INTRODUCTION TO

ACCOUNTING
MODULE 1
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.
• The better the understanding of the language, the better is the
management of financial aspects of living. Many aspects of our lives are
based on accounting, personal financial planning, investments, income-tax,
loans, etc.
• We have different roles to perform in life-the role of a student, of a family
head, of a manager, of an investor, etc. The knowledge of accounting is an
added advantage in performing different roles.
• However, we shall limit our scope of discussion to a business organisation
and the various financial aspects of such an organisation.
• Just like arithmetic is a procedural element of mathematics, book
keeping is the procedural element of accounting. It shows how an
accounting system operates in business and how the flow of
information occurs. THE ACCOUNTING SYSTEM will include the
following:
• People make decision.
• Business transactions occur.
• Accountants prepare reports to show the results of business
operations
DEVELOPMENT OF ACCOUNTING DISCIPLINE:
• The history of accounting can be traced back to ancient times. According to some
beliefs, the very art of writing originated in order to record accounting
information.
• Though this may seem to be an exaggeration, but there is no denying the fact
that accounting has a long history. Accounting records can be traced back to the
ancient civilizations of China, Babylonia, Greece and Egypt.
• Accounting was used to keep records regarding the cost of labour and materials
used in building great structures like the Pyramids. During 1400s, accounting
grew further because the needs for information of merchants in the Venis City of
Italy increased.
• The first known description of double entry book keeping was first published in
1994 by Lucas Pacioli. He was a mathematician and a friend of Leonardo Ileda
Vinci.
• The onset of the industrial revolution necessitated the development of more
sophisticated accounting system, rather than pricing the goods based on guesses
about the costs. The increase in competition and mass production of goods led to
the rise of accounting as a formal branch of study.
• With the passage of time, the corporate world grew. In the
nineteenth century, companies came up in many areas of
infrastructure like the railways, steel, communication, etc. It led to a
rapid growth in accounting.
• As the complexities of business grew, ownership and management of
business was divorced. As such, managers had to come up with well-
defined, structured systems of accounting to report the performance
of the business to its owners. Government also has had a lot to do
with more accounting developments.
• The Income Tax brought about the concept of ‘income’. Government
takes a host of other decisions, relating to education, health,
economic planning, for which it needs accurate and reliable
information. As such, the government demands stringent
accountability in the corporate sector, which forces the accounting
process to be as objective and formal as possible
FUNCTIONS OF ACCOUNTING
• Preparation of financial statements
• Management control
• Tax planning
• Auditing
• Information management
UTILITY OF ACCOUNTING
• Individuals may use accounting information to manage their routine affairs like operating
and managing their bank accounts, to evaluate the worthwhileness of a job in an
organization, to invest money, to rent a house, etc.
• Business Managers have to set goals, evaluate progress and initiate corrective action in
case of unfavourable deviation from the planned course of action. Accounting
information is required for many such decisions—purchasing equipment, maintenance of
inventory, borrowing and lending, etc.
• Investors and creditors are keen to evaluate the profitability and solvency of a company
before they decide to provide money to the organisation. Therefore, they are interested
to obtain financial information about the company in which they are contemplating an
investment.
• Financial statements are the principal source of information to them which are published
in annual reports of a company and various financial dailies and periodicals.
• Government and Regulatory agencies are charged with the responsibility of guiding the
socio-economic system of a country in such a way that it promotes common good. For
example, the Securities and Exchange Board of India (SEBI) makes it mandatory for a
company to disclose certain financial information to the investing public.
• The government’s task of managing the industrial economy becomes simplify if the
accounting information such as profits, costs, taxes, etc. is presented in a uniform
manner without any manipulation or ‘windowdressing’.
• Central and State governments levy various taxes. The taxation authorities,
therefore, need to know the income of a company to calculate the amount
of tax that the company would have to pay. The information generated by
accounting helps them in such computations and also to detect any
attempts of tax evasion.
• Employees and trade unions use the accounting information to settle
various issues related to wages, bonus, profit sharing, etc.
• Consumers and general public are also interested in knowing the amount
of income earned by various business houses.
• Accounting information helps in finding whether or not a company is over
charging or exploiting the customers, whether or not companies are
showing improved business performance, whether or not the country is
emerging from the economic recession, etc.
• All such aspects draw heavily on accounting information and are closely
related to our standard of living
TYPES OF ACCOUNTING
• The financial literature classifies accounting into two broad categories, viz, Financial
Accounting and Management Accounting.
