Unit-1

Definition of Accounting
Accounting can be defined as a process of reporting, recording, interpreting and summarising
economic data. The introduction of accounting helps the decision-makers of a company to
make effective choices, by providing information on the financial status of the business.

The American Institute of Certified Public Accountants (AICPA) had 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”.

Today, accounting is used by everyone and a good understanding of it is beneficial to all.

Accountancy act as a language of finance. To understand accounting efficiently, it is
important to understand the aspects of accounting.

Definition of Accounting

“Accounting is the process of identifying, measuring and communicating economic

information to permit informed judgments and decisions by users of the information.”

-- (Year 1966) American Accounting Association (AAA)

“Accounting is a service activity. Its function is to provide quantitative information,

primarily financial in nature, about economic entities that is intended to be useful in
making economic decisions.”

-- (Year 1970) Accounting Principles Board of AICPA (U.S.A)

 Economic Events- It is a consequence of a company has to undergo when the number

of monetary transactions is involved. Such as purchasing new machinery,
transportation, machine installation on-site, etc.

 Identification, Measurement, Recording, and Communication- The accounting

system should be outlined in such a way that the right data is identified, measured,
recorded and communicated to the right individual and at the right time.
  Organization-In refers to the size of activities and level of a business operation.

 Interested Users of Information- It is about communicating important financial

information to the customers, according to which they will make the correct decision.

Fundamentals of Accounting

 Assets- The economic value of an item which is possessed by the enterprise is

referred to as Assets. To put it in other words, assets are those items that can be
transformed into cash or that generates income for the enterprise shortly. It is useful in
paying any expenses of the business entity or debt.

 Liabilities- The economic value of an obligation or debt that is payable by the

enterprise to other establishment or individual is referred to as liability. To put it in
other words, liabilities are the obligations that are rising out of previous transactions,
which is payable by the enterprise, through the assets possessed by the enterprise.

 Owner’s Equity- Owner‟s equity is one of the 3 vital segments of a sole

proprietorship‟s balance sheet and one of the main aspects of the accounting equation:
Assets = Liabilities + Owner‟s Equity. It depicts the owner‟s investment in the trade
minus the owner‟s withdrawal from the trade + the net income since the business
concern commenced.

Accounting Concepts

1] Business Entity Concept

This accounting concept separates the business from its owner. As far as accounting is
concerned the owner and the business are two separate entities. This will help the
accountant identify the business transactions from the personal ones. All forms of
business organizations (proprietorship, partnership, company, AOP, etc) must follow
this assumption.

So for example, if the owner brings in additional capital into the business, we will
treat this as a liability on the balance sheet of the business.
2] Money Measurement Concept

This accounting concept states that only financial transactions will find a place in
accounting. So only those business activities that can be expressed in monetary terms
will be recorded in accounting. Any other transaction, no matter how significant, will
not find a place in the financial accounts.

So for example, if the company underwent a major management overhaul this would
have no effect on the accounting records. This concept is actually one of the major
drawbacks of accounting.

3] Going Concern Concept

The going concern concept assumes that a business will continue to operate
indefinitely. So it assumes that for the foreseeable future the business will not be
winding up. This leads to the assumption that the business will not have to sell its
assets any time soon and it will meet all its obligations as well.

So it justifies the financial statements as a part of a continuous series of statements.

The current statements are tentative and only reflect the financial position of that
particular period of time.

4] Accounting Period Concept

Every organization, according to its needs, chooses a specific period of time to

complete an accounting cycle. Generally, the time chosen is a year we call the
accounting year. The time period is mentioned in the financial statements.

So the indefinite life of an organization is divided into shorter, generally equal time
period. This facilitates a comparison of performances and allows stakeholders to get
timely information. Also in most cases, it is also a statutory require ment.

5] Cost Concept

This accounting concept states that all assets of the firm are entered into the books of
account at their purchase price (cost of acquisition + transport + installation etc). In
 the subsequent years to, the price remains the same (minus depreciation charged). The
market price of the asset is not taken into consideration.

6] Dual Aspect Concept

This concept is the basic principle of accounting, it is the heart and soul. It basically is
one of the golden rules of accounting – for every credit, there must be a corresponding
debit. So every transaction we record must have a two-fold effect, i.e. it will be
recorded in two places. This is the core concept of the double-entry system of
accounting.

So let us see an example of this in action. Say the business buys an asset worth Rs
10,000/-. So now the Fixed Assets of the company will increase bt 10,000/-. But at the
same time, the bank or cash balance will reduce by 10,000/-. And so the transaction
will have a dual effect in accounting. And also the Balance Sheet will stay balanced.

7] Realisation Concept

According to the realization accounting concept, revenue is only recognized when it is

realized. Now revenue is the cash inflow for a business arising from the sale of goods
or services. And we assume this revenue as realized only when it legally arises to be
received. So in simpler terms, the profit earned will be recorded when it is actually
earned.

