What is accounting? Importance of accounting.

Ans - What is Accounting

Accounting plays an important role in assisting all forms of economic activity in the various
sectors. Accounting is nothing but the language of business which is helpful in business
decisions. Without accounting, Business owners or managers would not know which
products were successful and which decisions were the right ones. With the help of an
accountant, they would get an idea of how much to pay in taxes, capital required for further
projects, whether to lease or buy an asset and so on. Accounting also helps investors to
understand how efficiently their capital or economic resources are being used.

What is meant by Accounting?

Accountancy is the flow or process of communicating financial transactions about a business
entity. Generally, it is a communication in the form of financial statements like Balance
sheets, income statements, cash flow, etc. also, we can say that it is an information system
that identifies, measures, and communicates the economic/business information of an entity
to its users who need the information for decision making. Accounting identifies financial
transactions and business events of a specific entity.

Definition of Accounting
“Accounting is the process of systematically recording, measuring, analyzing and
communicating information about business/financial transactions of an entity.”

According to the American Institute of Certified Public Accountants (AICPA) –

“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 financial character, and
interpreting the results thereof.”

Objective of Accounting
Following are the main objectives of Accounting.

 To keeping a systematic record of financial transactions.

 To determine the results of the operation/Production.
 To interpret the liquidity position.
 To facilitate business decision-making.
 To comply with requirements of law.

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Users of Accounting Information
Following are the users of accounting information:

 Business Owners
 Management
 Employees
  Creditors
 Government
 Investors
 Clients

Methods of accounting transaction

Business transactions are recorded in two different methods:

1. Single Entry Method

2. Double Entry

1. Single Entry Method:

It is an incomplete system of recording business transactions. In this entry method, the

business organization maintains only cash books and personal accounts of debtors and
creditors.

2. Double Entry Method:

It this method, every business transaction is having two effects with equal debits and credits.

Types of Accounts
There are mainly two types of accounts

1. Personal Account
2. Impersonal Account

1-Personal Accounts:

Accounts recording transactions with a person or group of persons are known as personal
accounts. Personal accounts are of the following types.

a) Natural person Account- An account recording transactions with an individual human

being is called as a natural person’s account. E.g. John account.

b) Artificial or legal persons Account- An account recording financial transactions with an

artificial person created by law or otherwise is called as an artificial person Account.

E.g. Cooperative society account.

2- Impersonal Account:

Accounts which are not personal are impersonal accounts. It can be divided into two parts.

1-Real Accounts-
Accounts relating to properties or assets are known as ‘Real Accounts’, a separate account is
maintained for each asset.

Real accounts can be further classified into

1. Tangible- These accounts represent assets and properties which can be seen, touched,
measured, purchased, and sold. E.g. Machinery account, Furniture account.
2. Intangible- These accounts represent assets and properties which cannot be seen,
touched, or felt, but they can be measured in terms of money. e.g., Goodwill accounts,
patents accounts.

2- Nominal Accounts

Accounts relating to income, revenue, gain expenses and losses are termed as nominal
accounts.

E.g. salary account.

Golden Rules of Accounting

1.Personal accounts

First Golden Rule for Personal Account

Dr- The Receiver

Cr-The Giver

2. Real Accounts

Second Golden Rule for Real Account-

Dr- What Comes in

Cr- What Goes out

3. Nominal Accounts

Third Golden Rule for Real Account-

Dr- All expenses and losses

Cr- all incomes and gains

Branches of Accounting
Following are the branches of accounting:

i) Financial accounting;

ii) Cost accounting; and

iii) Management accounting

i) Financial accounting:

Financial Accounting is mainly concerned with the preparation of financial statements for the
use of Investors or others like creditors, investors, and financial institutions. The financial
statements i.e., balance sheet, Income Statement, Cash Flow statement.

ii) Cost Accounting:

Cost accounting seeks to determine the cost of units produced and sold or the services
rendered by the business unit with a view to control cost and increasing the profitability and
efficiency of an entity. It generally relates estimation of future costs to be incurred.

iii) Management Accounting:

Management accounting is the presentation of accounting information is such a way as to

assist management for decisions making.