• Financial accounting is primarily concerned with the preparation of financial statements
whereas management accounting covers areas such as interpretation of financial
statements, cost accounting, etc.
• Financial accounting deals with the preparation of financial statements for the basic
purpose of providing information to various interested groups like creditors, banks,
shareholders, financial institutions, government, consumers, etc.
• Financial statements, i.e. the income statement and the balance sheet indicate the way
in which the activities of the business have been conducted during a given period of
time.
• Financial accounting is charged with the primary responsibility of external reporting. The
users of information generated by financial accounting, like bankers, financial
institutions, regulatory authorities, government, investors, etc. want the accounting
information to be consistent so as to facilitate comparison.
• Therefore, financial accounting is based on certain concepts and conventions which
include separate business entity, going concern concept, money measurement concept,
cost concept, dual aspect concept, accounting period concept, matching concept,
realization concept and conventions of conservatism, disclosure, consistency, etc.
• The significance of financial accounting lies in the fact that it aids the
management in directing and controlling the activities of the firm and to frame
relevant managerial policies related to areas like production, sales, financing, etc.
• However, it suffers from certain drawbacks. The information provided by financial
accounting is consolidated in nature. It does not indicate a break-up for different
departments, processes, products and jobs. As such, it becomes difficult to
evaluate the performance of different sub-units of the organisation.
• Financial accounting does not help in knowing the cost behaviour as it does not
distinguish between fixed and variable costs.
• The information provided by financial accounting is historical in nature and as
such the predictability of such information is limited.
• The management of a company has to solve certain ticklish questions like
expansion of business, making or buying a component, adding or deleting a
product line, deciding on alternative methods of production, etc.
• The financial accounting information is of little help in answering these questions.
The limitations of financial accounting, however, should not lead one to believe
that it is of no use.
• It is the basic foundation on which other branches and tools of accounting
analysis are based. It is the source of information, which can be further analysed
and interpreted according to the tailor-made requirements of decision-makers.
• Management accounting Management accounting is ‘tailor-made’
accounting. It facilitates the management by providing accounting
information in such a way so that it is conducive for policy making and
running the day-to-day operations of the business.
• Its basic purpose is to communicate the facts according to the specific
needs of decision-makers by presenting the information in a systematic and
meaningful manner.
• Management accounting, therefore, specifically helps in planning and
control. It helps in setting standards and in case of variances between
planned and actual performances, it helps in deciding the corrective action.
• An important characteristic of management accounting is that it is forward
looking. Its basic focus is one future activity to be performed and not what
has already happened in the past.
• Since management accounting caters to the specific decision needs, it does
not rest upon any well-defined and set principles. The reports generated by
a management accountant can be of any duration– short or long,
depending on purpose. Further, the reports can be prepared for the
organisation as a whole as well as its segments.
• Cost accounting One important variant of management accounting is the cost analysis.
Cost accounting makes elaborate cost records regarding various products, operations and
functions.
• It is the process of determining and accumulating the cost of a particular product or
activity. Any product, function, job or process for which costs are determined and
accumulated, are called cost centres.
• The basic purpose of cost accounting is to provide a detailed breakup of cost of different
departments, processes, jobs, products, sales territories, etc., so that effective cost
control can be exercised.
• Cost accounting also helps in making revenue decisions such as those related to pricing,
product-mix, profit-volume decisions, expansion of business, replacement decisions, etc.
• The objectives of cost accounting, therefore, can be summarized in the form of three
important statements, viz, to determine costs, to facilitate planning and control of
business activities and to supply information for short- and long-term decision.
• Cost accounting has certain distinct advantages over financial accounting. The cost
accounting system provides data about profitable and non-profitable products and
activities, thus prompting corrective measures.
• It is easier to segregate and analyse individual cost items and to minimize losses and
wastages arising from the manufacturing process. Production methods can be varied so
as to minimize costs and increase profits. Cost accounting helps in making realistic pricing
decisions in times of low demand, competitive conditions, technology changes, etc.
KEYWORDS
• Accrual: Recognition of revenues and costs as they are earned or incurred. It includes
recognition of transaction relating to assets and liabilities as they occur irrespective of
the actual receipts or payment.
• Cost: The amount of expenditure incurred on or attributable to a specified article,
product or activity.
• Expenses: A cost relating to the operations of an accounting period.
