MBA Chp-1 - Introduction To Accounting

Learning Outcomes
After studying this Chapter, you shall be able to:

 Know the meaning and need of Accounting.
 Learn the fundamentals of Accounting
 Identify the users of Accounting
 Evaluate the Qualitative Characteristics of Accounting.
 Know the different branches of Accounting.
1.1 INTRODUCTION
Every business performs different kinds of economic activities. These are undertaken
through transactions and events. The transactions may be related with purchase of goods for
the purpose of sale, expenses on value addition, payment of other expenses like rent,
salaries, purchase of machinery, etc. All these transactions are spread over the accounting
period and are very large in number. Due to this nature of transactions in terms of its
volume and meticulousness, it is necessary to develop a system of its timely record keeping.
It is neither possible nor feasible to depend upon human memory. Therefore, In order to
perform this function reliably, it is inevitable to record all the transactions in a systematic
and methodical manner. These recoded transactions are then classified and ultimately
summarized in the form of documents called as financial statements. Therefore, each and
every organization desires to keep records of all transactions and events in order to measure
their own performance and effectiveness of operations in the form of profit (loss) earned
(suffered) during the period. This also facilitates providing adequate information to all
interested parties.
To serve the purpose of measurement of economic activities, the accounting discipline has
been developed. This discipline considers inflow and outflow of economic resources. It also
helps in decision making process. The development of the business world and its changing
structure in terms of scope, area, operations, size, composition, etc. has a close
relationship with the growth of accounting as a discipline. The accounting aims to measure
the economic activities to meet the information needs of interested parties for rational and
sound decision making. That is why; Accounting is called as language of business.
ACCOUNTING AS A LANGUAGE:
Language is the medium to exchange ideas. In fact whenever any information need to be
communicated by one person or party to another person or party, then language is required.
Accounting is also a language of business, as with the help of Accounting, a business entity
communicates not only to internal parties but also to the external world. Such
Basic Accounting for Non-Commerce students(GMC) CA. (Dr.) K. M. Bansal & Dr. Ritu Gupta
Chapter 1 2 Introduction to Accounting
communication may be regarding its profitability, solvency, liquidity, etc. Like any other
language, accounting also has certain rules and principles. The double accounting book-
keeping system moves around the rules of debit and credit.
According to Anthony and Reece,” Accounting resembles a language in that some of its
rules are definite whereas others are not. Accountants differ as to how a given event should
be reported, just as grammarians differ as to the many matters of sentence structure,
punctuation and choice of words. Nevertheless, just as many practices are clearly poor
English (Language), many practices are definitely are poor accounting. Languages evolve and
change in response to the changing needs of society, and so does accounting.”
1.2 DEFINITION OF ACCOUNTING

Every economic entity has its own financial information which is required to be measured,
processed and definitely to be disseminated. Accounting provides tools to achieve such
objective. Accounting is a service activity which provides an information system where
transactions and events are the basic inputs, and through a systematic process they are
finally converted into financial statements. The importance of accounting can be understood
from the fact that every entity has a separate department which handles this work, called
as accounts department.
Definitions
The traditional definition of Accounting has been provided in 1941 by The American Institute
of Certified Public Accountants (AICPA) which is as follows:
“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 results thereof.”
As per this definition, the following are the main clauses:

(a) Accounting is an art.
(b) The major aspects are recording, classifying and summarizing.
(c) The transactions and events are measured in terms of money.
(d) The results are also interpreted.
The above definition clearly indicates the procedural aspects of accounting. The procedure
starts with the identification of those transactions and events which are of financial
character and can be expressed in terms of money. These are then recorded in the primary
books of account in the form of journal entries (or subsidiary books) followed by methodical
classification into ledgers in principal books. The transactions are ultimately summarized in
the form of final accounts. Inspite of all these features, this definition lacks the modern
aspects of accounting i.e. communication of results.
Another important definition was given by American Accounting Association in 1966. They
have defined accounting a process of identifying, measuring and communicating economic
information to permit informed judgments and decisions by the users of information. But
this definition is too general as there may be much economic information which may not be
directly related with accounting. For example, if a comparative study is made about
productivity of two pieces of land, then definitely it is economic information but not
accounting information.
In 1970, APB (Accounting Principle Board) of AICPA defined accounting as:

“Accounting is a service activity. Its main function is to provide quantitative information,
primarily financial in nature, about economic entities that is intended to be useful in
making economic decisions.”
According to Smith and Ashburne, “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”.
1.3 ACCOUNTING AND ACCOUNTANCY
Although terms ‘Accountancy’ and ‘Accounting’ are often considered as synonymous but are
fundamentally different. The ‘Accountancy’ term is much wider than the term ‘Accounting’.
‘Accountancy’ is a profession whereas ‘Accounting’ is the methodology.
According to F.W. Pixley, “Accountancy is the science which deals with recording of
monetary transactions of every description”.
According to Eric L. Kohler “Accountancy is the theory and practice of accounting: its
responsibilities, standards, conventions and activities.”
Accountancy also tells us the methods, procedures and ways how to communicate with the
interested parties. Thus the term ‘Accountancy’ refers to a systematic knowledge of
accounting with the principles and techniques of application in accounting. It provides rules,
principles methods, concepts and conventions for recording, classifying and summarizing of
financial transactions and accounting information in a systematic manner.
Accounting is based on the rules, principles and technique of application formulated by the
subject, accountancy.
Accountancy is the tree which contains whole work of accounting, managing and auditing. It
is clear that accounting is only a branch of Accountancy.
1.4 HISTORY OF ACCOUNTING

