INTRODUCTION TO ACCOUNTING

INTRODUCTION TO ACCOUNTING

1.1   Introduction

1.2   Meaning & definition of Book-keeping

1.3   Meaning & Definition of Accounting

1.4   Objectives of Accounting

1.5   Importance of Accounting

1.6   Process of Accounting

1.7   Branches of Accounting

1.8   Limitations of Accounting

1.9   Distinction between Book-Keeping and Accounting

1.10 Users of Accounting Information

1.11 Basic term of accounting

1.12 Self Assessment Questions

1.1 INTRODUCTION

In all activities (whether business activities or non-business activities) and in all organizations (whether business organizations like a manufacturing entity or trading entity or non-business organizations like schools, colleges, hospitals, libraries, clubs, temples, political parties) which require money and other economic resources, accounting is required to account for these resources. In other words, wherever money is involved, accounting is required to account for it. Accounting is often called the language of business. The basic function of any language is to serve as a means of communication. Accounting also serves this function.

1.2. MEANING AND DEFINITION OF BOOK- KEEPING

1.2.1 Meaning

Book- keeping is mainly concerned with the recording of business transactions in books in a regular & systematic manner. Book- keeping includes recording of journal, posting in ledgers and balancing of accounts. It is difficult for a business man to remember all receipts & payments that takes place during a particular period of time. So, book-keeping is an art & science of correctly recording business transaction in a systematic manner.

1.2.2 Definition

“Book- keeping is the art of recording business transactions in a systematic manner”.                A.H.Rosenkamph.

“Book- keeping is the science and art of correctly recording in books of account all those business transactions that result in the transfer of money or money’s worth”. R.N.Carter

Bookkeeping primarily deals in the art of recording transactions in books. Only those transactions related to business are recorded which can be expressed in terms of money.

1.3 ACCOUNTING

1.3.1 Meaning of Accounting

Accounting, as an information system is the process of identifying, measuring and communicating the economic information of an organization to its users who need the information for decision making. It identifies transactions and events of a specific entity.

 A transaction is an exchange in which each participant receives or sacrifices value (e.g. purchase of raw material). An event (whether internal or external) is a happening of consequence to an entity (e.g. use of raw material for production).  An entity means an economic unit that performs economic activities.

1.3.2 Definition of Accounting

American Institute of Certified Public Accountants (AICPA) which defines accounting 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 a financial character and interpreting the results thereof”.

Thus, accounting may be defined as the process of recording, classifying, summarizing, analysis & interpreting the financial transactions and communicating the results thereof to the persons interested in such information.

1.4 Objective of Accounting

Objective of accounting may differ from business to business depending upon

their specific requirements. However, the following are the general objectives of

accounting.

i) To keeping systematic record: It is very difficult to remember all the business transactions that take place. Accounting serves this purpose of record keeping by promptly recording all the business transactions in the books of account.

ii) To ascertain the operational profit or loss : Accounting helps in ascertaining result i.e., profit earned or loss suffered in business during a particular period. For this purpose, a business entity prepares either a Trading and Profit and Loss account or an Income and Expenditure account which shows the profit or loss of the business by matching the items of revenue and expenditure of the same period.

iii) To ascertain the financial position of the business: In addition to profit, a businessman must know his financial position i.e., availability of cash, position of

assets and liabilities etc. This helps the businessman to know his financial strength.

Financial statements are barometers of health of a business entity.

iv) To protect business properties: Accounting provides upto date information about the various assets that the firm possesses and the liabilities the firm owes, so that nobody can claim a payment which is not due to him.

v) To facilitate rational decision – making: Accounting records and financial statements provide financial information which help the business in making rational decisions about the steps to be taken in respect of various aspects of business.

vi) To satisfy the requirements of law: Entities such as companies, societies,

public trusts are compulsorily required to maintain accounts as per the law governing

their operations such as the Companies Act, Societies Act, and Public Trust Act etc.

Maintenance of accounts is also compulsory under the Sales Tax Act and Income Tax

Act.

1.5 Advantages of Accounting

The following are the advantages of accounting to a business:

1) Increase in Memory power:  human memory is limited. It is not possible to remember all the business transaction. Therefore, accounting helps in having complete record of business transactions.

2)  Information regarding performance & position: It gives information about the profit or loss made by the business at the close of a year and its financial conditions. The basic function of accounting is to supply meaningful information about the financial activities of the business to the owners and the managers.

3)  Helpful in decision making: It provides useful information for making economic decisions.

4) Comparison: It facilitates comparative study of current year’s profit, sales, expenses etc., with those of the previous years.

5)      Assistance to management: Accounting provides information to the management to enable it to do its work properly. Such information helps in the Planning, Decision making and Controlling.

