INTRODUCTION TO ACCOUNTING
Over the centuries, accounting has remained confined to the financial record-keeping
functions of the accountant. But, today’s rapidly changing business environment has forced
the accountants to reassess their roles and functions both within the organization and the
society. The role of an accountant has now shifted from that of a mere recorder of transactions
to that of the member providing relevant information to the decision-making team.
Broadly speaking, accounting today is much more than just bookkeeping and the preparation
of financial reports. Accountants are now capable of working in exciting new growth areas such
as: forensic accounting (solving crimes such as computer hacking and the theft of large
amounts of money on the internet); e commerce (designing web-based payment system);
financial planning, environmental accounting, etc. This realization came due to the fact that
accounting is capable of providing the kind of information that managers and other interested
persons need in order to make better decisions. This aspect of accounting gradually assumed
so much importance that it has now been raised to the level of an information system. As an
information system, it collects data and communicates economic information about the
organization to a wide variety of users whose decisions and actions are related to its
performance.
DEFINITION OF ACCOUNTING
In 1941, The American Institute of Certified Public Accountants (AICPA) had defined 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 financial character, and interpreting the
results thereof’.
With greater economic development resulting in changing role of accounting, its scope,
became broader. In 1966, the American Accounting Association (AAA) defined accounting as
“the process of identifying, measuring and communicating economic information to permit
informed judgments and decisions by users of information”.
In 1970, the Accounting Principles Board of AICPA also emphasized that the function of
accounting is to provide quantitative information, primarily financial in nature, about economic
entities, that is intended to be useful in making economic decisions. Accounting can therefore
be defined as the process of identifying, measuring, recording, and communicating the
required information relating to the economic events of an organization to the interested users
of such information. To appreciate the exact nature of accounting, we must understand the
following relevant aspects of the definition: • Economic Events • Identification, Measurement,
Recording and Communication • Organization • Interested Users of Information.
HISTORY AND DEVELOPMENT OF ACCOUNTING
Accounting enjoys a remarkable heritage. The history of accounting is as old as civilization. The
seeds of accounting were most likely first sown in Babylonia and Egypt around 4000 B.C. who
recorded transactions of payment of wages and taxes on clay tablets.
Historical evidence reveal that Egyptians used some form of accounting for their treasuries
where gold and other valuables were kept. The in charge of treasuries had to send day wise
reports to their superiors known as Wazirs (the prime minister) and from there month wise
reports were sent to kings.
Babylonia, known as the city of commerce, used accounting for business to uncover losses
taken place due to frauds and lack of efficiency.
In Greece, accounting was used for apportioning the revenues received among treasuries,
maintaining total receipts, total payments, and balance of government financial transactions.
Romans used memorandum or daybook where in receipts and payments were recorded and
where from they were posted to ledgers on monthly basis. (700 B.C to 400 A.D).
China used sophisticated form of government accounting as early as 2000 B.C.
Accounting practices in India could be traced back to a period when twenty-three centuries
ago, Kautilya, a minister in Chandragupta’s kingdom wrote a book named Arthashasthra, which
also described how accounting records had to be maintained.
LUCA PACIOLI (father of modern accounting)
Franciscan friar (merchant class), book Summa de Arithmetica, Geometria, Proportion at
Proportionality (Review of Arithmetic and Geometric proportions) in Venice (1494) is
considered as the first book on double entry book keeping. A portion of this book contains
knowledge of business and book-keeping.
However, Pacioli did not claim that he was the inventor of double entry book-keeping but
spread the knowledge of it. It shows that he probably relied on then–current book-keeping
manuals as the basis for his masterpiece. In his book, he used the present day popular terms
of accounting Debit (Dr.) and Credit (Cr.).
These were the concepts used in Italian terminology. Debit comes from the Italian debito which
comes from the Latin debita and debeo which means owed to the proprietor. Credit comes
from the Italian credito which comes from the Latin ‘credo’ which means trust or belief (in the
proprietor or owed by the proprietor. In explaining double entry system, Pacioli wrote that ‘All
entries… have to be double entries, that is if you make one creditor, you must make some
debtor’. He also stated that a merchants responsibility include to give glory to God in their
enterprises, to be ethical in all business activities and to earn a profit. He discussed the details
of memorandum, journal, ledger and specialised accounting procedures.