Accounting has a rich heritage. The early development of accounting began thousands of
years ago and can be traced to ancient civilizations mainly Babylonia and Egypt around 4000
B.C. They recorded transaction of payment of wages and taxes on clay tablets. Babylonia,
also known as the city of Commerce, used accounting for business to detect frauds,
inefficiencies and also to trace losses taking place due to theft or otherwise.
The Romans (700 B.C. to 400 A.D.) started preparing memorandum or day book where
receipts and payments were recorded and posted to ledgers on monthly basis.
In India, the accounting could be traced back to a period when 23 centuries ago, Kautilya, a
minister in Chandragupta’s kingdom wrote a book named Arthashastra, which also described
the method of maintaining accounts.
In 1494, an Italian mathematician Luca Fra Pacioli wrote a book ‘Summa de Arihmetica,
Geometria, Proportion at Proportionality’ (Review of Arithmetic and Geometric
proportions). A portion of this book contained the knowledge of business and book-keeping
for the first time. He used the words Debito (Owned to) and Credito (Owned by) to record
business transactions. These words came from Latin words debeo and credo. The terms
debit and credit used today have its origin from debito and credito. Pacioli explained the
double entry system stating that if one made creditor, someone else should be made debtor.
He is honored as the Father of Accounting. He suggested three books:
(i) Memorandum or Day Book wherein all transactions are to be entered chronologically
with explanation.
(ii) Journal to record all such transactions from memorandum using debito and credito
and measuring in terms of money.
(iii) Ledger to post all journal entries.
Did You Know INTERNATIONAL ACCOUNTING DAY & CHARTERED ACCOUNTANTS’ DAY
International Accounting Day :
It is celebrated on 10th November. At international level, this is the professional holiday of all
accountants. At this date in 1494, the book titled Summa de Arithmetica, Geometria;
Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion) was
published in Venice.
Chartered Accountants’ Day:
The Institute of Chartered Accountants of India (ICAI) is the national professional accounting
body of India. It was established on 1 July 1949 as a body corporate under the Chartered
Accountant Act, 1949 enacted by the Parliament to regulate the profession of Chartered
Accountancy in India. ICAI is the second largest professional accounting body in the world in
terms of membership, after American Institute of Certified Public Accountants (AICPA). ICAI
celebrates its Foundation Day as the Chartered Accountants’ Day on 1st July every year.
1.5 OBJECTIVES OF ACCOUNTING
The word objective means something that is intended to be achieved through one’s efforts
or actions. According to Statements of Financial Accounting Concepts No. 1 issued by FASB
(The Financial Accounting Standards Boards), the objective of accounting is to provide
information that is useful for making business and economic decisions. Specifically, the
information should be useful to investors and lenders, be helpful in determining a
company's cash flows, and report the company's assets, liabilities, and owner's equity and
the changes in them.
According to International Financial Reporting Standards, the objective of financial

reporting is: “To provide financial information about the reporting entity that is useful to
existing and potential investors, lenders and other creditors in making decisions about
providing resources to the entity.”
It is quite clear that the objective of accounting is much more than mere recording only.
These may be summarized as follows:
1. Systematic Recording of Transactions: The basic objective of accounting is to record
those business transactions which can be expressed in terms of money. Unless this
recording is made systematically, classification and summarization cannot be done at
all.
2. To find out results of operations: The preparation of income statement may also be
taken as one of the objective of accounting. The accounting helps in knowing the
financial performance of the entity during a particular period.
3. To depict the financial position: The ascertainment of financial position of the
business is served by the accounting through the preparation of Balance sheet. The
stakeholders are not only interested in knowing the results of the enterprise but are
also interested to know the status of assets and liabilities as on a particular point of
time.
4. Providing information to users: Accounting as a language communicates the financial
information of an entity to the interested parties. In fact, Accounting is intended to
meet the information needs of the decision makers so that they are able to make
rational decision.
1.6 PROCEDURAL ASPECTS OF ACCOUNTING
On the basis of various definitions of Accounting, it emerges that the whole process of
Accounting passes through the following six stages. These are also called as the procedural
aspects of accounting.
Procedure of Accounting
Recording
Classifying
Summarising
Analysing
Interpreting
Communicating
1. Recording
On the basis of source documents like sales bill, purchases invoice, pass book, etc. the
business transactions are recorded. The special book which is used to record the
transactions is called as journal. As per American system of accounting, this journal book
may be subdivided into eight different books called as subsidiary books. These are Cash
Book, Purchases Book, Sales Book, Purchases Return Book, Sales Return Book, Bills
Receivable Book, Bills Payable Book and Journal Book. It is important to note that Recording
is called as basic function of accounting.
2. Classifying
After recording there is a need to group the entries of similar nature at one place. For
example there may be monthly entries for payment of salaries. Now at the end of the year,
we require the total amount paid towards salaries for the year. One method could be to
scroll the journal and just search the related entries and then take their total. But it is
unsystematic and cumbersome process and cannot be applied for all heads. Moreover there
are fair chances of making errors. Alternatively, if we take the help of ledger then the same
work may be done methodically in efficient and error free manner. This second phase of
accounting is concerned with the systematic analysis of the recorded data. This book which
contains classified information is called as Ledger. The process of transferring a transaction
from journal to ledger is called as Posting. The ledger book is divided into serially numbered
pages. Each page is technically called as folio. It may be noted that like journal, ledger may
also be subdivided into Debtor’s Ledger, Creditor’s Ledger and General Ledger.
3. Summarizing
At the end of the period, there is a need to find out the ultimate result of current year’s
business operations and also to disclose the financial position. The Financial performance is
determined by Income Statement and financial position is reflected by Balance Sheet. It is
clear that summarizing is concerned with the preparation and presentation of the classified
data. Infact after balancing of accounts, a statement is prepared to show the net balances
of all the ledger accounts called as trial balance. Trial balance provides basis for the
preparation of Final accounts.
4. Analyzing
Analysis refers to the methodical classification of the data provided by the financial
statements. It is concerned with establishment of relationship between the various items of
income statement or balance sheet. For example when we calculate the ratio of current
assets and current liabilities i.e. current ratio, then it is a subject matter of analyzing. It
provides basis for interpretation.
5. Interpretation
Interpretation is related with explaining the meaning and significance of relationship

