INTRODUCTION TO ACCOUNTING

I . Accounting

Accounting is a system meant for measuring business activities, processing of information into reports and making the findings available to decision-makers. The documents, which communicate these findings about the performance of an organisation in monetary terms, are called financial statements.

Usually, accounting is understood as the Language of Business. However, a business may have a lot of aspects which may not be of financial nature. As such, a better way to understand accounting could be to call it The Language of Financial Decisions.

EVOLUTION OF ACCOUNTING –

Evolution of Accounting as per Indian mythology Chitra Gupta is responsible for maintaining accounts in God’s court. A book on  Arthashasthra written by Kautilya who was a minister in Chandra Gupta’s kingdom twenty three centuries ago mentions about the accounting practices in India. It describes how accounting records have to be maintained. In China and in Egypt accounting was used for maintaining revenue records of the government treasury.

A book on Arithmetica  Geometrica, Proportion at Proportionality (Review of Arithmetic and Geometric proportion) by an Italian Luca Pacioli is considered as the first authentic book on double entry book keeping. In his book he used the present day popular terms of accounting Debit (Dr.) and Credit (Cr). He also discussed the details of memorandum, journal, ledger and specialised accounting procedures. He also stated that, “all entries have to be double entries, i.e. if you make one creditor you must make some debtor.

 II. Concepts of Accounting-

The traditional meaning of Accounting was provided by the American Institute of Certified Public Accountants (AICPA) in 1961 when it defined accounting as: . "the art of recording, classifying and summarising 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.

Accounting is an Art:

Accounting and business people cannot be separated. The businessmen are interested in earning more and more and also accumulating more and more wealth. Accounting as an art helps in ascertaining or knowing the financial results in the form of income (i.e., earnings) and financial position (i.e., wealth)

Recording:

It means that transactions must be written down as early as possible in the books of account e.g. Cash Book, Sales Book, Purchase Book etc., as the case may be, so that a complete record is available about business activities. In general, accountants keep books, ledger files, computer files and commercial . documents- all of which are records.

Classifying:

The purpose of classification is to group the recorded transactions or information of the same type at one place under appropriate headings or account titles. For example, expenses on salaries may be classified at one place under the heading or account title: namely, Salaries Account.

Summarising/ Reporting:

To summarise means to bring together a number of accounts or terms in a single account or term. For example, the accounts of various credit customers like Ram, Aarti, and Rachna etc., are grouped under a single account title of Debtors and so are the accounts of credit suppliers of goods under the title of Creditors.

III.  Accounting Cycle-

Events: Identification of a transaction in terms of money

 An event means any happening or occurrence. Accounting can be applied to it only if it is in terms of money. For example, sales promotion of a new computer is a business event or accounting event because money is paid on its advertisement. All transactions are events, but all events are not transactions.

It means an accounting transaction is:

Action + Money = Transaction

Recording-

It refers to recording the data in the books of accounts in the form of individual transactions termed as journal

Classifying in the form of ledgers-

Ledgers are tables which collect everything in the journal in their individual tables

Summarising & Analyzing transactions-

Preparation of Profit & loss account and noting down all the assets and liabilities of a business. After completion of the summary analysis of the data is done. This would mean to study the trend of profits or losses, turnover of the business ,etc.

Interpretation:

Now the accountants are expected to explain the contents of their two basic statements, namely, the Income Statement (or profit and loss account) and Balance Sheet. For example, the accountant has to give the reasons for high or low profitability of the enterprise and increase or decrease in the net wealth. (i.e., Assets minus Liabilities). This is called or referred to as interpretation of financial statements.

Organisation :

 refers to a business enterprise whether for profit or not for profit motive.

IV. Interested users of accounting-

Accounting information consists of financial statements, highlights about profitability trends, financial position, and capital structure and so on, given in the annual reports of the companies.

1. Creditors and Short Term Lenders:

Creditors include suppliers of goods and services on credit. Short Term lenders include bankers and other financial institutions. They would like to know that they would be paid on due dates. Their main interest lies in liquidity (cash position) and profitably of business enterprise. They depend on financial statements for their dealings with the business enterprise regarding supply of goods on credit or giving loans.