ECONOMIC EVENTS
Business organizations involves economic events. An economic event is known as a happening
of consequence to a business organization which consists of transactions, and which are
measurable in monetary terms. For example, purchase of machinery, installing and keeping it
ready for manufacturing is an event which comprises number of financial transactions such as
buying a machine, transportation of machine, site preparation for installation of a machine,
expenditure incurred on its installation and trial runs. Thus, accounting identifies bunch of
transactions relating to an economic event. If an event involves transactions between an
outsider and an organization, these are known as external events.
The following are the examples of such transactions:
• Sale of merchandise to the customers.
• Rendering services to the customers by ABC Limited.
• Purchase of materials from suppliers.
• Payment of monthly rent to the landlord.
An internal event is an economic event that occurs entirely between the internal wings of an
enterprise, e.g., supply of raw material or components by the stores department to the
manufacturing department, payment of wages to the employees, etc.
IDENTIFICATION, MEASUREMENT, RECORDING AND COMMUNICATION
Identification : It means determining what transactions to record, i.e., to identity events which
are to be recorded. It involves observing activities and selecting those events that are of
considered financial character and relate to the organization. The business transactions and
other economic events therefore are evaluated for deciding whether it has to be recorded in
books of account. For example, the value of human resources, changes in managerial policies
or appointment of personnel are important but none of these are recorded in books of
account. However, when a company makes a sale or purchase, whether on cash or credit, or
pays salary it is recorded in the books of account.
Measurement : It means quantification (including estimates) of business transactions into
financial terms by using monetary unit, viz. rupees and paise as a measuring unit. If an event
cannot be quantified in monetary terms, it is not considered for recording in financial accounts.
That is why important items like the appointment of a new managing director, signing of
contracts or changes in personnel are not shown in the books of accounts.
Recording : Once the economic events are identified and measured in financial terms, these
are recorded in books of account in monetary terms and in a chronological order. Recording is
done in a manner that the necessary financial information is summarized as per well-
established practice and is made available as and when required.
Communication : The economic events are identified, measured and recorded in order that the
pertinent information is generated and communicated in a certain form to management and
other internal and external users. The information is regularly communicated through
accounting reports.
These reports provide information that are useful to a variety of users who have an interest in
assessing the financial performance and the position of an enterprise, planning, and controlling
business activities and making necessary decisions from time to time.
The accounting information system should be designed in such a way that the right information
is communicated to the right person at the right time. Reports can be daily, weekly, monthly,
or quarterly, depending upon the needs of the users.
An important element in the communication process is the accountant’s ability and efficiency
in presenting the relevant information.
ORGANIZATION
Organization refers to a business enterprise, whether for profit or not-for profit motive.
Depending upon the size of activities and level of business operation, it can be a sole-proprietor
concern, partnership firm, cooperative society, company, local authority, municipal
corporation, or any other association of persons.
INTERESTED USERS OF INFORMATION
Accounting is a means by which necessary financial information about business enterprise is
communicated and is also called the language of business. Many users need financial
information to make important decisions.
These users can be divided into two broad categories: internal users and external users.
Internal users include: Chief Executive, Financial Officer, Vice President, Business Unit
Managers, Plant Managers, Store Managers, Line Supervisors, etc.
External users include: present and potential Investors (shareholders), Creditors (Banks and
other Financial Institutions, Debenture holders and other Lenders), Tax Authorities,
Regulatory Agencies (Department of Company Affairs, Registrar of Companies, Securities
Exchange Board , Labor Unions, Trade Associations, Stock Exchange and Customers, etc.
Since the primary function of accounting is to provide useful information for decision-making,
it is a means to an end, with the end being the decision that is helped by the availability of
accounting information.
WHY DO THE USERS WANT ACCOUNTING INFORMATION?
❖ The owners/shareholders use them to see if they are getting a satisfactory return on
their investment, and to assess the financial health of their company/business.
❖ The directors/managers use them for making both internal and external comparisons
in their attempts to evaluate the performance. They may compare the financial analysis
of their company with the industry figures to ascertain the company’s strengths and
weaknesses. Management is also concerned with ensuring that the money invested in
the company/organization is generating an adequate return and that the
company/organization is able to pay its debts and remain solvent.
❖ The creditors (lenders) want to know if they are likely to get paid and look particularly
at liquidity, which is the ability of the company/organization to pay its debts as they
become due.
❖ The prospective investors use them to assess whether or not to invest their money in
the company/organization.