• Revenue: Total amount received from sales of goods/services.
• Income/ Profit: Excess of revenue over expenses.
• Loss: Excess of expenses over revenue.
• Capital: Generally refers to the amount invested in an enterprise by its owner.
• Fund: An account usually of the nature of a reserve or provision which is represented by
specifically earmarked Assets.
• Gain: A monetary benefit, profit or advantage resulting from a transaction or group of
transactions.
• Investment: Expenditure on assets held to earn interest, income, profit or other benefits.
• Liability: The financial obligation of an enterprise other than owners’ funds.
• Net Profit: The excess of revenue over expenses during a particular accounting period.
GAAP
• Generally accepted accounting principles encompass the conventions,
rules and procedures necessary to define accepted accounting
practice at a particular time....... generally accepted accounting
principles include not only broad guidelines of general application,
but also detailed practices and procedures.
• Accounting Principles as those rules of action or conduct which are
adopted by the accountants universally while recording accounting
transactions. Accounting principles are man-made.
• They are accepted because they are believed to be useful. The
general acceptance of an accounting principle usually depends on
how well it meets the following three basic norms: (a) Usefulness; (b)
Objectiveness; and (c) Feasibility.
• A principle is useful to the extent that it results in meaningful or relevant
information to those who need to know about a certain business. In other
words, an accounting rule, which does not increase the utility of the
records to its readers, is not accepted as an accounting principle.
• A principle is objective to the extent that the information is not influenced
by the personal bias or Judgement of those who furnished it. Accounting
principle is said to be objective when it is solidly supported by facts.
Objectivity means reliability which also means that the accuracy of the
information reported can be verified.
• Accounting principles should be such as are practicable. A principle is
feasible when it can be implemented without undue difficulty or cost.
• Although these three features are generally found in accounting principles,
an optimum balance of three is struck in some cases for adopting a
particular rule as an accounting principle.
• For example, the principle of making the provision for doubtful debts is
found on feasibility and usefulness though it is less objective. This is
because of the fact that such provisions are not supported by any outside
evidence
Accounting Principles
• Accounting principles have been defined by the Canadian Institute of
Chartered Accountants as “The body of doctrines commonly
associated with the theory and procedure of accounting serving as an
explanation of current practices and as a guide for the selection of
conventions or procedures where alternatives exists. Rules governing
the formation of accounting axioms and the principles derived from
them have arisen from common experience, historical precedent
statements by individuals and professional bodies and regulations of
Governmental agencies”.
• According to Hendriksen (1997), Accounting theory may be defined as
logical reasoning in the form of a set of broad principles that (i)
provide a general frame of reference by which accounting practice
can be evaluated, and (ii) guide the development of new practices
and procedures. Theory may also be used to explain existing practices
to obtain a better understanding of them. But the most important
goal of accounting theory should be to provide a coherent set of
logical principles that form the general frame of reference for the
evaluation and development of sound accounting practices.
• The American Institute of Certified Public Accountants (AICPA) has
advocated the use of the word “Principle” in the sense in which it
means “rule of action”.
• It discuses the generally accepted accounting principles as follows:
• Financial statements are the product of a process in which a large
volume of data about aspects of the economic activities of an
enterprise are accumulated, analysed and reported.
• This process should be carried out in conformity with generally
accepted accounting principles. These principles represent the most
current consensus about how accounting information should be
recorded, what information should be disclosed, how it should be
disclosed, and which financial statement should be prepared.
• Thus, generally accepted principles and standards provide a common
financial language to enable informed users to read and interpret
financial statements.
KINDS OF ACCOUNTING PRINCIPLES
• In dealing with the framework of accounting theory a number of
words and terms have been used by different authors to express and
explain the same idea or notion.
• The various terms used for describing the basic ideas are: concepts,
postulates, propositions, assumptions, underlying principles,
fundamentals, conventions, doctrines, rules, axioms, etc. Each of
these terms is capable of precise definition.
• But, the accounting profession has served to give them lose and
overlapping meanings. One author may describe the same idea or
notion as a concept and another as a convention and still another as
postulate.
Concepts and Conventions
• The term ‘Concept’ is used to connote the accounting postulates, i.e.,
necessary assumptions and ideas which are fundamental to
accounting practice.
• In other words, fundamental accounting concepts are broad general
assumptions which underline the periodic financial statements of
business enterprises.
• The reason why some of these terms should be called concepts is
that they are basic assumptions and have a direct bearing on the
quality of financial accounting information.