8] Matching Concept

This concept states that the revenue and the expenses of a transaction should be
included in the same accounting period. So to determine the income of a period all the
revenues and expenses (whether paid or not) must be included.

The matching accounting concept follows the realization concept. First, the revenue is
recognized and then we match the costs associated with the revenue. So costs are
matched with revenue, the reverse would be an incorrect system.

9] Full Disclosure Concept

This concept states that all relevant information will be disclosed in the accounting
statements. A lot of external users depend on these financial statements for their
information to make investing decisions. So no information/transactions etc of
relevance to anyone of them will be omitted from these statements for the benefit of
the company.

10] Consistency Concept

Once the company decides on a certain accounting policy it should not be frequently
changed. Unless there is a statutory requirement or it allows better representation of
the accounts accounting policies should be consistent for long periods of time. This
allows users to make inter-firm and inter-period comparisons. Also, frequent changes
in policies may be to manipulate the accounts and this must be prevented.

11] Conservatism Concept

This accounting concept promotes prudence in accounting. It states that profit should
not be included until it is realized. However, losses even those not realized but with
the remote possibility of occurring should be included in the financial statements. So
all losses are recognized – those that have occurred or are even likely to occur. But
only realized profits are recognized.

12] Materiality Concept

Materiality states that all material facts must be a part of the accounting process. But
immaterial facts, i.e. insignificant information should be left out. The materiality of a
transaction will depend on its nature, value and its significance to the external user. If
the information can affect a person‟s investing decision then it is definitely a material
fact.

13] Objectivity Concept

Finally, we come to the last accounting concept – objectivity. This concept states the
obvious assumption that the accounting transaction recorded should be objective, i.e.
free from any bias of the person recording it. So each transaction should be verifiable
 by supporting documents like vouchers, bills, letters, challans, certificates, invoices
etc.

Objectives of Accounting
The main objectives of accounting are:

To maintain a systematic record of business transactions

 Accounting is used to maintain a systematic record of all the financial transactions in

a book of accounts.

 For this, all the transactions are recorded in chronological order in Journal and then
posted to principle book i.e. Ledger.

To ascertain profit and loss

 Every businessman is keen to know the net results of business operations periodically.

 To check whether the business has earned profits or incurred losses, we prepare a
“Profit & Loss Account”.

To determine the financial position

 Another important objective is to determine the financial position of the business to

check the value of assets and liabilities.

 For this purpose, we prepare a “Balance Sheet”.

To provide information to various users

 Providing information to the various interested parties or stakeholders is one of the

most important objectives of accounting.

 It helps them in making good financial decisions.

To assist the management

 By analysing financial data and providing interpretations in the form of reports,

accounting assists management in handling business operations effectively.

Characteristics of Accounting:
The following attributes or characteristics can be drawn from the definition of Accounting:

(1) Identifying financial transactions and events

 Accounting records only those transactions and events which are of financial nature.

 So, first of all, such transactions and events are identified.

(2) Measuring the transactions

 Accounting measures the transactions and events in terms of money which are
considered as a common unit.

(3) Recording of transactions

 Accounting involves recording the financial transactions inappropriate book of

accounts such as Journal or Subsidiary Books.

(4) Classifying the transactions

 Transactions recorded in the books of original entry – Journal or Subsidiary books are
classified and grouped according to nature and posted in separate accounts known as
„Ledger Accounts‟.

(5) Summarising the transactions

 It involves presenting the classified data in a manner and in the form of statements,
which are understandable by the users.

 It includes Trial balance, Trading Account, Profit and Loss Account and Balance
Sheet.

(6) Analysing and interpreting financial data

 Results of the business are analyzed and interpreted so that users of financial
statements can make a meaningful and sound judgment.

(7) Communicating the financial data or reports to the users

 Communicating the financial data to the users on time is the final step of Accounting
so that they can make appropriate decisions.

Advantages of Accounting
The following are the main advantages of accounting:

1. Provide information about financial performance

 Accounting provides factual information about financial performance during a given period of
time

 Like, profit earned or loss incurred over a period and financial position at a particular point of
time.

2. Provide assistance to management

 Accounting helps management in business planning, decision making and in exercising

control.

 For this, it provides financial information in the form of reports.

3. Facilitates comparative study

 By keeping systematic records and preparation of reports at regular intervals, accounting

helps in making a comparison.

4. Helps in settlement of tax liability

 Systematic accounting records help in settlement of various tax liabilities. Such as – Income
Tax, GST, etc.

5. Helpful in raising loan

 Banks and Financial Institutions grant a loan to the firm on the basis of appraisal of the
financial statement of the firm.