established by analysis of accounting data. For example analysis shows what the current
ratio is. But what this ratio indicates can be known by its interpretation only. Like if it is
2.5:1 then it reflects good short term solvency position of the entity. This information is
important for the suppliers in deciding whether the goods to be sold to the entity on credit.
6. Communication
The oldest form of accounting was basically to discharge stewardship function. The wealthy
men used to employ stewards to manage their personal property. But with the advent of
twenty first century, the form and nature of accounting have tremendously changed. Now it
is more of reporting than accounting. It can be seen that now accounting standards have
also been changed to financial reporting standards. The communication aspect of accounting
is concerned with the transmission of summarized, analyzed and interpreted information.
1.7 ACCOUNTING AS AN INFORMATION SYSTEM
System: Any system comprises of a set of connected things or parts that work together in an
integrated manner to achieve specific goals. The organized body of things, material or immaterial,
together constitutes a system. System performs various functions. It is always specific. Let us take
an example of human digestive system. The whole process of digestion involves the breakdown of
food into smaller and smaller parts until they are absorbed and assimilated into the body. It
operates through many stages. Since it is a set of interconnected activities odf digestive organs
with specific role of each part, it is a system and because it is related with human digestion, it may
be called as human digestive system.
Information System: The Britannica Encyclopedia has defined Information system as, “An
integrated set of components for collecting, storing, and processing data and for
providing information, knowledge, and digital products.” The information system has its utility for
every business firm. The information system actually helps to organize, perform and manage their
operations.
Accounting Information System: As per definition given by Investopedia, “An accounting
information system (AIS) is a structure that a business uses to collect, store, manage, process,
retrieve and report its financial data so that it can be used by accountants, consultants, business
analysts, managers, chief financial officers (CFOs), auditors and regulatory and tax agencies.” The
Accounting Information System has been defined by Wikipedia in the same manner as a system of
collecting, storing and processing financial and accounting data that are used by decision makers.
As already discussed in para 1.6, initially the financial information is gathered followed by
identification of monetary and non-monetary. All transactions and events which are of financial
nature and can be expressed in terms of money are then recorded, classified and summarized. The
summarized, analysed and interpreted information is then communicated to interested parties. It is
clear that with the help of accounting, the financial transactions are ultimately converted into
financial statements. Now if we compare accounting with a system, then it can be said that
financial information is the input, recording, classifying, summarizing, etc. are processing part and
prepared financial statements are the output. That is why accounting may be regarded as
information system. The following figure depicts accounting as information system.
Accounting Information System
INPUT PROCESSING OUTPUT

[Accounting Cycle]
Business  Recording  Income

Transactions
 Classification Statement
and Events,
 Summarization  Balance Sheet
in financial
terms [Preparing  Cash Flow
financial Statement
statements]
It is important to note that when we prepare the financial statement, it is a part of processing or
accounting cycle. But at the same time, after preparation these financial statements become
output also. This final output is communicated to the users both internal and external. It is clear
that communication is a part of output.
1.8 BOOK - KEEPING

As per J. R. Batliboi, “Book-keeping is an art of recording business transactions in a set of
books.” The procedural stages of accounting up to the preparation of trial balance are
covered under book-keeping. Book-keeping is an activity concerned with the recording of
financial data in a significant and orderly manner. The main responsibility of a book keeper
is limited up to recording. A substantial portion of the book-keeping work is of a clerical
nature.
Only transactions expressed in terms of money are recorded in the books. It is a continuity
activity, the recording being done in chronological order.
Book keeping is the basis of Accounting. Today many pre-packaged accounting packages are
available which performs the functions of book keeping and accounting also.
DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

The terms book-keeping and accounting are not synonymous. But, they are related to each
other. Book-keeping is a primary stage whereas accounting is secondary stage. Accounting
starts where book-keeping ends and auditing starts where accounting ends. The following
are the points of differences between the two:
Book-Keeping Accounting
1. It includes recording, classifying and It is related with summarizing of
preparation of Trial Balance. recorded transactions.
2. Financial statements do not form part Financial Statements form part of
of Book-keeping. Accounting.
3. There is no sub-field of book-keeping. There are many sun-fields of accounting
like financial accounting, management
accounting, cost accounting, etc.
4. It provides basis to accounting. It provides summarized information to

the users of financial information.
Therefore, it is treated as language of
accounting.
5. It does not reflect financial position. Accounting reflects the financial
position.
1.9 SUB-FIELDS OF ACCOUNTING
Unlike book-keeping, accounting has many sub-fields which are as follows:
Financial Accounting
It is commonly known as Accounting. It is historical in nature with main focus on recording