❖ The government and regulatory agencies such as Registrar of companies, Custom
departments IRDA, RBI, etc. require information for the payment of various taxes such
as Value Added Tax (VAT), Income Tax (IT), Customs and Excise duties for protecting
the interests of investors, creditors(lenders), and also to satisfy the legal obligations.
ACCOUNTING AS A SOURCE OF INFORMATION
As discussed earlier, accounting is a definite process of interlinked activities, that begins with
the identification of transactions and ends with the preparation of financial statements. Every
step in the process of accounting generates information. Generation of information is not an
end itself. It is a means to facilitate the dissemination of information among different user
groups. Such information enables the interested parties to take appropriate decisions.
Therefore, dissemination of information is an essential function of accounting.
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 underlying
assumptions on matters subject to interpretation, evaluation, prediction, or
estimation;
• provide information on activities affecting the society.
The role of an accountant in generating accounting information is to observe, screen and
recognize events and transactions to measure and process them, and thereby compile reports
comprising accounting information that are communicated to the users. These are then
interpreted, decoded and used by management and other user groups. It must be ensured that
the information provided is relevant, adequate and reliable for decision-making. The
apparently divergent needs of internal and external users of accounting information have
resulted in the development of sub-disciplines within the accounting discipline namely,
financial accounting, cost accounting and management accounting.
Financial accounting assists keeping a systematic record of financial transactions the
preparation and presentation of financial reports to arrive at a measure of organizational
success and financial soundness. It relates to the past period, serves the stewardship function
and is monetary in nature. It is primarily concerned with the provision of financial information
to all stakeholders.
Cost accounting assists in analyzing the expenditure for ascertaining the cost of various
products manufactured or services rendered by the firm and fixation of prices thereof. It also
helps in controlling the costs and providing necessary costing information to management for
decision-making.
Management accounting deals with the provision of necessary accounting information to
people within the organization to enable them in decision-making, planning and controlling
business operations. Management accounting draws the relevant information mainly from
financial accounting and cost accounting which helps the management in budgeting, assessing
profitability, taking pricing decisions, capital expenditure decisions and so on. Besides, it
generates other information (quantitative and qualitative, financial and non-financial) which
relates to the future and is relevant for decision-making in the organization.
Such information includes: sales forecast, cash flows, purchase requirement, manpower needs,
environmental data about effects on air, water, land, natural resources, flora, fauna, human
health, social responsibilities, etc. As a result, the scope of accounting has become so vast, that
new areas like human resource accounting, social accounting, responsibility accounting have
also gained prominence.
QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION
Qualitative characteristics are the attributes of accounting information which tend to enhance
its understandability and usefulness. To assess whether accounting information is decision
useful, it must possess the characteristics of reliability, relevance, understandability, and
comparability.
• Reliability means the users must be able to depend on the information. The reliability
of accounting information is determined by the degree of correspondence between
what the information conveys about the transactions or events that have occurred,
measured, and displayed. A reliable information should be free from error and bias and
faithfully represents what it is meant to represent. To ensure reliability, the information
disclosed must be credible, verifiable by independent parties use the same method of
measuring and be neutral and faithful.
• Relevance To be relevant, information must be available in time, must help in
prediction and feedback, and must influence the decisions of users by : (a) helping them
form prediction about the outcomes of past, present or future events; and/or (b)
confirming or correcting their past evaluations.
• Understandability means decision-makers must interpret accounting information in
the same sense as it is prepared and conveyed to them. The qualities that distinguish
between good and bad communication in a message are fundamental to the
understandability of the message. A message is said to be effectively communicated
when it is interpreted by the receiver of the message in the same sense in which the
sender has sent. Accountants should present the comparable information in the most
intelligible manner without sacrificing relevance and reliability.
• Comparability It is not sufficient that the financial information is relevant and reliable
at a particular time, in a particular circumstance or for a particular reporting entity. But
it is equally important that the users of the general-purpose financial reports are able
to compare various aspects of an entity over different time period and with other
entities. To be comparable, accounting reports must belong to a common period and
use common unit of measurement and format of reporting.
BRANCHES OF ACCOUNTING
The economic development and technological advancements have resulted in an increase in
the scale of operations and the advent of the company form of business organization. This has
made the management function more and more complex and increased the importance of
accounting information. This gave rise to special branches of accounting. These are briefly
explained below :
Financial accounting : The purpose of this branch of accounting is to keep a record of all
financial transactions so that: (a) the profit earned or loss sustained by the business during an
accounting period can be worked out, (b) the financial position of the business as at the end of
the accounting period can be ascertained, and (c) the financial information required by the
management and other interested parties can be provided.
