good evidence in a court
of law.
(v) If a business is to be sold as a going concern, then the values of different assets as shown by the balance
sheet helps in bargaining proper price for the business.

Instructor: Farhan Bajwa

 Principles of Accounting

1.7 Objectives of Accounting:

The objectives of Accounting are –
i. To have a systematic record all business transactions which are of financial nature.
ii. To know the result of business operations for a particular period of time. If Revenue / Income
exceeds the Expenses, then it is said that the business is running profitably, but if the Expenses
exceed the Revenue, then the business is operating at a loss.
iii. To know the financial position of the business. This will help answer questions like how much
Assets and Liabilities that the business has on any date, whether the business is solvent, i.e. ability
to meet its liabilities in the short run and also in the long run as and when they fall due.
iv. To provide information to Users for decision making. Accounting, as the language of business,
communicates the financial result of enterprises, to various Users. Accounting aims to meet the
information needs of the decision maker and help them in rational decision making.
Objectives of Accounting
Systematic record of all Ascertainment of results of Ascertainment of Providing information to
business transactions business operation financial position Users

Book–Keeping, i.e. Journal, Trading and Profit & Loss Financial Statements and
Balance Sheet
Ledger and Trial Balance Account Reports

1.8 Functions of Accounting:

The American Principles Board of the AICPA enumerated the following functions of accounting:
Measurement: Accounting measures the performance of the business entity and depicts its current
financial position.
Forecasting: Accounting helps in forecasting future performance and financial position of enterprise using
past data.
Decision–making: Accounting provides relevant information to the Users of accounts to aid rational
decision–making.
Comparison & 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.
Control: Accounting identifies weaknesses in the operational system and provides feedback regarding
effectiveness of measures to rectify such weaknesses.
Government Regulation: Accounting provides necessary information to the Government, to exercise
control on the entity as well as in collection of direct and indirect tax revenues.

1.9 Advantages & Disadvantages of Accounting:

Below are the advantages and disadvantages of accounting.

Advantages of Accounting
i. Maintenance of business records
ii. Preparation of financial statements
iii. Comparison of results
iv. Decision making
v. Evidence in legal matters
vi. Provides information to related parties
vii. Helps in taxation matters

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 Principles of Accounting

viii. Valuation of business

ix. Replacement of memory

(i) Maintenance of business records

It records all the financial transaction pertaining to the respective year systematically in the books of
accounts. It is not possible for management to remember each and every transaction for a long time due
to their size and complexities.

(ii) Preparation of financial statements

Financial statements like Trading and profit and loss account, Balance Sheet can be prepared easily if there
is a proper recording of transactions. Proper recording of all the financial transactions is very important
for the preparation of financial statements of the entity.

(iii) Comparison of results

It facilitates the comparison of the financial results of one year with another year easily. Also, the
management can analyze the systematic recording of all the financial transactions according to the
policies of the entity.

(iv) Decision making

Decision making becomes easier for management if there is a proper recording of financial transactions.
Accounting information enables management to plan its future activities, make budgets and coordination
of various activities in various departments.

(v) Evidence in legal matters

The proper and systematic records of the financial transactions act as evidence in the court of law.

(vi) Provides information to related parties

It makes the financial information of the organization available to stakeholders like owners, creditors,
employees, customers, government etc. easily.

(vii) Helps in taxation matters

Various tax authorities like income tax, indirect taxes depends on the accounts maintained by the
management for settlement of taxation matters.

(viii) Valuation of business

For proper valuation of an entity’s business accounting information can be utilized. Thus, it helps in
measuring the value of the entity by using the accounting information in the case of sale of the entity.

(ix) Replacement of memory

Proper recording of accounting transactions replaces the need to remember transactions.

Disadvantages of Accounting
i. Expresses Accounting information in terms of money
ii. Accounting information is based on estimates
iii. Accounting information may be biased
iv. Recording of Fixed assets at the original cost
v. Manipulation of Accounts
vi. Money as a measurement unit changes in value

Instructor: Farhan Bajwa

 Principles of Accounting

Expresses Accounting information in terms of money

Non-financial transactions cannot be given effect to in books of accounts. Only transactions of financial
nature are measurable by the accountant. In fact, financial transactions are expressed in terms of money.

Accounting information is based on estimates

There are some accounting data which are based on estimates. Thus, inaccuracy in estimates is possible.