2. Owners/Shareholders:

 The primary aim of Accounting is to provide necessary information to the owners/shareholders to enable them for a) Setting targets for future periods b) Measuring or obtaining the performance of the business as a whole and also of various departments of the business. c) Comparing the actual performance with the targets and noting the deviations, if any. d) Taking such corrective action as may be necessary to overcome the shortfalls, if any.

3. Investors:

 This category includes the existing and also future shareholders. They are interested in the amount of returns like dividends they are likely to get from the business. They would like to know the profitability of the enterprise from the income statements for a number of years.

 4. Employees (or Labour Unions):

In this category, are included individual employees and groups of employees called Trade Unions. They are interested in more wages or salary, bonus, overtime payments, medical facilities and their demands for these matters are based on profitability as provided by income statement.

5. Government:

The Central, State and Local Governments are interested in the financial statements, primarily for taxes like income tax, sales tax, excise duties etc., since the Government activities and welfare schemes are financed through collection of different types of taxes.

6. Researchers:

 They need accounting information for the purpose of studying the financial aspects of business enterprises and their effect on the economy as a whole.

7. Customers:

They are interested to know if a company will continue to honour product warranties and continue to provide its products in future.

To be useful, the accounting information should ensure to:

• provide information for making economic decisions;

• serve the users who rely on financial statements as their principal source of information;

• provide information useful for predicting and evaluating the amount, timing and uncertainty of potential cash-flows;

• provide information for judging management’s ability to utilise resources effectively in meeting goals;

• provide factual and interpretative information by disclosing underlyingassumptions on matters subject to interpretation, evaluation, prediction, or estimation; and

• provide information on activities affecting the society.

V. BRANCHES OF ACCOUNTING -

Different branches of accounting came into existence keeping in view various types of accounting information needed by a different class of people which can be found within the entity or outside the entity.

Financial accounting

It is concerned with recording the transactions of financial character, summarising and interpreting them and communicating the results to the users. It ascertains profit earned or loss incurred during a period (usually one year as accounting year) and the financial position as on the date when the accounting period ends. It can provide financial information required by the management and other parties. The word accounting and financial accounting are used interchangeably. At present we are concerned with financial accounting only.

Cost accounting

It analyses the expenditure so as to ascertain the cost of various products manufactured by the firm and fix the prices. It also helps in controlling the costs and providing necessary costing information to management for decision making.

Management accounting

It is concerned with generating information relating to funds, cost and profits etc. This enables the management  in decision making. Basically, it is meant to assist the management in taking rational policy decisions and to evaluate the impact of its decisions and actions and the performance of various departments.

Tax accounting

This branch of accounting has grown in response to the difficult tax laws such as relating to income tax, sales tax etc. An accountant is required to be fully aware of various tax legislations.

Social accounting

This branch of accounting is also known as social reporting or social responsibility accounting. It discloses the social benefits created and the costs incurred by the enterprise. Social benefits include such facilities as medical, housing, education, canteen, provident fund and so on while the social costs may include such matters as exploitation of employees, industrial interest, environment pollution, unreasonable terminations, social evils resulting from setting up industries etc.

Human resource accounting

It is concerned with human resource of an enterprise. Accounting methods are applied to evaluate the human resources in money terms. It is, therefore, an accounting for the people of the organisation.

National resource accounting

It means the accounting for the resources of the nation as a whole such as water resources, mining, forests etc. It is generally not concerned with the accounting of individual business entities and is not based on generally accepted accounting principles. It has been developed by the economists.

Inflation Accounting

Inflation Accounting is concerned with the adjustment in the value of assets (current and fixed) and of profit in the light of changes in the price level. In a way, it is concerned with the overcoming of limitations that arise in financial statements on account of the cost assumption (that is recording of the assets at their historical or original cost) and the assumption of stable monetary unit (these are discussed in detail in the next unit). It thus aims at correcting the distortions in the reported results caused by price level changes. Generally, rising prices during inflation have the distorting influence of overstating the profit.

Stewardship Accounting

 In earlier times in history, wealthy people employed `stewards' to manage their property. These stewards rendered an account of their stewardship to their owners periodically. This notion lies at the root of financial reporting even today which essentially involves the orderly recording of business transactions, commonly known as 'book-keeping'. Indeed the accounting concepts and procedures, in use today for systematic recording of business transactions have their origin in the practices employed by merchants in Italy during the 15th century. The Italian method which specifically began to be known as `double entry book-keeping' was adopted by other European countries during the 19th century. Stewardship accounting, in a sense, is associated with the need of business owners to keep records of their transactions, the property and tools they owned, debts they owed, and the debts others owed them.