Cost Accounting : The purpose of cost accounting is to analyse 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 : The purpose of management accounting is to assist the
management in taking rational policy decisions and to evaluate the impact of its decisons and
actions.
OBJECTIVES OF ACCOUNTING
As an information system, the basic objective of accounting is to provide useful information to
the interested group of users, both external and internal. The necessary information,
particularly in case of external users, is provided in the form of financial statements, viz., profit
and loss account and balance sheet. Besides these, the management is provided with
additional information from time to time from the accounting records of business. Thus, the
primary objectives of accounting include the following:
➢ Maintenance of Records of Business Transactions
Accounting is used for the maintenance of a systematic record of all financial
transactions in book of accounts. Even the most brilliant executive or manager cannot
accurately remember the numerous amounts of varied transactions such as purchases,
sales, receipts, payments, etc. that takes place in business every day. Hence, a proper
and complete records of all business transactions are kept regularly. Moreover, the
recorded information enables verifiability and acts as evidence.
➢ Calculation of Profit and Loss
The owners of business are keen to have an idea about the net results of their business
operations periodically, i.e. whether the business has earned profits or incurred losses.
Thus, another objective of accounting is to ascertain the profit earned or loss sustained
by a business during an accounting period which can be easily workout with help of
record of incomes and expenses relating to the business by preparing a profit or loss
account for the period. Profit represents excess of revenue (income), over expenses. If
the total revenue of a given period is ` 600,000 and total expenses are 540,000 the
profit will be equal to ` 60,000(` 600,000 – ` 540,000). If however, the total expenses
exceed the total revenue, the difference reflects the loss.
➢ Depiction of Financial Position
Accounting also aims at ascertaining the financial position of the business concern in
the form of its assets and liabilities at the end of every accounting period. A proper
record of resources owned by business organization (Assets) and claims against such
resources (Liabilities) facilitates the preparation of a statement known as balance sheet
position statement.
➢ Providing Accounting Information to its Users
The accounting information generated by the accounting process is communicated in
the form of reports, statements, graphs, and charts to the users who need it in different
decision situations.
As already stated, there are two main user groups, viz. internal users, mainly
management, who needs timely information on cost of sales, profitability, etc. for
planning, controlling and decision-making and external users who have limited
authority, ability, and resources to obtain the necessary information and have to rely
on financial statements (Balance Sheet, Profit and Loss account).
Primarily, the external users are interested in the following:
❖ Investors and potential investors-information on the risks and return on investment; •
Unions and employee groups-information on the stability, profitability and distribution
of wealth within the business;
❖ Lenders and financial institutions-information on the creditworthiness of the company
and its ability to repay loans and pay interest;
❖ Suppliers and creditors-information on whether amounts owed will be repaid when
due, and on the continued existence of the business;
❖ Customers-information on the continued existence of the business and thus the
probability of a continued supply of products, parts and after sales service; •
Government and other regulators- information on the allocation of resources and the
compliance to regulations;
❖ Social responsibility groups, such as environmental groups-information on the impact
on environment and its protection;
❖ Competitors-information on the relative strengths and weaknesses of their
competition and for comparative and benchmarking purposes. Whereas the above
categories of users share in the wealth of the company, competitors require the
information mainly for strategic purposes.
ROLE OF ACCOUNTING
For centuries, the role of accounting has been changing with the changes in economic
development and increasing societal demands. It describes and analyses a mass of data of an
enterprise through measurement, classification, and summarization, and reduces those date
into reports and statements, which show the financial condition and results of operations of
that enterprise. Hence, it is regarded as a language of business. It also performs the service
activity by providing quantitative financial information that helps the users in various ways.
Accounting as an information system collects and communicates economic information about
an enterprise to a wide variety of interested parties. However, accounting information relates
to the past transactions and is quantitative and financial in nature, it does not provide
qualitative and non-financial information. These limitations of accounting must be kept in view
while making use of the accounting information
BASIC TERMS IN ACCOUNTING
• Entity means a reality that has a definite individual existence. Business entity means a
specifically identifiable business enterprise like Super Bazaar, Hire Jewellers, ITC
Limited, etc. An accounting system is always devised for a specific business entity (also
called accounting entity).
• Transaction An event involving some value between two or more entities. It can be a
purchase of goods, receipt of money, payment to a creditor, incurring expenses, etc. It
can be a cash transaction or a credit transaction.
