Basic Concepts of Accounting

Agenda: Introduction to Accounting Features of Accounting Branches of Accounting Users of Accounting General purpose Financial Statements Qualitative characteristics of Accounting Information Bases of Accounting Basic Assumptions and conventions

Accounting History and Evolution Accounting owes its origin to the origin of mankind. It is as old as money itself. Franciscan Monk Luca Pacioli is known to be the father of modern accountancy. However, sufficient evidence exist to conclude that art and practice of accounting, as a highly developed system, was in vogue in India even during the times of Vedas, Sutras and Upanisads. It was in 19th century that accounting was recognized as a independent profession by incorporation of bodies like Institute of Chartered Accountants of England and Wales and American Institute of Certified Public Accountants . Accounting has since undergone tremendous changes in concepts, conventions and other policies and procedures owing to the industrial development in last two centuries and it is in continuous process of adapting itself to ever changing business environment.

Accounting Meaning and definition The most frequently quoted definition of Accounting is the one coined by AICPA as: 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 . Another widely used definition is given by American Accounting Association which defines accounting as the process of identifying, measuring and communicating economic information, to permit informed judgments and decisions by a user of information

Features of Accounting A combined reading of the two definitions gives the below features of accounting: It is a process not confined to one single event. Identification of economic activities which means transactions of economic consequences are to be dealt with in accounting e.g. building business contacts/relations may not have economic consequence till such contacts are converted in transactions measurable in terms of money. Measuring and valuing the accounting activities in terms of money. Recording of the transactions, as measured above, appropriately. Classifying different types of transactions according to the nature of the transaction. Summarizing the results of measurement, recording and classifying in the form of financial statements. Communicating the results to all the users/stakeholders of information. Permit informed judgments by the users of the information.

Branches of Accounting Accounting can be classified based on the user s of the information: Financial Accounting : It is primarily aimed to serve needs of the outsiders including owners of the entity. The reports includes the Balance Sheet, Profit & Loss statement, Statement of Cash flows and Statement of Retained Earnings. Additionally, it also includes the schedules and explanations forming part the Balance sheet and P&L statement. These reports provides position of the entity on the reporting date as well as performance of the entity during the period. Management Accounting: It aims at reporting the activities of the entity to the managers so as to enable them to plan and control the activities of the entity. Social responsibility accounting: It is concerned with the social benefits derived and the costs incurred to derive such social benefits. Human Resource Accounting: It is a method to measure the effectiveness of personnel management activities and the use of people in an organization.

Users of Accounting Information: Shareholders Suppliers and creditors Lenders Employees Customers Government and regulatory services Security analysts and advisors Management Public

General Purpose Financial Statements: General Purpose Financial Statements include four specific statements: Profit & loss Account/Income Statement Balance Sheet Statement of Cash flows Statement of Changes in Equity

Qualitative Characteristics: Qualitative characteristics of Financial statements are prescribed by ICAI in the document titled Framework for preparation of financial statements . Accordingly, below are the broad primary qualitative characteristics: Understandability Relevance Materiality Reliability Faithful representation Substance over form Unbiased Prudence Completeness Timeliness Verifiability Comparability

Bases of Accounting: Cash basis of accounting: Transactions are recorded only when cash is actually received or actually paid. It is difficult to ascertain true profit in this case as items relating to the current account period are not included for the simple reason that cash is not received or paid. Accrual basis of accounting: Incomes are recognized when they are earned and expenses are recognized when they are incurred and not when cash is received or paid. They are considered on the basis of accounting period to which they relate.

Basic assumptions and conventions Three fundamental assumptions for accounting: Going concern assumption: The entity is normally viewed as continuing in operations in foreseeable future. It is assumed that the entity has neither the need nor the intention of liquidation or curtailing materially the scale of it operations. It facilitates classification of assets as short term or long term. It facilitates the process of depreciation of assets. However, it would provide a wrong picture if the company went into liquidation immediately after the release of financials Accrual concept: Revenues are recognized as and when they are earned and cost/expenses are recognized as and when they are incurred irrespective of when the cash is actually received or paid. Consistency: The convention of consistency simply states that accounting practices and methods remain unchanged from one accounting period to other. In case there is a change, such change, reason for change and any effect of financial statements due to such change should be disclosed.

Other concepts and conventions: Entity concept: For accounting purposes, business is treated as a unit or entity separate from its owners. All transactions of the business are recorded in the books of the business but any transaction of the personal nature of the proprietor shall not be recorded. Money measurement concept: Only those transactions and events are recorded which can be expressed in terms of money. Limitation of this are: Records only those transactions which are measured in terms of money: Events like resignation of a key official, manager s ability, quality of goods, increase in competition cannot be recorded. Does not consider changes in Purchasing Power of money.

Realization concept: Revenues are said to be earned when the title in the goods are passed on to the buyer. Further, revenues are recognized when there is a reasonable certainty of recovering the amount due. In case of doubts on the recovery of amount due, provision for Bad debts are created.

Cost concept: Cost is an expenditure which is incurred in acquiring an asset or service. The expenditure or the cost is an asset to the extent it is useful in future or it is unexpired. Expired cost is an expense. Expense is the amount spent in order to produce and sell goods or services which produce the revenue. Costs are recognized as and when they are incurred. There are three principles of recognizing costs to be used for income determination: i. The principle of associating cause and effect. ii. The principle of systematic and rational allocation: Applies cost which are incurred during the accounting period but cannot be associated with specific revenues e.g. rent, salaries, taxes etc. iii. The principle of immediate recognition: Applies to costs that expire without generating any revenues e.g. loss of stock due to fire, theft of cash in hand etc. Matching concept: All costs/expenses incurred to earn the revenue of the period will be charged against the revenue to determine the net income of the business enterprise. Convention of conservatism (Prudence): Accountant should not anticipate profits but he should make provision for all loses. Neither window dressing nor creating secret reserves are permitted. Convention of materiality: All material information should be disclosed which is necessary to make the financial statements clear and understandable.