Accounting information may be biased

Accountants personal influence affects the accounting information of the entity. Different methods of
inventory valuation, depreciation methods, treatment of revenue and capital expenses etc can be
adopted by the accountant for measurement of income of the entity.
Hence, the income arrived in certain cases might be incorrect due to the lack of objectivity.

Recording of Fixed assets at the original cost

There can be a difference between the original cost and current replacement cost of a fixed asset due to
efflux of time, change in technology etc. Thus, the balance sheet may not show the true financial status
of an entity.

Manipulation of Accounts
The accountant or management can manipulate or misrepresent the profits of an entity.

Money as a measurement unit changes in value

Stability in the value of money is not possible. Accounting information will not show the true financial
position if changes in the price level are not considered.

1.10 Users of Financial Information:

Users Purp
ose
Management For day–to–day decision–making and performance evaluation.
Proprietor / To analyse performance, profitability and financial position.
Shareholders Note: Prospective investors are interested in the track record of the Company.
Lenders – Banks & To determine the financial position and strength of the Company, Debt Service Coverage, etc.
Fin. Institutions
Suppliers To determine the credit worthiness of the Company.

Instructor: Farhan Bajwa

 Principles of Accounting

Users Purp
ose
Customers To know general business viability before entering into long–term contracts and
arrangements.
To know the stability, continuity and growth of the enterprise, and its ability to pay
Employees
remuneration, retirement & other benefits, and to enhance career opportunities.
 To ensure prompt collection of Direct and Indirect Tax revenues,
Government
 To evaluate performance and contribution to social objectives.
Research Scholars For study, research and analysis purposes.
To see whether the enterprise is making a reasonable / substantial contribution to the local
Public at Large
economy, e.g. employment opportunities, patronage of local suppliers.

1.11 Relationship of Accounting with other Disciplines:

The relationship of Accounting with other disciplines is highlighted as under –
Discipline Relations
hip
Auditing process reviews the Financial Statements, which are the outcome of the accounting process.
1. Auditing Thus, The Auditor should have a thorough and sound knowledge of Accounting Standards and
Generally Accepted Accounting Principles for reviewing the Financial Statements.
 Economics uses the database provided by Accounting System, for developing decision–models
and for rational decision–making on the use of scarce resources.
2. Economics  Economic Theories have influenced the development of decision–making tools used in
accounting.
 However, there are differences between the Economists’ and Accountants’ concepts of
Income, Capital and Valuation of Assets.
 Transactions and events are governed by the laws of the land like the law of Contracts, Sale of
Goods, Negotiable Instruments and Taxation Laws.
 The entity itself is governed by specific statutes like Partnership Act, Companies Act, Co–
operative Societies Act, which have a bearing on maintenance of account books.
3. Law  The format of Financial Statements is also prescribed by certain Statutes like Companies Act,
Banking Regulation Act, etc.
 Also, accounting influences law in the sense that legislation about accounting system cannot be
enacted unless there is a corresponding development in the accounting discipline, e.g.
formulation of Accounting Standards and adoption by Companies Act.
 Knowledge of arithmetic and algebra is a pre–requisite for accounting computations and
measurements, e.g. Depreciation, Use of interest and annuity tables, Lease Rentals, Hire
4. Mathematics Purchase Instalments, etc.
 Ratios, Graphs, and Operations Research Models have been widely used in accounting
Management relies on accounting and other data for effective decision–making. Accounting
5. Management
System can be designed to serve management purposes.
In accounting, many ratios and financial calculations are based on statistical methods, which help in
6. Statistics averaging them over a period of time. Thus, Statistics is helpful in development of accounting data
and in their interpretation, using Pie–Charts, Graphs and Trend Curve Diagrams, etc.

1.12 Summary:
Accounting can be understood as the language of financial decisions.
It is an ongoing process of performance measurement and reporting the results to decision makers. The
discipline of accounting can be traced back to very early times of human civilization. With the
advancement of industry, modern day accounting has become formalized and structured. A person who
maintains accounts is known as the account. The information generated by accounting is used by various

Instructor: Farhan Bajwa

 Principles of Accounting

interested groups like, individuals, managers, investors, creditors, government, regulatory agencies,
taxation authorities, employee, trade unions, consumers and general public. Depending upon purpose
and method, accounting can be broadly three types; financial accounting, cost accounting and
management accounting. Financial accounting is primarily concerned with the preparation of financial
statements. It is used on certain well-defined concepts and conventions and helps in framing broad
financial policies. However, it suffers from certain limitations.

Instructor: Farhan Bajwa