and classifying monetary transactions and preparations of financial statements. This branch
or sub-field is concerned with the recording, classifying and summarizing the business
transactions, primarily of financial nature. It basically helps in determination of the net
results of financial performance for an accounting period and the financial position at the
end of the year. The two important documents/ reports by financial accounting are income
statement (Profit and Loss Account) and positional statement (Balance sheet). These are
prepared for the period which is already complete. It means the financial statements for
year 2015-2016 shall be prepared after 31-3-2016. These are usually prepared on annual
basis, which may be calendar year, financial year or otherwise. However, Companies Act,
2013 has made it compulsory for the joint stock companies to follow financial year i.e. from
1st April to the following 31st March as their accounting year. The final accounts is different
from financial statements.
AS PER SECTION 2(40) OF COMPANIES ACT, 2013

Financial Statement in relation to a company, includes –
(i) A Balance Sheet
(ii) A Profit and Loss Account
(iii) Cash Flow Statement
(iv) Statement of Changes in Equity
(v) Any explanatory note annexed to or forming part of any of the above documents.
Cost Accounting
According to the Institute of Cost and Management Accountants of England, “Cost

accounting is the process of accounting for cost which begins with the recording of income
and expenditure or the basis on which they are calculated and ends with the preparation of
periodical statements and reports for ascertaining and controlling costs.”
The Chartered Institute of Management Accountants (CIMA) has defined Cost Accounting as,”
The process of accounting for cost from the point at which expenditure is incurred or
committed to establishment of its ultimate relationship with cost centres and cost units. In
its widest usage, it embraces the preparations of statistical data, the application of cost
control methods and the ascertainment of the profitability of activities carried or

planned.”
Cost accounting is frequently used to facilitate internal decision making and provides tools
with which management can appraise performance and control costs of doing business. The
cost is identified with products and services up to the last possible level. Cost accounting
includes cost ascertainment, cost control and cost reduction.
COST ACCOUNTING IS DIFFERENT FROM COST ACCOUNTANCY

As per CIMA, England, Cost Accountancy is the application of Costing and Cost Accounting
principles, methods and techniques to the science, art and practice of cost and the
ascertainment of profitability. It includes the presentation of information derived therefrom for
the purpose of management decision making.
Management Accounting
The Management Accounting emerged as a sub-field of accounting in the 20th century. As

already stated the financial accounting was mainly concerned with the recording and
analyzing the financial transactions. But there was a need for specific information designed
to help management so as to take managerial decisions. Management Accounting has shifted
this focus of accounting.
According to the Institute of Management Accountants (IMA): "Management accounting is a

profession that involves partnering in management decision making, devising planning and
performance management systems, and providing expertise in financial reporting and
control to assist management in the formulation and implementation of an organization's
strategy".
According to the Chartered Institute of Management Accountants (CIMA), “Management

accounting is the process of identification, measurement, accumulation, analysis,
preparation, interpretation and communication of information used by management to plan,
evaluate and control within an entity and to assure appropriate use of and accountability for
its resources.” Management accounting is concerned with internal reporting.
Social Responsibility Accounting
The basic objective of a business enterprise is profit and wealth maximization. Professor
David Pearce viewed that such wealth maximization policy will not give sustainable
development. In fact, the environment is enormously damaged due to the economic
activities undertaken by the business entities. The increasing social awareness led to the
demand for specialized accounting to meet the requirement of social responsibility
reporting.
As per Howard R. Bowen, “Social responsibility of business means the obligation to pursue
those policies, to make those decisions, or to follow those lines of action which are
desirable in terms of the objectives and values of the society.” Social responsibility
accounting is concerned with accounting for social cost incurred by the enterprise and the
social benefits generated.
SOCIAL COSTS AND SOCIAL BENEFITS

Social Cost includes environmental problems like human beings engaged in hazardous
processes causing damage to their health, worsening ozone layer whole, deforestation,
causing greenhouse effect, soil erosion, growing levels of toxic and radioactive waste. For
example the development of telecommunication devices like mobile phones has caused
extinction of sparrows and small birds.
Social Benefits are reflected by the increase in the welfare of a society that is derived from
the course of action of the business enterprise. For example when a business unit is started,
it opens new avenues in the form of employment generation, improvement in vicinity, better
approach roads, utilization of human resources, etc.
Human Resource Accounting
As per the encyclopedia (Wikipedia), Human resource accounting is the process of

identifying and reporting investments made in the human resources of an organization that
are presently unaccounted for in the conventional accounting practices. It is an extension of
standard accounting principles. Measuring the value of human resources can assist
organizations in accurately documenting their assets. This subfield is related with the
accounting methods, systems, and techniques, which coupled with special knowledge and
ability, assist personnel management in the valuation of personnel in their knowledge,
ability and motivation in the same organization as well as from organization to organization.
It means that some employees become a liability instead of becoming a human resource.
HRA facilitates decision making about the personnel i.e. either to keep or to dispense with
their services or to provide mega-training. There are many limitations that make the
management reluctant to introduce HRA.
As per American Accounting Association, “Human resource accounting is the process of

identifying and measuring data about human resources and communicating this information
to interested parties.”
It aims to identify, quantify and report the investments made by an organization in its
human resources.
1.10 QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