Methods of Accounting
There are two types of accounting methods-

1. Cash basis accounting

2. Accrual basis accounting

This accounting method states how the company’s transactions are recorded in the company’s
financial books

1. Cash basis accounting-

When cash is received for the sale of goods or services, a deposit is made, no matter when the
sale was made. In this method, Revenues or sales are recorded when they are actually
received and vice versa.in this method, entry of receivables are not made. Also, entry
accounts payable are not made.

2. Accrual basis accounting-

This accounting method matches sales to the time frame in which they are earned and
matches expenses to the time period in which they are incurred. This accounting method
allows you to track Account receivables and Account payables.

3. Where is accounting used ?

Accounting plays important role for correct and satisfied operating of any
organization. As a matter of fact, the development of any business is only possible, if
we record all business transactions with correct method and analyze them. There are
following main uses of Accounting:-

1. Avoidance of the limitation of memorizing power:-

Businessman can not remember all business transactions due to the limitation of
human memory. Accounting is helpful for recording all business transaction and when
businessman checks the record, he can easily remember it and use it for his business
purposes.

2. Compliance of Statutory provisions:-

From accounting point of view, recording of business transaction is compulsory.
Hereby, accounting helps to fulfill all statutory provisions. In India, it is compulsory
to record of all cash, bank and purchase and sale transaction for joint stock
companies.

3. Ascertainment of profit and loss of the business:-

Any business concern is established for the motive of earning profit. Net profit or loss
is pure result of business. For correct calculation of business profit, it is necessary to
record correctly by adopting the principles of accounting.
4. Ascertainment of financial position of the business:-

At specific date, company finds the knowledge of his assets and liabilities from
financial statement. Assets means all sources of business and liabilities means all
payable amounts of business. Business can calculate correct financial position, if
businessman records all assets and liabilities in accounting.

5. Assessment of Tax:-
 Nowadays, a businessman has to pay many taxes. For example income tax, sale tax,
property tax , excise duty , import duty and custom duty etc. Its correct estimation is
only possible, if businessman record correctly all his income, production and sale with
the help of accounting. If businessman does not keep his record properly, then
Assessing officer calculates amount of tax with his own estimation.

6. Knowledge of Debtors and Creditors:-

With accounting, businessman can easily find what amount is due from his debtors
and what amount is payable to his creditors. If he maintains the accounting records
properly.

7. Determination of sale price of business:-

If businessman wants to sell his active business to other party , then the total sale
value of business can easily determine, if businessman records all investments in
business.

8. Evidence in the court of law:-

If any disputes are presented between two parties in court. Then books
of accounts can show as proofs, court accepts these records as evidence of transaction.

9. Assistance in taking managerial decisions:-

Accounting is helpful for many managerial decisions like calculation the price of
goods and services , calculating the product mix and sale mix , purchase decisions ,
different uses of plants , determination of the productivity of different sources of
productions , continue or close of business decisions , replacement of machinery
decisions , decision regarding accepting of any specific order , decision regarding
tenders etc.

10. Development of nation :-

Nation can also develop with the help of accounting, if all the businessman records
correctly. With this, the can not save black money and with huge amount of tax, Govt.
can utilize these funds for development programmes of nation. After this development
of nation is possible. Read also the Accounting facts of other countries

4. Difference between Book keeping and Accounting.

Bookkeeping Accounting

Definition

Bookkeeping deals with identifying and Accounting refers to the process of summarising, interpreting
recording financial transactions only and communicating the financial data of an organisation.