6. Helpful in decision making

 Accounting provides useful information to the management for taking decisions.

Limitations of Accounting
Following are the limitations of accounting:

 Accounting is not precise: Accounting is not completely free from personal bias or
judgment.
  Accounting is done on historic values of assets: Accounting records assets at their historical
cost less depreciation. It does not reflect their current market value.

 Ignore the effect of price level changes: Accounting statements are prepared at historical
cost. So changes in the value of money are ignored.

 Ignore the qualitative information: Accounting records only monetary transactions. It

ignores the qualitative aspects.

 Affected by window dressing: Window dressing means manipulation in accounting to

present a more favourable position of the business than the actual position.

Types of Accounting Information

Accounting information is the base all important decisions which are taken by owners,
management, potential investors, creditors, lenders, employees, government , researchers and
public. They are the interested parties in accounting information. Different people need
different accounting information. So, it is necessary to classify the accounting information in
different [Link] are the main types of accounting information which are generated
from accounting records for providing the benefits to interested parties.
1. Accounting Information of Financial Performance and Financial Position

This is the main type and common accounting information. Every user need the
information of net profit or net loss of company. At the end of year, what is
amount of net profit or net loss of company. If net profit's value is very high,
every user will take benefit from this data. Employees can demand more salary.
Shareholders may demand more dividend. Investors can invest their money in
the company because it is the good chance that they will receive more return on
their investment. For getting this information, it is necessary business has to
make the profit and loss account. This accounting information is also called the
information of financial performance. Next common information is financial
position. We can find the financial position by seeing the balance sheet. Balance
sheet's understanding is helpful for telling whether financial position is strong
or weak. Financial Accounting provides such accounting information.

2. Accounting Information of Total Cost and Per Unit Cost

Second type of accounting information is of value of total cost and per unit
cost. If you have to sell your product in the market, you need to know what is
your total cost and per unit cost. All cost accounting records will be helpful for
providing such accounting information. When businessman gets this
information, it will be very easy for him for fixing his estimated sale price by
adding profit margin in it.

3. Accounting Information for Planning and Control of Business

There are lots of accounting information which are need for planning and
control over the business. Such information is added in the third type. For
example, we are interested to paying fastly to our creditor. For this planning, we
have to check creditor turnover ratio and average conversion period. Like this,
there are lots of ratios which are helpful for different planning. Through budget,
 we get different accounting information for controlling the business. Cash flow
statement is provide the information of source and application of cash. Such
information is helpful to control of cash which is used in operation activities,
investing activities and financial activities. All these accounting information, we
can get from management accounting.

4. Accounting Information for Tax Management

This is the important type of accounting information. In this type, we collected

information which are only need for tax management. For example, for
calculating income tax on the profit, we need profit before tax and dividend
distribution. For VAT Input, we need information of purchase of different
products which are bought in day from one party. For VAT Output, we need the
information of sale of different product which are sold in a day to one party. For
getting this accounting information, it is very need to study tax accounting of
business.

5. Accounting Information for Social Responsibility

Through social accounting, we collect the accounting information for social

responsibility. In big corporate, a social account is made which provide the
information of benefits to society and cost of natural resources which are taken
by corporate. Future benefits like product safety, financial support to
manpower, customer satisfaction and pollution control can be given on these
accounting information.

Users of Accounting Information:

Users may be categorised into internal users and external users.

(A) Internal Users

 Owners: Owners contribute capital in the business and thus they are exposed to maximum
risk. So, they are always interested in the safety of their capital.

 Management: Accounting information is used by management for taking various decisions.

  Employees: Employees are interested in the financial statements to assess the ability of the
business to pay higher wages and bonuses.

(B) External Users

 Banks and financial institutions: Banks and Financial Institutions provide loans to business.
So, they are interested in financial information to ensure the safety and recovery of the loan.

 Investors: Investors are interested to know the earning capacity of business and safety of the
investment.

 Creditors: Creditors provide the goods on credit. So they need accounting information to
ascertain the financial soundness of the firm.

 Government: The government needs accounting information to assess the tax liability of the
business entity.

 Researchers: Researchers use accounting information in their research work.

 Consumers: They require accounting information for establishing good accounting control,
which will reduce the cost of production.

Interested users/parties of Accountings information’s and their Needs

There are number of users interested in knowing about the financial soundness and the
profitability of the business.

Users Classification Information the user want

Return on their investment, financial health of their

1. Owner
company/business.

To evaluate the performance to take various decisions.

2. Management

Internal

Profitability to claim higher wages and bonus, whether

3. Employees
their dues
 (PF, ESI, etc.) deposited regularly.

1. Investors and potential To know about Safety, growth of their investments

investors and future of the business.