VI. Objectives of Accounting

i) Maintainance of records of Business transactions:

Accounting is done to keep a systematic record of financial transactions, like purchase of goods, sale of goods, cash receipts and cash payments. Systematic record of various assets and liabilities of the business is also to be maintained.

 ii) To ascertain the net effect of the business operations i.e., profit or loss of business:

We know that the primary objective of business is to make profit and the businessman is very much interested in knowing the same. A proper record of income and expenses facilitates the preparation of the profit and loss account (income statement). The profit and loss account reveals the profit earned or loss incurred by the business firm during a particular period.

 iii) To ascertain the financial position of the business:

The businessman is not only interested in knowing the operating results, but also interested in knowing the financial position of his business i.e., where it stands. In other words, he wants to know when the business owes to others and what it owns and what happened to his capital – whether the capital increased or decreased or remained constant. A systematic record of various assets and liabilities facilitates the preparation of a statement known as ‘balance sheet’ (position statement) which answers these questions.

 iv) To provide accounting information to interested parties:

 Apart from the owners, there are various other parties who are interested in knowing about the business firm, such as the management, the bank, the creditors, the tax authorities, etc. For this purpose, the accounting system has to furnish the required information.

Bookkeeping , Accounting & Accountancy

According to G.A. Lee, the accounting system has following two stages :

i) the making of routine records, in prescribed form and according to set rules, of all events which affect the financial state of the organisation; and

 ii) the summarisation from time to time of the information contained in the records, its presentation in a significant form to interested parties, and its interpretation as an aid to decision making by these parties.

Stage (i) is called Book-keeping and stage (ii) is called Accounting.

Basis	Book-keeping	Accounting
Definition	Book-keeping is thus a narrow term concerned mainly with the maintenance of the books of account and covers the first four activities listed in the scope of accounting viz., identifying the transactions and events to be recorded, measuring them in terms of money, recording them in the books of prime entry, and posting them into ledger	Accounting, on the other hand, is concerned with summarising the recorded data, interpreting the financial results and communicating them to all interested parties.
Sequence	Accounting succeeds bookkeeping.	Accounting starts where bookkeeping ends
Scope	Book-keeping has a narrower scope	Accounting has a broader scope
Level of management	Handled by lower management –clerical level for recording transactions	Handled and reviewed by senior accountant and finance department heads
Ends at	Ends at recording the transactions in the books of accounts	Not only records but also summarizes the recorded data, interprets the financial results

Accountancy-

The term 'Accountancy' refers to a systematised knowledge of accounting and is regarded as an academic subject like economics, statistics, chemistry, etc. It explains 'why to do' and 'how to do' of various aspects of accounting. In other words, while  Accounting refers to the actual process of preparing and presenting the accounts, Accountancy tells us why and how to prepare the books of account and how to summarise the accounting information and communicate it to the interested parties. Thus, Accountancy is a science (a body of systematised knowledge) whereas Accpunting is the art of putting such knowledge into practice.

System of Accounting

Single Entry System

This system is also known as pure entry system. It does not follow the traditional dual recording format. Instead, in a single entry system, only a Cash Book will be maintained. All cash transactions will be recorded in the Cash Book. No other Ledgers find a place in this system. All transactions of personal nature are simply recorded in a rough book.
Double Entry System

This is the more traditional and conventional system for recording transactions in financial accounting. This is a scientific method which has some rules and principles which must be followed. The basic essence of the double entry system is that every transaction will affect two accounts. This is known as the debit and credit rule – every credit entry, there must be a corresponding debit entry.

• Accounting provides information on

1. Cost and income for managers
2. Company's tax liability for a particular year
3. Financial conditions of an institutions
4. All of the above

Accounting provides information on Cost and income for managers, Company's tax liability for a particular year and Financial conditions of an institutions.

Answer – All of the above

• The following  is a statement  showing the financial Status of a company at any time

1. Trading account
2. Profit & Loss statement
3. Balance Sheet   
4. Cash Book

 

Balance Sheet is a statement showing the financial status of the comapany at any given time. The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements.