6)      Evidence in the court: Systematic record of transactions is often treated by the courts as good evidence.

7) Helpful in tax assessment : It helps in complying with certain legal formalities like filing of income tax and sales-tax returns. If the accounts are properly maintained, the assessment of taxes is greatly facilitated.

1.6 Process of Accounting / Accounting Cycle

Accounting cycle refers to a complete sequence of accounting procedures which are required to be repeated in same order during each accounting period. Accounting cycle includes:

1)      Recording:

First, all transactions should be recorded in the journal or books of original entry known as subsidiary books as and when they take place.

     2)      Classifying:

All entries in the journal of books of original entry should be posted to the appropriate ledger accounts to find out at a glance the total effect of all such transactions in a particular account.

           3)      Summarizing:

Summarize the data by preparing a list (i.e. Trial balance) showing the balances of each and every account to verify whether the sum of debit is equal to the sum of credits.

4)      Analysis & Interpretation:

Trading and profit and loss a/c as well as balance sheet is prepared to analyze and interpret the data.

5)      Communicating the Results:

Accounting is the language of business. Various transactions are communicated through accounting. There are many parties - owners, creditors, government, and employees etc, who are interested in knowing the results of the firm. The fourth function of accounting is to communicate the results to interested parties. The accounting shows a real and true position of the firm of the business.

Accounting Cycle

1.7 BRANCHES OF ACCOUNTING

The changing business scenario over the centuries gave rise to specialized branches of accounting which could cater to the changing requirements. The branches of accounting are;

i) Financial accounting;

ii) Cost accounting; and

iii) Management accounting.

Now, let us understand these terms.

1.7.1 Financial Accounting

The accounting system concerned only with the financial state of affairs and financial results of operations is known as Financial Accounting. It is the original form of accounting. It is mainly concerned with the preparation of financial statements for the use of outsiders like creditors, debenture holders, investors and financial institutions.

1.7.2 Cost Accounting

It is that branch of accounting which seeks to ascertain the cost of unit produced and sold or the services rendered by the business unit with a view to exercising control over these costs to assess profitability and efficiency of the enterprise. It generally relates to the future and involves an estimation of future costs to be incurred. The process of cost accounting based on the data provided by the financial accounting.

1.7.3 Management Accounting

It is an accounting for the management i.e., accounting which provides necessary information to the management for discharging its functions. According to the Anglo-American Council on productivity, “Management accounting is the presentation of accounting information is such a way as to assist management in the creation of policy and the day-to-day operation of an undertaking.”

1.8 Limitations of Accounting

1)      Historical in nature: Accounting is historical in nature: It does not reflect the current financial position or worth of a business.

2)      Non recording of non-monetary transactions: Transactions of non-monetary mature do not find place in accounting. Accounting is limited to monetary transactions only. It excludes qualitative elements like management, reputation, employee morale, labour strike etc.

3)      Can be manipulated: Facts recorded in financial statements are greatly influenced by accounting conventions and personal judgements of the Accountant or Management and hence can be manipulated. Yet have to believe it’s true.

4)      Conflicting Principles: Accounting principles are not static or unchanging-alternative accounting procedures are often equally acceptable. Therefore, accounting statements do not always present comparable data

5)      Inadequate information for reports: It does not provide adequate information for reports to outside agencies such as banks, government, insurance companies and trade associations.

6)      Price level changes are ignored: In accounting, all transactions are recorded at the historical cost, i.e. the cost actually incurred. It totally ignores the changes in the value of money. Accounting statements do not show the impact of inflation.

1.9  DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

Basis of difference	Book-keeping	Accounting
1)      Objective	The main objective is to prepare the original books of accounts by making a record of business transactions.	The main objective is to record, classify, summarize, analyze & interpret the business transactions. The accuracy of recorded transactions is checked.
2)      Origin	It is the first stage of accounting.	It is the second stage of accounting which starts where book-keeping ends.
3)      Level of Work	It is restricted to clerical work & is done by the lower level of management.	It is done by senior staff like accountants, finance managers.
4)      Scope	It has limited scope.	It is wider in scope.
5)      Income Statement and Balance Sheet	Preparation of trading, Profit & loss account and balance sheet is not included in book keeping.	Preparation of trading, profits and loss account and balance sheet is included in it.
6)      Rectification of errors	These are not included in book-keeping	These are included in accounting.
7)      Knowledge required	Simple knowledge is required for recording of transactions.	The accountant must possess a higher level of knowledge and skill.