• The term ‘convention’ is used to signify customs or tradition as a
guide to the preparation of accounting statements. The following are
the important accounting concepts and conventions:
Concepts and Conventions of Accounting
• Accounting Concepts • Accounting Conventions
• Separate Business Entity Concept • Convention of Materiality
• Money Measurement Concept • Convention of Conservatism
• Dual Aspect Concept • Convention of consistency
• Accounting Period Concept • Convention of disclosure
• Cost Concept
• The Matching Concept
• Accrual Concept
• Realisation Concept
ACCOUNTING CONCEPTS
• The more important accounting concepts are briefly described as
follows:
1. Separate Business Entity Concept: In accounting we make a
distinction between business and the owner. All the books of
accounts records day to day financial transactions from the view
point of the business rather than from that of the owner. The
proprietor is considered as a creditor to the extent of the capital
brought in business by him.
2. Money Measurement Concept: In accounting, only those business
transactions are recorded which can be expressed in terms of
money. In other words, a fact or transaction or happening which
cannot be expressed in terms of money is not recorded in the
accounting books.
3. Dual Aspect Concept: Financial accounting records all the
transactions and events involving financial element. Each of such
transactions requires two aspects to be recorded. The recognition of
these two aspects of every transaction is known as a dual aspect
analysis. According to this concept every business transactions has dual
effect.
4. Going Concern Concept: Accounting assumes that the business
entity will continue to operate for a long time in the future unless there
is good evidence to the contrary. The enterprise is viewed as a going
concern, that is, as continuing in operations, at least in the foreseeable
future. In other words, there is neither the intention nor the necessity
to liquidate the particular business venture in the predictable future.
5. Accounting Period Concept: This concept requires that the life of the
business should be divided into appropriate segments for studying the
financial results shown by the enterprise after each segment. Although
the results of operations of a specific enterprise can be known precisely
only after the business has ceased to operate, its assets have been sold
off and liabilities paid off, the knowledge of the results periodically is
also necessary.
6. Cost Concept: The term ‘assets’ denotes the resources land building,
machinery etc. owned by a business. The money values that are
assigned to assets are derived from the cost concept. According to this
concept an asset is ordinarily entered on the accounting records at the
price paid to acquire it.
7. The Matching concept: This concept is based on the accounting
period concept. In reality we match revenues and expenses during the
accounting periods. Matching is the entire process of periodic earnings
measurement, often described as a process of matching expenses with
revenues.
In other words, income made by the enterprise during a period can be
measured only when the revenue earned during a period is compared
with the expenditure incurred for earning that revenue.
Broadly speaking revenue is the total amount realised from the sale of
goods or provision of services together with earnings from interest,
dividend, and other items of income. Expenses are cost incurred in
connection with the earnings of revenues.
8. Accrual Concept: It is generally accepted in accounting that the basis
of reporting income is accrual. Accrual concept makes a distinction
between the receipt of cash and the right to receive it, and the
payment of cash and the legal obligation to pay it.
This concept provides a guideline to the accountant as to how he
should treat the cash receipts and the right related thereto. Accrual
principle tries to evaluate every transaction in terms of its impact on
the owner’s equity. Thus it helps in proper measurement of income.
9. Realisation Concept: Realisation is technically understood as the
process of converting non-cash resources and rights into money. As
accounting principle, it is used to identify precisely the amount of
revenue to be recognised and the amount of expense to be matched to
such revenue for the purpose of income measurement. According to
realisation concept revenue is recognised when sale is made.
ACCOUNTING CONVENTIONS
1. Convention of Materiality: Materiality concept states that items of
small significance need not be given strict theoretically correct
treatment. In fact, there are many events in business which are
insignificant in nature. The cost of recording and showing in
financial statement such events may not be well justified by the
utility derived from that information.
2. Convention of Conservatism: This concept requires that the
accountants must follow the policy of ‘‘playing safe” while recording
business transactions and events. That is why, the accountant
follow the rule anticipate no profit but provide for all possible
losses, while recording the business events.
3. Convention of Consistency: The convention of consistency requires
that once a firm decided on certain accounting policies and methods
and has used these for some time, it should continue to follow the
same methods or procedures for all subsequent similar events and
transactions unless it has a sound reason to do otherwise. In other
worlds, accounting practices should remain unchanged from one
period to another.