The basic purpose of accounting is to provide information about financial position (Balance
Sheet), performance (Income Statement) and changes in financial position of an enterprise.
This accounting information should provide a clear, true and fair view of the affairs of
enterprise. There are certain qualitative characteristics which must be embodied in
accounting information so as to command respect. These qualitative characteristics are as
follows:
1. Reliability: The users depend upon accounting information to take decisions. This
information at which major decisions are based must be reliable or else the decision can go
wrong. As per SFAC-2 “ Reliability means that the quality of information that assures that
information is reasonably free from error and bias and faithfully represents what it
purports to represent.” So, Reliability requires the information to be true and free from
bias. Another important aspect of reliability is that the information must also be complete.
Half-truth can never be treated as reliable as the decision maker may take wrong decision in
that case. When we consider reliability as a primary decision making specific quality, SFAC-2
has described three basic ingredients as under:
a. Verifiability: The accounting information should be verifiable. It means any person

should be able to check its truthfulness through source documents. Verifiability
means the ability to ensure that method of measurement has been used without
error or bias. It also includes that “should be information” and “actual information”
are same. It means the information represents is what it purported to be
represented.
b. Neutrality: As per SFAC-2, “Neutrality refers to absence in reported information of
bias intended to attain a predetermined result or to induce a particular mode of
behavior.” It implies that an entity should not work backwards in preparation of
financial information. Under Backward approach, firstly, the desired results are pre-
determined and then financial information is moulded and financial statements are
prepared in such a manner so as to show the pre-determined result. This kind of
financial statement cannot be said to be neutral and thus definitely not reliable.
c. Representational Faithfulness: As per SFAC-2, “It refers to Correspondence or
agreement between a measure or description and the phenomenon that it purports
to represent (sometimes called validity)”.
2. Relevance: As per SFAC-2 “ Relevance is the capacity of information to make a difference

in a decision by helping users to form predictions about the outcomes of past, present, and
future events or to confirm or correct prior expectations.” Relevant information is one that
has the ability to influence the economic decision of the user. Information is said to be
relevant when it provides feedback value and predictive value. When we consider relevance
as a primary decision making specific quality, SFAC-2 has described three basic ingredients
as under:
a. Predictive Value: Predictive value is derived from information concerning future
events. It is the quality of information that helps users to increase the likelihood of
correctly forecasting the outcome of past or present events.
b. Feedback Value: Feedback value is derived from information concerning past
events. It is the quality of information that enables users to confirm or correct prior
expectations.
c. Timeliness: The relevant information should also be timely. This means that
information should be available to a decision maker before it loses its capacity to
influence decisions.
3. Understandability: The financial accounting information is useful for owners, investors,
creditors, lenders and other decision makers. That is why, in order to maintain its
usefulness, it should be understandable. It is fairly assumed that the users of information
have knowledge of business accounting and economic activity and they can reasonably
understand the accounting information. However, complex matters that are relevant should
not be avoided, just to make the statements simple and easy to understand. Hence, the
financial information should be complete but should be presented in a simple form to the
maximum extent, it is possible.
Tutorial Note on Understandability

The Understandability is definitely a quality aspect. But this does not mean that financial
information is tailored for everyone. The GAAP requires financial information to be
understandable to a reasonably informed person. It means the set of financial statements
might not be understood by average or uninformed person.
4. Consistency: It is one of the fundamental accounting assumptions. According to Accounting

Standard 1 (Disclosure of Accounting Policies), “The principle of consistency refers to the
practice of using same accounting policies for similar transactions in all accounting periods.
The consistency improves comparability of financial statements through time.” The
comparability improves reliability. The convention of consistency is applied particularly
when alternative methods of accounting are equally acceptable. For example, in applying
the principle 'that fixed asset is depreciated over its useful life', an entity may adopt
Straight Line Method, Written down Value or any other method of depreciation. Consistency
requires that once a method is chosen, the entity would consistently follow the same
method. It is also important to note that consistency is not an excuse to continue with
inappropriate policies.
5. Comparability: The information must be comparable. Users should be able to see

similarities and differences amongst events and conditions. They can compare the
information over a period of time to see how the entity is growing and they may also
compare across different entities in the same industry in order to evaluate their relative
performance and position. A closely held notion with comparability is the concept of
consistency. As information can be comparable over a time period only if it follows the same
accounting concepts and conventions consistently.
ACCOUNTING QUALITIES as per SFAC-2 issued by FASB
In May 1980, FASB has issued Statement of Financial Accounting Concepts No. 2 (SFAC-2) on
Qualitative Characteristics of Accounting Information. As per this statement, the characteristics of
information that make it a desirable commodity can be viewed as a hierarchy of qualities, with
usefulness for decision making of most importance. These are the following:
1. User Specific Quality :
It is understandability
2. Primary Decision-Specific Qualities:
These are Relevance and Reliability. Their ingredients are
(a) For Relevance: Predictive & Feedback Value and Timeliness
(b) For Reliability: Verifiability, Neutrality and Representational Faithfulness
3. Secondary and Interactive Qualities:
These are Comparability and Consistency
1.11 BASES OF ACCOUNTING