Decision making

Data provided by bookkeeping is not Management can take important decisions based on the data
sufficient for decision making obtained from accounting

Preparation of Financial Statement

Not done in the case of bookkeeping Financial statements are a part of the accounting process

Analysis

No analysis is required in the Accounting analyses the data and creates insights for the
bookkeeping business

Persons Involved

The person concerned with bookkeeping The person concerned with accounting is known as an
is known as a bookkeeper accountant

Determining Financial Position

Bookkeeping does not show the financial Accounting helps in showing a clear picture of the financial
position of a business position of a business

Level of Learning

No high-level learning required High-level learning required for understanding and analysing
accounting concepts

5. Principles of Accounting
Ans Accounting Principles 1. Accounting Entity or Business Entity Principle:
Business is treated as a separate entity distinct from its owners.
2. Money Measurement Principle: Transactions and events that can be expressed in,
money or in money terms are recorded in the books of account.
3. Accounting Period Principle: Life of an enterprise is divided into time intervals
which are known as accounting periods, at the end of which an income statement and
position statement are prepared to show the performance and financial position.
4. Full Disclosure Principle: According to this convention, financial statements
should be prepared and to that end, full disclosure of all significant information
should be made.
5. Materiality Principle: Items or events having a significant effect should be
disclosed.
6. Prudence or Conservatism Principle: Do not anticipate profits but provide for all
possible losses.
7. Cost Concept or Historical Cost Principle: The underlying principle of cost concept
is that the asset be recorded at its cost price, which is the cost of acquisition less
depreciation.
 8. Matching Concept or Matching Principle: Cost incurred during a particular period
should be set out against the revenue of that period to ascertain profits.
9. Dual Aspect Concept or Duality Principle: Every transaction has two aspects: one
aspect of a transaction is debited while the other is credited.
10. Revenue Recognition Concept: Revenue is recognised in the period in which it is
earned irrespective of the fact whether it is received or not during that period.
11. Verifiable Objective Concept: There must be objective evidence of transactions
which are capable of verification.

6. Difference between Cost accounting and financial accounting

Ans -

BASIS FOR
COST ACCOUNTING FINANCIAL ACCOUNTING
COMPARISON

Meaning Cost Accounting is an accounting Financial Accounting is an

system, through which an
organization keeps the track of
various costs incurred in the
business in production activities.
accounting system that captures the
records of financial information
about the business to show the
correct financial position of the
company at a particular date.

Information type Records the information related to Records the information which are in
material, labor and overhead, monetary terms.
which are used in the production
process.

Which type of cost Both historical and pre- Only historical cost.
is used for determined cost
recording?

Users Information provided by the cost Users of information provided by the

accounting is used only by the
internal management of the
organization like employees,
directors, managers, supervisors
etc.
financial accounting are internal and
external parties like creditors,
shareholders, customers etc.

Valuation of Stock At cost Cost or Net Realizable Value,

whichever is less.

Mandatory No, except for manufacturing Yes for all firms.

 BASIS FOR
COST ACCOUNTING FINANCIAL ACCOUNTING
COMPARISON

firms it is mandatory.

Time of Reporting Details provided by cost Financial statements are reported at

accounting are frequently the end of the accounting period,
prepared and reported to the which is normally 1 year.
management.

Profit Analysis Generally, the profit is analyzed Income, expenditure and profit are
for a particular product, job, batch analyzed together for a particular
or process. period of the whole entity.

Purpose Reducing and controlling costs. Keeping complete record of the

financial transactions.

Forecasting Forecasting is possible through Forecasting is not at all possible.

budgeting techniques.