Assessing the financial capability, ability of the business

2. Creditors
to pay its debts.

3. Lenders Repaying capacity, credit worthiness.

External
Assessment of due taxes, true and fair disclosure of
4. Tax Authorities
accounting information,

To compile national income and other information.

5. Government
Helps to take policy decisions.

Customers, Researchers etc., may seek different in-

6. Others
formation for different reasons.

Qualitative Characteristics of Accounting Information

Qualitative characteristics are the attributes of accounting information, which enhance its
understandability and usefulness:

 Reliability: Reliability implies that the information must be free from material error and
personal bias.

 Relevance: Accounting information must be relevant to the decision-making requirements of

the users.

 Understandability: Information should be disclosed in financial statements in such a manner

that these are easily understandable.

 Comparability: Both intra-firm and inter-firm comparison must be possible over different
time periods.
Role of Accounting in Business
1. Budget Planning

For every business, budgeting is a key factor. Budget planning help business to
develop strategies, save money and observing any expenses that exceed the budgeted
amount. In order to make a budget for a business, a business needs certain previous
records. This will only be possible if records are maintained through accounting
because they form the basis for planning and budget makings.

2. Banks and lenders

To get a loan from a financial institution, you need to provide a financial statement.
To make a financial statement, you need to have a proper accounting system. Various
books of record such as profit, expenses, assets and liabilities, tax paid need to be
maintained. The financial institution will then scrutinize in detail in order to provide a
loan to the organization

3. Records Keeping

The organization needs to have a record of its transaction to run the business
smoothly. To do so, accounting plays a key role in keeping records. These records are
collected, organized, and then interpreted to communicate to end-users.

4. Decision Making

There are different types of decision making being a manager. Accounting in

decision-making plays a key role. For this business, the organization needs a financial
statement. A financial statement is made as a result of the accounting system.
Executive management cannot make a sound decision if there is no proper record of
accounting in business organizations and hence it is impossible for them to achieve
objectives.
5. Investors

Many stakeholders need financial information in the form of a financial statement.

Examples of stakeholders that need financial information are investors, creditors,
government, debtors, customers, and employees. The investor will move away if the
organization is lacking financial records and accounts. They need this information to
know about business progress.

6. Reporting Business Profits

The main objective of a business is to make a profit. In order to ascertain whether a

business is making a profit or not, just needs to maintain an accounting system
regardless of size. This enables interested parties to make a decision on the growth of
business output.

7. Monitoring Cash Flow

Well prepare accounting systems helps in managing working capital requirements and
other cash requirements within an organization.

8. Statutory Complaint

A proper accounting system ensures time ly recording of liabilities and which to be

paid within the time frame. This may include pension fund, provident fund, few or all
taxes including the sale, VAT, and income. Timely payment of these liabilities helps
businesses to the statutory complaint.

9. Help in filing a financial statement to Stock Exchanges and tax authorities

Listed companies are required to submit a financial statement to stock exchanges. For
both direct and indirect tax filing purposes, financial statements and other financial
requirements must be provided to tax authorities. Such information can only be
provided if a proper accounting record is maintained within a business organization.
10. PREVENTION AND Detection OF FRAUD

In order to prevent and detect fraud, good internal control in place is required within
the business organization. Good internal control can only place where a proper record
of events is taken place. The only way to maintain and keep track of transactions
effectively and efficiently is to implement an accounting and accounting system.

11. Planning and Forecasting

To expand a business, an organization need more finance to support this expansion.

For this bookkeeper look at the financial statement which type of finance they need.
At the end of the year, the business needs to dis tribute profit to investors.

The chief finance officer then considers how much to distribute to investors, how
much debt to be paid off, and how much reserve in the form of cash need to be
maintained for expansion and any other future need. Such planning and forecasting
can only be achieved if proper accounting and accounting systems are maintained in a
business organization.

12. Improved Payment Cycles

Another reason for preparing and keeping accounting and accounting systems within
a business organization is to enhance the business payment cycle such as payable and
receivable cycles.

Investor‟s share on profit needs to be determined, daily wages and monthly salaries
need to be calculated and payment should be made to lenders on a timely basis. The
payment cycle can only be improved if a proper accounting system is implemented
within a business organization.

13. Credit building and reputation

Credit building and reputation are established by implementing and operating a

sound accounting information system. It is believed that when there is an efficient
 accounting system in an organization, all another aspect of business operation is
effectively managed.

14. Transparency

As stakeholder make their decision on the basis of the financial statement, it must be
clear and easy to understand. The investor does not take a risk on the incomplete and
complex financial statement. Any information such as profit before interest and tax,
profit after tax, depreciation, and amortization is some information that is vital
information to stakeholders and shareholders. These need to be accurate because any
difference in these can make a huge difference. Therefore transparency is a key factor
to represent this information which can only be achieved if all business transaction is
recorded and maintained in the accounting system.

References

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