The accounting can be done on the following basis:
1. Cash Basis: There are two major items of transactions to be recorded i.e. revenue and
expenditure. Under cash basis of accounting, both are recognised on receipt and payment
basis respectively i.e. revenues are recognised in the period in which cash is received and
expenditures are recognised in the period in which cash is paid. The credit transactions are
totally ignored. So, the profit is the excess of cash receipts and cash payments. The cash
receipts are in respect of sales of goods, rendering of services and other income whereas
the cash payments are for purchase of goods, services, properties and for expenses. It is
clear that in computation of such profit or loss of the enterprise for the accounting period,
the outstanding or prepaid expenses, accrued income and income received in advance are
not considered at all and no adjustments are made for these while calculating profit. For
example if salaries have been paid only for eleven months and are outstanding for one
month, then the actual amount paid for 11 months will be taken into account under cash
basis, while preparing the financial statements. Due to this reason, under cash basis,
outstanding and prepaid items do not appear in accounts.
When we consider cash basis, the total outflow in respect of acquisition of fixed asset is also
treated as an expense in the year of purchase rather than the periods during which the
benefits are expected to be received. So, matching principle is not followed in this system.
The profit calculated by this basis may not reflect the true and fair view of profit or loss.
Even the financial position of the business enterprise is also not depicted truly.
As an improvement to this traditional cash basis system, modified cash basis of accounting
may be used wherein expenditures of revenue nature are recognised on cash basis but the
expenditures in the nature of capital expense, like purchase of fixed assets, are capitalised.
Another improvement may be to consider expenses on due basis and revenues on cash basis.
On the principle of conservatism or prudence this hybrid system of accounting is used by
professionals like doctors, advocates, Chartered Accountants, etc.
2. Accrual Basis:
It is also called as mercantile system of Accounting. Under this system, revenue is
recognised in the period in which it is earned whether the same has actually been received
or not. Similarly expenses are recognised when due or incurred whether they have been
actually paid or not. For example unpaid salaries, rent due to landlord, etc. are also
considered in determination of total expenses. It means the profit or loss for the accounting
period is calculated on the basis of revenue earned and expenses incurred. In case these
items of revenue and expenses have not been received or paid, the adjustment entries are
passed and these are considered as accrued/outstanding income or outstanding expenses.
Similarly if the same have been received or paid for the following period i.e. in advance,
then adjustment entries are required for these unearned incomes or prepaid expenses. It is
also relevant to note that expenditures of revenue nature are considered for income
determination and capital expenditures are taken to balance sheet. A portion of capital
expenditure, which reflects the cost of expired utility, is taken into account. For example if
a machinery has been purchased during the year at Rs. 4,00,000, then a portion called as
depreciation will be taken as part of total expense for income determination and written
down value would be shown in the balance sheet. This system is also prescribed under
Companies Act, 2013. Section 128(1) of the Act requires that every company shall
prepare and keep its books of account on accrual basis and according to the double
entry system of accounting. It means it is mandatory for the joint stock companies
to follow accrual system of accounting.
1.12 DIFFERENCE BETWEEN CASH AND ACCRUAL BASIS
Basis Cash Basis Accrual Basis

1. Nature of Transactions are recorded on cash Transactions are recorded on due
Transactions basis. i.e. at the time of actual inflow basis. i.e. both cash and credit
recorded or outflow of cash. transactions are recorded.
2. Adjustment No adjustment entries are required. Adjustment entries are passed .
entries for
outstanding
and prepaid
Expenses
3. Effect of There is understatement of profit as As compared with cash basis income
accrued income for current year has not been statement will show higher profits.
incomes and considered and expenses for next year
prepaid are charged.
expenses
4. Effect of It will lead to overstatement of As compared with cash basis income
outstanding profits. statement will show lower profits.
expenses and
income
received in
advance
5. Status under It is not recognised. It has been prescribed under section
Companies 128(1) of Companies Act, 2013
act
6. This system will not reflect the true It is reliable as true results are
Reliability
amount of profit. reflected through income statement.
7. Expenses All types of expenses are taken Expenses of revenue nature are taken.
taken for whether revenue or capital in nature.
income
determination
8. Depreciation No method is available as entire There are number of methods
and other capital expenditure is debited to the available for depreciation.
non- cash profit and loss A/c of same period in
expenses which it is incurred.
1.13 USERS OF ACCOUNTING INFORMATION
As defined by Elliot, Barry & Elliot, Jamie in their book, “Financial accounting and
reporting” Accountancy is the process of communicating financial information about a
business entity to users such as shareholders and managers. Accounting provides
information which is helpful to users in taking better financial decisions. These users may
either be internal or external.
INTERNAL USERS: The internal users are basically the organizational participants. Usually
top and middle level management requires information for planning and controlling the
operations. They are the primary users and the information is made available in the form of
management accounts, budgets, forecasts and financial statements.
EXTERNAL USERS: The external users neither have direct access to all the records of the
enterprise nor they can influence or participate or can take part in decision making of the
enterprise. They are the secondary users to whom the accounting information is usually
given in the form of financial statements.
Following are the various users of accounting information:

1. Owners: They are the providers of funds in the business. The number of owners depends
upon the form of business organization. Like in case of sole proprietor, only one owner is
there whereas more than one person is in involved in partnership. Every owner is obviously
interested in knowing not only the profit on their investments but also the risk involved in
return. The accounting information is equally relevant for new or prospective investors in
order to judge and take investment decision.
In case of joint stock public company there is no limit on number of investors. All these
shareholders cannot run the company together. Therefore they appoint their representatives
in the form of board of directors who are entrusted with the responsibility of managing the
affairs of the company. The financial statements are means by which the shareholders are
aware of how their funds are being put to use.
2. Management: The accounting policies are decided by the management. The management
people have the ultimate responsibility for the financial performance. Therefore they
periodically compile and interpret the financial statements. When they analyses the
outcome of these financial statements they are able to judge their efficiency and
performance. For evaluating the performance of entity and also to take appropriate
measures to improve the results, financial statements are of immense importance.
3. Lenders: The requirement of funds in the business may be huge and is not possible for the
owners to contribute themselves. Even if it is possible to arrange the funds, some level of
leverage is always desired in the capital structure to increase the rate of return of the
owners. Therefore the business resorts to borrowed funds. The providers of loans to the
business entity are called as lenders. The lenders are interested to know whether the entity
would be able to give them reasonable return in the form of interest and the safety of their
principal. The creditworthiness of the entity is judged from the financial statements. The
financial statements indicate the income which ensures the safety of their interest and the
financial position reflects the solvency of the firm which ensures safety of the repayment of
Principal. Financial statements also reflect the status of existing debts. The lenders can
take informed decision regarding extending further credit or not.
4. Creditors and Suppliers: The creditors emerge when goods are purchased by business on
credit. They are concerned about the recovery of their dues and also about the credit
period. They are interested in finding out the short term solvency of the business. The
financial statements facilitate the creditors in ascertaining whether they will be able to
receive timely consideration for the goods supplied and services rendered.
5. Customers: There are some customers who use the product as a raw material. They are
interested in assessing the stability of the business operations. These customers are
generally industrial or bulk customers. Legal obligations like guarantees and warranties
given to the customers can also be fulfilled only if the business remains stable.
6. Employees: Employees have vested interest in the continuity and profitability of the entity
and they are interested in financial statements and reports for three reasons. First, a loss
making company cannot sustain for long period of time and thus there is always a risk and
uncertainty of layoff or retrenchment. It jeopardizes the job security. On the other hand a
profit making entity has the capability of providing job security. Second, the financial
statements reveal the profits that entitles workers lawfully bonus and other incentives
based on profits. The workers together with trade unions can negotiate better and this
information enhances their bargaining power. Third, the financial reports also indicate what
the management has done for the welfare of the workers and employees and what further
plan of action is for the betterment of the workers.
7. Government and other regulatory agencies: Government performs lot of sovereign
functions and carries on economic and welfare activities which are majorly funded through
tax collection. They have keen interest in the profitability of all the entities as it
determines their tax revenue and also to check that there is no tax evasion. Securities and
Exchange Board of India, Reserve Bank of India and Insurance regulatory authorities have
keen interest in the financial statements for the purpose of investors’ safety and protection.
8. Research Scholars and Financial Analysts: There are many people who approach the
business firms to seek financial information. These persons include academicians,
researchers, analysts, etc. They are the external users who are not directly interested in the
financial performance or position of the business.
1.14 DIFFERENCE BETWEEN INTERNAL AND EXTERNAL USERS
INTERNAL USERS EXTERNAL USERS

1. They are the primary users. They are the secondary users.
2. The accounting information may be given in The accounting information is usually given in
any form like budget, reports, etc. and the form of Financial Statements only.
including financial statements.
3. They are the participants of managerial They are either external people or internal
decision making team. but have no say and no access to documents
and working papers that lead to preparation
of financial statements. Only the final
outcome in the form of Financial statement is
available to them.
4. The examples are management, board, The examples are investors, creditors,
partners, officer, directors, etc. lenders, government, customers, workers,
etc.
1.15 ADVANTAGES OF ACCOUNTING

There are many advantages of good accounting system. The main advantages can be
enumerated as follows:
1. Maintenance of systematic business records:
All the business transactions are spread over the accounting period and are very
large in number. Due to this nature of transactions in terms of its volume and
meticulousness, it is necessary to develop a system of its timely record keeping. It is
neither possible nor feasible to depend upon human memory. Accounting helps in
maintaining a complete and systematic recording of all business transactions.
2. Preparation of Financial Statements:
There are two basic components of financial statements namely the income
statement and balance sheet. The income statement is prepared to ascertain profit
or loss for a particular accounting period. The balance sheet depicts the financial
position of the business as at a particular date. The preparation of these statements
is possible, if and only if the business transactions have been recorded in a proper
manner.
3. Facilitates Comparison:
The proper and systematic records help to compare the profits and financial position
of the business entity from one accounting period to another accounting period. It is
called as intra-firm comparison or time series analysis. At the same time accounting
also facilitates the comparison of financial results of one business entity with
another business entity, called as inter-firm comparison or cross sectional analysis.
4. Assistance to Management:
The management has to perform planning activities for future. These activities
comprise of budget preparation in respect of cash, production, sales, inventory, etc.
The co-ordination between all the departments is necessary. For example, the
production department should prepare their budget in co-ordination with the sales
department. In the absence of this, there may be the situation of excess or short
production. The accounting helps in such co-ordination. This is the benefits of
accounting for internal users.
5. Assistance to External users:
The external users of accounting information are creditors, suppliers, lenders,
debtors, workers, etc. They require information for various purposes. Accounting
provides the required information to them.
6. Legal evidence and Taxation matters:
The records of business transactions are treated as satisfactory evidence in the court
of law. Any dispute with debtors or creditors may be settled easily through
accounting records. The maintenance of proper records is mandatory for income tax,
sales tax, value added tax, etc.
7. Valuation of business:
In the case of sale of business, merger with other firm, to judge the feasibility of
business proposal, etc. the valuation of business is required. Accounting can be used
for ascertaining the value of business.
1.16 LIMITATIONS OF ACCOUNTING