1.10         Users of Accounting Information

Accounting, as an information system, is very helpful to parties interested in it such as owners, management, creditors, investors, employees etc. Figure below shows the users of accounting information relating to business.

i)                    Owners: The owners provide funds or capital for the business. They always want to know whether the business financial position is sound or not and whether the capital is being employed properly or not. Owners, being businessmen, always keep an eye on the returns from the investment.

ii)                  Management: The management of the business is greatly interested in knowing the position of the firm. Thus, the management is interested in financial accounting to find whether the business carried on is profitable or not. The financial accounting is the “eyes and ears of management and facilitates in drawing future course of action, further expansion etc.”

iii)                Employees: Payment of bonus depends upon the amount of profit earned by the firm. The demand for wage rise, bonus, better working conditions etc. depend upon the profitability of the firm and in turn depends upon financial position. For these reasons, this group is interested in accounting.

iv)                Creditors: Creditors are the persons who supply goods on credit. They require information about the short term solvency of a business i.e. whether the business is able to pay short term debt as and when becomes due.

v)                  Investors: The prospective investors, who want to invest their money in a firm, of course wish to see the progress and prosperity of the firm, before investing their amount, by going through the financial statements of the firm. This is to safeguard the investment. For this, this group is eager to go through the accounting which enables them to know the safety of investment.

vi)                Lenders : Banks and other financial institutions who lend money to a business require information that helps them determined whether loans and interest will be paid when due on business.

vii)              Government: Government agencies keep a close watch on the firms which yield good amount of profits. The tax authorities are interested in the financial statements to know the earnings for the purpose of taxation.

viii)            Customers : Customers are interested in accounting statements and reports to know whether proper control is exercised on production, selling and distribution expenses etc. to control the price to goods.

ix)                Researchers: Accounting information, being a mirror of the financial performance of a business organization, is of immense value to the research scholar who wants to make a study into the financial operations of a particular firm.

1.9  Basic terms of Accounting

(i)     Business: It includes any activity undertaken for the purpose of earning profit e.g., banking business, and insurance business, a merchant business etc.

(ii)   Transaction: Any dealing between two persons or things in a transaction. It may relate to purchase and sale of goods, receipt and payment of cash and rendering of services by one party to another. Transaction is of two kinds - cash transaction and credit transaction. When cash is paid or received as a result of an exchange, the transaction is said to be a cash transaction. When the payment or receipt of cash is postponed for future date, this transaction is said to be credit transaction.

(iii)  Proprietor: He is the owner of a business. He invests capital in it, gives his time and attention to it. He is entitled to receive the profit or bear loss arising out of it.

(iv) Capital: It refers to money or money’s worth invested in a business. It is treated as owner’s equity and liability of a business.

Capital = Assets - Liabilities

(v)   Revenue: It is the amount received or earned by a business. It includes sales, rent received, interest and dividend received etc.

(vi) Expenses: Money paid or payable for good or services in the running of business operations. Such as salary, freight, rent, carriage paid etc.

(vii)           Expenditure: Money paid or payable to acquire assets or services. It may involve purchasing assets such as land, building, machinery, etc.

(viii)         Drawings: The cash or goods taken away by the proprietor from the business for his personal uses are called as drawings.

(ix) Purchases: Goods purchased are called purchases. When the goods purchased for cash they are called cash purchases but if they are purchased for which payment will have to be made at some future date it is known as credit purchases.

(x)   Purchases Returns: If goods purchased are found defective or unsatisfactory, they are sometimes returned to the persons from whom they were purchased or to suppliers are called purchases returns or returns outwards.

(xi) Sales: Goods sold are called sales. When goods are sold for cash they are called cash sales, but when they are sold without having received payment, they are credit sales.

(xii)           Sales Returns: If a person to whom goods have been sold finds that they are defective or unsatisfactory and returns them, are called sales returns or returns inwards.

(xiii)         Debtor (Account Receivable): A person who owes money to business is a debtor. Business will receive the money from debtors in future.

(xiv)         Creditor (Accounts Payable): Creditor is a person to whom the business owes money. It is also termed as accounts payable. Business will pay the money to creditors.

(xv)           Assets: These are the things of value possessed by a trader such as building, land, machinery, furniture, etc. which can be expressed in terms of money.

(xvi)         Liabilities: They are the debt due by a business to its proprietor and others.

(xvii)       Account: A summarized record of transactions relating to person or thing is called an account.

(xviii)     Goods (Merchandise): It includes all merchandise commodities which are purchased by the business for selling.

(xix)         Stock (Inventory): Goods or merchandise on hand, that is goods remaining unsold, is called stock, stock in trade, or inventory.

(xx)           Final Statements: There two final statements are Trading and Profit & Loss a/c (Income statement) and Balance sheet.

1.10       Self Assessment questions

1.      Define Accounting and accounting cycle.

2.      Explain the objectives & importance of accounting?

3.      Discuss the advantages & limitations of accounting.

4.      Distinguish between book-keeping and accounting.

5.      Who are the main users of accounting information and what are their information needs?