Answer - Balance Sheet   

Basic terminologies-

Asset: Any thing which has economic value.

Real Assets-

Real assets are physical assets that have an intrinsic worth due to their substance and properties. Real assets include precious metals, commodities, real estate, land, equipment, and natural resources.

A. Fixed assets-

Fixed assets are long-term assets that a company has purchased and is using for the production of its goods and services. Fixed assets are noncurrent assets, meaning the assets have a useful life of more than one year. Fixed assets include property, plant, and equipment (PP&E) and are recorded on the balance sheet.

i) Tangible Assets-

A tangible asset is an asset that has a finite monetary value and usually a physical form. Tangible assets can typically always be transacted for some monetary value though the liquidity of different markets will vary. Tangible assets are the opposite of intangible assets which have a theorized value rather than a transactional exchange value.

• Wasting assets
• A wasting asset is an item that has a limited life span and irreversibly declines in value over time. Such fixed assets could be vehicles and machinery. However, in the financial markets, the term refers to options contracts since the contract will continually lose time value after purchase.

B. Current assests-

Current assets are all the assets of a company that are expected to be sold or used as a result of standard business operations over the next year. Current assets include cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid liabilities, and other liquid assets.

Liquid assets-

A liquid asset is something you own that can quickly and simply be converted into cash while retaining its market value.

Some examples of assets that would be considered liquid are:

1. Cash

2. Bank balance

3. Marketable securities

Floating assets:

These do not have stable value and day by day they are in the changing mode e.g. Cash on hand, cash at bank, stock of goods, bills receivables etc.

ii) Intangible Assets-

An intangible asset is an asset that is not physical in nature. Goodwill, brand recognition and intellectual property, such as patents, trademarks, and copyrights, are all intangible assets. Intangible assets exist in opposition to tangible assets, which include land, vehicles, equipment, and inventory.

Fictitious assets-

Fictitious assets are the assets which has no tangible existence, but are represented as actual cash expenditure. The main purpose is to create this account for expenses which are not placed in any account headings.

In other words, fictitious means fake or not real, these are not assets at all but they show in financial statements. Expenses incurred in starting a business, goodwill, patents, trademarks, copy rights comes under expenses which cannot be placed any headings.

• Fictitious assets have no physical existence.
• No realisable value.
• They are amortised in one or more profitable financial years.

Capital:

Owner's investment or equity in a firm. Amount invested by the owner in the firm is known as capital. It may be brought in the form of cash or assets by the owner for the business entity capital is an obligation and a claim on the assets of business. It is, therefore, shown as capital on the liabilities side of the balance sheet.

Liability:

 The financial obligation of an enterprise other than owners’ funds. Liabilities are obligations or debts that an enterprise has to pay at some time in the future. They represent creditors’ claims on the firm’s assets. Both small and big businesses find it necessary to borrow money at one time or the other, and to purchase goods on credit.

Non- current Liabilities-

The amount business entities owes and is to be paid for over a period of more than year.

Long- term borrowings-

Loans to be paid in more than a year time

Deferred tax liability-

Deferred tax liability arises when there is a difference between what a company can deduct as tax and the tax that is there for accounting purposes. A deferred tax liability signifies that a company may in future pay more income tax because of a transaction in the present.

Long term provisions-

Long term provisions are usually money set aside for employee benefits such as gratuity; leave encashment, provident funds etc.

Expenses: A cost relating to the operations of an accounting period.

 Revenue: Total amount received from sales of goods/services.

Expenditure

Whenever payment and/or incurrence of an outlay are made for a purpose other than the settlement of an existing liability, it is called expenditure. Expenditure means the spending of money or incurring a liability for some benefit/ service received by the business entity.

Purchase of machinery, purchase of furniture, payment of salaries, rent, etc., are some examples of expenditure.

Revenue Expenditure –

 If the benefit of an expenditure is limited to one year, it is treated as an expense (also called revenue expenditure) such as payment of salaries and rent.

Capital expenditure-

On the other hand, if the benefit of an expenditure is available for more than one accounting year, it is treated as an asset (also called capital expenditure) such as purchase of furniture and machinery.