Assets and Liabilities

The term ‘asset’ signifies all kinds of resources that help generate revenue as well as
receivables. Assets are resources which often help to reduce expenses, enhance profitability
and generate robust cash flow as they help convert raw materials or can be converted into
cash or cash equivalents. Further, being of economic value, they can be quickly sold or
exchanged. Notably, such resources are reported on the left side of the Balance Sheet that is
maintained by any entity involved in commercial practice
Generally, the sum of total liabilities and equities owned helps compute the value of assets.
Consequently, it can be said Formula: Total assets = Liabilities (accounts payable) + Owner’s
equity
The term liability signifies all types of account payables. It can further be defined as a
financial obligation that individuals must meet. Usually, the liabilities tend to play a
significant role when it comes to financing expansion or ensuring smooth processing of
everyday operations of commercial practices.
Further, depending on the type of a company, such liabilities can either be limited or
unlimited. In the case of the former, owners are not entirely obligated to compensate or pay
off for the venture’s liability, whereas in the latter, the resulting liability is solely the
responsibility of the owners. The obligations of a commercial entity are reported on the right
side of the Balance Sheet.
The difference between total assets and owner’s equity helps compute the value of existing
liabilities. The same can be expressed as Total liabilities = Assets (accounts receivable) –
Owner’s equity.
Types of Assets
1. Current assets or short term assets
These types of assets can be readily converted into cash or its equivalent resources
typically within a year and are known as liquid assets. For example, cash equivalents,
stock, marketable securities and short-term deposits are some of the most common
current assets.
2. Fixed assets or long-term assets- Also known as hard assets and fixed assets, these
resources are not easy to convert into cash or its equivalent kind. Generally, land,
machinery, equipment, building, patents, trademarks, etc. are considered as fixed
assets.
3. Tangible Assets -Similarly, assets with a physical existence are categorised as
tangible assets. Resources like stock, land, building, office supplies, equipment,
machinery and marketable securities, among others are functioning examples of
tangible assets.
4. Intangible assets- On the contrary, assets which do not possess a physical existence
come under the category of intangible assets. The best examples of such assets would
be market goodwill, corporate intellectual property, patents, copyrights, permits, trade
secrets, brand, etc.
5. Operating assets- Assets like cash, building, machinery, equipment, copyright,
goodwill, stock, etc. are termed as operating assets. Typically, such assets are used to
generate revenue and to maintain daily operation.
6. Non- Operating assets- Though these assets are not used for performing daily
operations, they tend to help generate significant revenue. Some of the best examples
of non-operating assets are short-term investments, vacant land, income generated
through fixed deposits etc

Liabilities
1. Current Liabilities- Mostly, the account payables under this category are short-
term in nature, which are to be meted out within a year. Payables like bills, trade
creditors, bank overdrafts and outstanding bills among others are examples of
current liabilities
2. Non current liabilities- Also, known as fixed liabilities, these payables comprise
long-term obligations that are generally not accounted for in a year. Usually, these
types of liabilities are used for expansion purposes or for purchasing fixed assets.
Debentures, long-term loans, bonds payable, etc. are among the common
examples of non-current liabilities.
3. Contigent Liabilities- These are usually the types of obligations which may or
may not occur for a commercial entity in the course of its operation. Guarantee for
loans, claim against product warranty and lawsuits are examples of contingent
liability. Business ventures are required to provide an estimate of contingent
liabilities as a footnote on their respective balance sheet.

7. What are Debtors and Creditors.

Debtor and Creditor Definitions

A creditor is an entity or person that lends money or extends credit to another party. A
debtor is an entity or person that owes money to another party. Thus, there is a creditor
and a debtor in every lending arrangement. The relationship between a debtor and a
creditor is crucial to the extension of credit between parties and the related transfer of
assets and settlement of liabilities. The actions of the creditor are somewhat different
when it is lending money, versus when it is extending credit.

The Distinction Between a Debtor and a Creditor

The key differences between a debtor and creditor are as follows:

 Lending money. The creditor frequently demands collateral and/or a personal

guarantee, as well as loan covenants, from the debtor. This is because the amount
of loaned funds can be quite large, so the creditor is at considerable risk of loss
over a potentially lengthy period of time. An entity that lends money is likely to
be in business solely for this purpose.

 Extending credit. The creditor is extending a relatively small amount of credit to a

debtor for a short period of time, and so is more concerned with the size of the
credit line granted and payment terms than the need for collateral or personal
guarantees. Covenants are unheard of when granting trade credit. An entity that
extends credit is in the business of selling goods or services, and only engages in
the extension of credit as an ancillary function. It may be necessary to extend
credit simply to be competitive in the marketplace.