4. Convention of Disclosure: This convention requires that accounting
statements should be honestly prepared and all significant information
should be disclosed therein. That is, while making accountancy records,
care should be taken to disclose all material information. Here the
emphasis is only on material information and not on immaterial
information.
Accounting standards
• Accounting standards are needed to:
a) provide a basic framework for preparing financial statements to be
uniformly followed by all business enterprises,
b) make the financial statements of one firm comparable with the
other firm and the financial statements of one period with the financial
statements of another period of the same firm,
c) make the financial statements credible and reliable, and
d) create general sense of confidence among the outside users of
financial statements.
• In order to harmonise varying accounting policies and practices, the
Institute of Chartered Accountants of India (ICAI) formed the
Accounting Standards Board (ASB) in April, 1977. ASB includes
representatives from industry and government.
• The main function of the ASB is to formulate accounting standards.
This Board of the Institute of Chartered Accountants of India has so
far formulated around 27 Accounting Standards, the list of these
accounting standards is furnished.
• Regarding the position of Accounting standards in India, it has been
stated that the standards have been developed without first
establishing the essential theoretical framework. As a result,
accounting standards lack direction and coherence. This type of
limitation also existed in UK and USA but it was remedied long back.
• KEYWORDS
• Creditor: Amount owned by an enterprise on account of goods purchased or services
received.
• Debtor: Persons from whom amounts are due for goods sold or services rendered.
• Reserve: The portion of earnings of an enterprise appropriated by the management for a
general or specific purpose.
• Provision: Amount retained by way of providing for any known liability the amount of
which cannot be determined with substantial accuracy.
• Net Realisable Value: Actual selling price of an asset in the ordinary course of business
less cost incurred in order to make the sale.
• Inventory: Tangible property held for sale in the ordinary course of business or in the
process of production for such sale.
• Interim Report: The information provided with reference to a date before the close of
the accounting period to owners or other interested persons concerning its
operations/financial position.
• Depreciation: Decrease in the value of fixed assets.
• Balance Sheet: A statement of the financial position of an enterprise as at a given date.
• Capital: Generally refers to the amount invested in an enterprise by its owners.
INTERNATIONAL ACCOUNTING STANDARDS
ISSUED BY ISAC
• IAS-1 Disclosure of Accounting Policies.
• IAS-2 Valuation and Presentation of Inventories in the context of historical cost system.
• IAS-3 Consolidated financial statements.
• IAS-4 Depreciation accounting
• IAS-5 Information to be disclosed in financial statements
• IAS-6 Accounting responses to changing prices
• IAS-7 Cash flow statement
• IAS-8 Unusual and prior period items and changes in accounting policies
• IAS-9 Accounting for research and development activities
• IAS-10 Contingencies and events occurring after balance sheet date
• IAS-11 Accounting for construction contracts
• IAS-12 Accounting for taxes on income
• IAS-13 Presentation of current assets and current liabilities
• IAS-14 Reporting financial information by segments
• IAS-15 Information reflecting the effects of changing prices
• IAS-16 Accounting for property, plant and equipment
• IAS-17 Accounting for leases
• IAS-18 Revenue recognition
• IAS-19 Accounting for retirement benefits in the financial statements of employees
• IAS-20 Accounting for government grants and disclosure of government assistance.
• IAS-21 Accounting for effects of changes in Foreign Exchange Rates
• IAS-22 Accounting for business combinations
• IAS-23 Capitalisation of borrowing costs
• IAS-24 Related party disclosures
• IAS-25 Accounting for investments
• IAS-26 Accounting and reported by retirement benefit plans
• IAS-27 Consolidated financial statements and accounting for investments in subsidiaries
• IAS-28 Consolidated financial statements and accounting for investments in subsidiaries
• IAS-29 Financial reporting in Hyper inflationary economics
• IAS-30 Disclosure in the financial statements of bank and similar financial institutions
• IAS-31 Financial reporting of interests in joint ventures
• IAS-32 Financial instruments: disclosure and presentation.
REVISED IAS ISSUED BY ISAC
• IAS-2 Inventories
• IAS-8 Net Profit or loss for the period, fundamental Errors changes in
Accounting Policies
• IAS-9 Research and Developments costs
• IAS-11 Construction Contracts
• IAS-16 Property, Plant and Equipment
• IAS-18 Revenue
• IAS-19 Retirement Benefit costs
• IAS-21 The effects of changes in foreign exchanges rates
• IAS-22 Business Combinations