• Assets are economic resources of an enterprise that can be usefully expressed in
monetary terms. Assets are items of value used by the business in its operations. For
example, Super Bazar owns a fleet of trucks, which is used by it for delivering foodstuffs;
the trucks, thus, provide economic benefit to the enterprise. Assets can be broadly
classified into two types: current and Non-current.
• 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. Liabilities are classified as current and non-current.
• Capital 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.
• Sales are total revenues from goods or services sold or provided to customers. Sales
may be cash sales or credit sales
• Revenues These are the amounts of the business earned by selling its products or
providing services to customers, called sales revenue. Other items of revenue common
to many businesses are: commission, interest, dividends, royalities, rent received, etc.
Revenue is also called income.
• Expenses Costs incurred by a business in the process of earning revenue are known as
expenses. Generally, expenses are measured by the cost of assets consumed or services
used during an accounting period. The usual items of expenses are: depreciation, rent,
wages, salaries, interest, cost of heater, light and water, telephone, etc.
• Expenditure Spending money or incurring a liability for some benefit, service or
property received is called expenditure. Purchase of goods, purchase of machinery,
purchase of furniture, etc. are examples of expenditure. If the benefit of expenditure is
exhausted within a year, it is treated as an expense (also called revenue expenditure).
On the other hand, the benefit of an expenditure lasts for more than a year, it is treated
as an asset (also called capital expenditure) such as purchase of machinery, furniture,
etc.
• Profit The excess of revenues of a period over its related expenses during an accounting
year is profit. Profit increases the investment of the owners.
• Gain A profit that arises from events or transactions which are incidental to business
such as sale of fixed assets, winning a court case, appreciation in the value of an asset.
• Loss The excess of expenses of a period over its related revenues its termed as loss. It
decreases in owner’s equity. It also refers to money or money’s worth lost (or cost
incurred) without receiving any benefit in return, e.g., cash or goods lost by theft or a
fire accident, etc. It also includes loss on sale of fixed assets.
• Discount is the deduction in the price of the goods sold. It is offered in two ways.
Offering deduction of agreed percentage of list price at the time selling goods is one
way of giving discount. Such discount is called ‘trade discount’. It is generally offered
by manufactures to wholesalers and by wholesalers to retailers. After selling the goods
on credit basis the debtors may be given certain deduction in amount due in case if
they pay the amount within the stipulated period or earlier. This deduction is given at
the time of payment on the amount payable. Hence, it is called as cash discount. Cash
discount acts as an incentive that encourages prompt payment by the debtors.
• Voucher The documentary evidence in support of a transaction is known as voucher.
For example, if we buy goods for cash, we get cash memo, if we buy on credit, we get
an invoice; when we make a payment we get a receipt and so on.
• Goods It refers to the products in which the business unit is dealing, i.e. in terms of
which it is buying and selling or producing and selling. The items that are purchased for
use in the business are not called goods. For example, for a furniture dealer purchase
of chairs and tables is termed as goods, while for other it is furniture and is treated as
an asset. Similarly, for a stationery merchant, stationery is goods, whereas for others it
is an item of expense (not purchases)
• Drawings Withdrawal of money and/or goods by the owner from the business for
personal use is known as drawings. Drawings reduces the investment of the owners.
• Purchases are total amount of goods procured by a business on credit and on cash, for
use or sale. In a trading concern, purchases are made of merchandise for resale with or
without processing. In a manufacturing concern, raw materials are purchased,
processed further into finished goods, and then sold. Purchases may be cash purchases
or credit purchases.
• Stock (inventory) is a measure of something on hand-goods, spares, and other items in
a business. It is called Stock in hand. In a trading concern, the stock on hand is the
amount of goods which are lying unsold as at the end of an accounting period is called
closing stock (ending inventory). In a manufacturing company, closing stock comprises
raw materials, semi-finished goods and finished goods on hand on the closing date.
Similarly, opening stock (beginning inventory) is the amount of stock at the beginning
of the accounting period.
• Debtors are persons and/or other entities who owe to an enterprise an amount for
buying goods and services on credit. The total amount standing against such persons
and/or entities on the closing date, is shown in the balance sheet as sundry debtors on
the asset side.
• Creditors are persons and/or other entities who must be paid by an enterprise an
amount for providing the enterprise goods and services on credit. The total amount
standing to the favor of such persons and/or entities on the closing date, is shown in
the Balance Sheet as sundry creditors on the liabilities side.