8. What is Capital Expenditure

Capital expenditures refer to funds that are used by a company for the purchase,
improvement, or maintenance of long-term assets to improve the efficiency or
capacity of the company. Long-term assets are usually physical, fixed and non-
consumable assets such as property, equipment, or infrastructure, and that have a
useful life of more than one accounting period.
Also known as CapEx or capital expenses, capital expenditures include the purchase
of items such as new equipment, machinery, land, plant, buildings or warehouses,
furniture and fixtures, business vehicles, software, or intangible assets such as a patent
or license.
The expenditure amounts for an accounting period are disclosed in the cash flow
statement. Capital expenditures normally have a substantial effect on the short-term
and long-term financial standing of an organization. Therefore, making wise CapEx
 decisions is of critical importance to the financial health of a company. Many
companies usually try to maintain the levels of their historical capital expenditure to
show investors that the managers of the company are continuing to invest in the
growth of the business.

9. What is Goodwill?

Ans What is Goodwill?

Goodwill is an intangible asset associated with the purchase of one company by another.
Specifically, goodwill is recorded in a situation in which the purchase price is higher than the
sum of the fair value of all visible solid assets and intangible assets purchased in the
acquisition and the liabilities assumed in the process. The value of a company’s brand name,
solid customer base, good customer relations, good employee relations, and any patents or
proprietary technology represent some examples of goodwill.

Goodwill Meaning in Accounting

Goodwill arises when a company acquires another entire business. The amount of goodwill is
the cost to purchase the business minus the fair market value of the tangible assets, the
intangible assets that can be identified, and the liabilities obtained in the purchase.

How to Calculate Goodwill

To calculate goodwill, we should take the purchase price of a company and subtract the fair
market value of identifiable assets and liabilities.
Goodwill Formula:
Goodwill = P−(A+L)
where,
P = Purchase price of the target company
A = Fair market value of assets
L = Fair market value of liabilities

Types of Goodwill
There are two distinct types:

 Purchased: Purchased goodwill is the difference between the value paid for an
enterprise as a going concern and the sum of its assets less the sum of its liabilities,
each item of which has been separately identified and valued.
 Inherent: It is the value of the business in excess of the fair value of its separable net
assets. It is referred to as internally generated goodwill, and it arises over a period of
time due to the good reputation of a business. It can also be called as self-generated or
non-purchased goodwill.
For example, suppose you are selling an outstanding product or providing excellent service
consistently. In that case, there is a high chance of an increase in goodwill.

10. What is profit and loss

The term profit and loss (P&L) statement refers to a financial statement that
summarizes the revenues, costs, and expenses incurred during a specified period,
usually a quarter or fiscal year. These records provide information about a company's
ability or inability to generate profit by increasing revenue, reducing costs, or both.
P&L statements are often presented on a cash or accrual basis. Company managers
and investors use P&L statements to analyze the financial health of a company.

11. What is loss operating and non operating profit

A company’s income can be classified into two categories: operating and non-
operating. Operating income is also known as earnings before interest and taxes
(EBIT). It is the income generated through the company’s core business operations. It
shows the company’s performance on its recurring day-to-day operations.
Non-operating income includes the gains and losses (expenses) generated by other
activities or factors unrelated to its core business operations.

12. What is Management Accounting?

Management accounting also is known as managerial accounting and can be defined as a
process of providing financial information and resources to the managers in decision
making. Management accounting is only used by the internal team of the organization,
and this is the only thing which makes it different from financial accounting. In this
process, financial information and reports such as invoice, financial balance statement is
shared by finance administration with the management team of the company. Objective
of management accounting is to use this statistical data and take a better and accurate
decision, controlling the enterprise, business activities, and development.
Financial accounting is the recording and presentation of information for the benefit of
the various stakeholders of an organization. Management accounting, on the other hand,
is the presentation of financial data and business activities for the internal management
of the organization. In this article, we will learn what is management accounting and its
functions