Inspite of many advantages, there are certain limitations of accounting. These are as
follows:
1. Ignorance of Non-monetary information:
Based on money measurement concept, accounting considers only those transactions and
events which can be measured in terms of money. It does not consider qualitative aspects
like quality control, good management, skills of the managers, experienced and trained
work force etc. But at times there is very critical event which may affect the entire
functioning of the business.
2. Personal Judgment:
Accounting is based on certain assumptions, concepts and conventions. This brings
subjectivity in accounting. For example depreciation is calculated on the basis of cost,
estimated scrap value and estimated life. It is clear that one can manipulate the amount of
depreciation by choosing estimated parameters as per own discretion.
3. Historical Cost Concept:
Accounting does not consider fair value or market value as it is based on cost concept only.
For example land may be appearing in the books at its original cost whereas the present
market price may be much higher than book value. It is the basic concept underlying
measurement of business income. In fact unrealised gains are not considered in accounting.
However, the economic income considers unrealised gains as well.
4. Ignorance of Social cost:
In the process of economic activities of the enterprise, there are some undesirable by-
products like damage to the environment, air, water and noise pollution, soil erosion, etc.
Accounting ignores these social costs.
5. Window Dressing:
Window dressing is a technique used by the management in order to manipulate financial
statements and reports to show more favorable results for a period. This manipulation may
be by overstatement of stock, understatement of expenses, recording sale of fixed asset as
sale of goods, raising invoices in last month of the year in respect of sales of next period,
etc. Using this technique, the accounting information may be manipulated by the entities.
The users relying on this information may be misguided.
Objective Type questions

State whether the following statements are True (T) of False (F).
(1) Management accounting is related with cost ascertainment, cost control and cost reduction.
(2) Accounting is a service activity.
(3) Accounting does not include communication.
(4) As per the definition of Accounting by AICPA, Accounting is a science.
(5) The ingredients of relevance are Predictive & Feedback Value and Timeliness.
(6) Window dressing is one of the main advantages of accounting.
(7) Luca fra Pacioli is regarded as father of Accounting.
(8) Book keeping includes preparation of Balance sheet.
(9) Two primary qualitative characteristics of financial statements are reliability and relevance.
(10) Creditors and customers are the internal users of accounting information.
[Answers: True:- 2,5,7,9 False:- 1,3,4,6,8,10]
Theoretical Questions
1. Define Accounting and explain its functions. How it is different from Accountancy?
2. Write short note on purposes and limitations of Accounting.
3. Distinguish between:
a. Book-keeping and Accounting
b. Internal and External Users
c. Accounting and Accountancy
4. Distinguish between accrual and cash basis of accounting.
5. Who are the various users of accounting information?
6. Write short note on mercantile system of Accounting.
7. Explain the qualitative characteristics of accounting information. Explain the ingredients of relevance
and reliability.

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Learning Outcomes

After studying this Chapter, you shall be able to:

1.2 DEFINITION OF ACCOUNTING

“Accounting is the art of recording, classifying and summarizing in a significant manner,

As per this definition, the following are the main clauses:

In 1970, APB (Accounting Principle Board) of AICPA defined accounting as:

1.4 HISTORY OF ACCOUNTING

1.5 OBJECTIVES OF ACCOUNTING

According to International Financial Reporting Standards, the objective of financial

1.6 PROCEDURAL ASPECTS OF ACCOUNTING

Interpretation is related with explaining the meaning and significance of relationship

1.7 ACCOUNTING AS AN INFORMATION SYSTEM

Accounting Information System

INPUT PROCESSING OUTPUT

Business  Recording  Income

1.8 BOOK - KEEPING

DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

4. It provides basis to accounting. It provides summarized information to

1.9 SUB-FIELDS OF ACCOUNTING

Unlike book-keeping, accounting has many sub-fields which are as follows:

It is commonly known as Accounting. It is historical in nature with main focus on recording

AS PER SECTION 2(40) OF COMPANIES ACT, 2013

According to the Institute of Cost and Management Accountants of England, “Cost

control methods and the ascertainment of the profitability of activities carried or

COST ACCOUNTING IS DIFFERENT FROM COST ACCOUNTANCY

The Management Accounting emerged as a sub-field of accounting in the 20th century. As

According to the Institute of Management Accountants (IMA): "Management accounting is a

According to the Chartered Institute of Management Accountants (CIMA), “Management

Social Responsibility Accounting

SOCIAL COSTS AND SOCIAL BENEFITS

Human Resource Accounting

As per the encyclopedia (Wikipedia), Human resource accounting is the process of

As per American Accounting Association, “Human resource accounting is the process of

1.10 QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

a. Verifiability: The accounting information should be verifiable. It means any person

2. Relevance: As per SFAC-2 “ Relevance is the capacity of information to make a difference

Tutorial Note on Understandability

4. Consistency: It is one of the fundamental accounting assumptions. According to Accounting

5. Comparability: The information must be comparable. Users should be able to see

1.11 BASES OF ACCOUNTING

1.12 DIFFERENCE BETWEEN CASH AND ACCRUAL BASIS

Basis Cash Basis Accrual Basis

1.13 USERS OF ACCOUNTING INFORMATION

Following are the various users of accounting information:

1.14 DIFFERENCE BETWEEN INTERNAL AND EXTERNAL USERS

INTERNAL USERS EXTERNAL USERS

1.15 ADVANTAGES OF ACCOUNTING

1.16 LIMITATIONS OF ACCOUNTING

Objective Type questions

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