Deferred Revenue Expenditure –

The term deferred means “postponement”.

Deferred revenue expenditure is the expenditure that is written off( charged) in more than one accounting period because the benefit of such expenditure will accrue in more than one accounting year.

Following points of distinction between capital expenditure and revenue expenditure are worth noting : (a) Capital expenditure increases earning capacity of business whereas revenue expenditure is incurred to maintain the earning capacity.

Difference between capital & revenue expenditure

(a) Capital expenditure is incurred to acquire fixed assets for operation of business whereas revenue expenditure is incurred on day-to-day conduct of business.

 (b) Revenue expenditure is generally recurring expenditure and capital expenditure is non-recurring by nature.

 (c) Capital expenditure benefits more than one accounting year whereas revenue expenditure normally benefits one accounting year.

 (d) Capital expenditure (subject to depreciation) is recorded in balance sheet whereas revenue expenditure (subject to adjustment for outstanding and prepaid amount) is transferred to trading and profit and loss account.

  

 

Summary of Accounting terminologies-

1. Capital: Owner's investment or equity in a firm.

2. Cash Discount: An allowance given by the creditor to the debtor on the amount due for prompt payment.

3. Creditor: One to whom the business owes some amount.

4. Debtor: One who owes some amount to the business.

5. Drawings: Amount withdrawn by the owner from the business for personal use.

6. Equity: The claim or right over the assets of the firm. It includes both the owner's and the creditor's claims.

7. Expenditure: Spending of money or incurring a liability for some benefit or service received by the business.

8. Gain: Profit arising from peripheral or incidental transactions.

9. Goods: Good are the mercantile things in which the business deals.

10. Income: It is the amount earned through business operations.

11. Revenue: Amount realized for the goods sold or services rendered.

12. Stock: Raw materials, semi-finished goods and finished goods lying in stores.

13. Trade Discount: An allowance given by the seller to the buyer on the list price at the time of sale.

14. Voucher: A documentary (written) evidence of a transaction is called a voucher. For example, if we buy goods for cash we get cash memo: if we buy on credit we get an invoice; and so on. Entries in books of account are made with the help of such vouchers.

15. Solvent: A person who is in a position to pay his debts as they become due.

 16. Insolvent: A person who is not in a position to pay his debts in full and is so declared by the court.

17.  Bad debts: The amount of debt which is unrealizable from a debtor who became insolvent.

18. Capital Expenditure: An expenditure which results in the acquisition of a fixed asset or addition to a fixed asset, or improvement of the earning capacity of the asset.

 19. Capital Losses: Losses which do not arise in the normal course of business.

20. Capital Profits: Profits not earned in the regular course of business.

21. Capital Receipts: Receipts in the form of additions to capital, liabilities or sale proceeds of fixed assets.

22. Deferred Revenue Expenditure: A revenue expenditure which involves a heavy amount and the benefit of which is likely to spread over a number of years.

23.  Revenue Expenditure: An expenditure whose benefit is limited to one year.

24. Revenue Losses: .Losses that occur in the regular course of business.

25. Revenue Profits: Profits earned in the normal course of business.

26. Revenue Receipts: Receipts arising out of services rendered or goods sold.

27. Capital Reserve : Reserve created out of capital profits.

28. Open Reserves : Reserves which are clearly shown in the financial statements.

29. Provision : Amount set aside of current earnings of a business for depreciation, repairs or renewals or meeting a known liability the amount of which is uncertain.

 30. Reserve : Amount set aside out of profits or surplus to meet unexpected contingencies or provide funds for growth.

31.  Revenue Reserve : Reserve created out of normal business profits.

32. Reserve Fund : That part of reserve which is invested outside the business.

33. Sinking Fund : A fund created out of earnings to repay a long term liability or replace an asset.

34.  Secret Reserves : Reserves, the existence of which is not revealed in the financial statements.

35. Books of Account: These are the different sets of records, whether in the form of bound books or loose sheets wherein the various business events and transactions are recorded e.g., journal and ledger. If necessary, the journal and also the ledger may be sub-divided into a number of books.

36.  Entry: The recording or entering a transaction or event in the books of account is called an entry. Journal: Journal is the book of prime entry. It is used for recording all transactions and events of a business entity in the first stage.