CHAPTER- 1

ACCOUNTING SYSTEM

According to the American Institute of certified public accountants

(AICPA) :

“Accounting is an art of recording, classifying and summarizing in a significant

manner & in terms of money, transactions and events which are in part of at
least of a financial character and interpreting the results thereof.”

Book-keeping : It is the process of recording business transactions in a

systematic manner and classifying them into ledgers.

Difference b/w Book-keeping and Accounting :

1) Book keeping is concerned with the recording of business transactions

ina systematic manner and classifying them into ledgers. It is mechanical
& repetitive in nature. It is a part of accounting.

2) Accounting is used in a wider sense. Accounting includes design of

accounting system, preparation of financial statements, interpretation of
financial statements and communication of accounting information to
its users.

Accounting Information System :

The system of collecting and processing transaction data and disseminating

information to interested parties is known as the accounting information
system.

The design of accounting information system depend on :

1) Nature of the business

 2) Transactions in which the entity engages
3) Size of the firm
4) The volume of the data
5) Informational demands of the users

A person cannot remember all the transactions and events which take place in
an organization. Therefore, the owner/manager of a business organization has
to depend on the accounting process.

Accounting is the system of identifying transactions and events which are to

be recorded and then recording them into the subsidiary books , classifying
the recorded transactions in the ledgers and periodically summarizing the
transactions by preparing profit and loss account, balance sheet and other
statements.

INPUT --------------PROCESSING----------------OUTPUT----------------USERS

Here, Input : Business transactions of financial character

Processing : Recording, classification, summarizing the business transactions

based on accounting principles, standards, management estimates,
Companies Acct, Income Tax act and others acts & regulations etc.

Output : P&L a/c, Balance sheet, Cash flow statement , explanatory notes etc.

Users : Owners, lenders, investors, managers, suppliers, customers, employees

& government regulatory authorities.
Users of financial accounting info. & their information needs :

1) Internal Users : These ppl are from the management itself like the
owners and the managers in case of sole proprietorship concern &
partners and managers in case of partnership firm & directos,
managerial personnel in case of company or a corporate body.

Internal users have access to not only the general financial statements
but also to the specific purpose statements. Further they have access to
various internal reports which are prepared for the internal use and are
not published.

2) External Users : These are those users who are outside the
management group such as investors, suppliers, customers. They are
mainly communicated general purpose financial statements, as they are
prepared keeping in mind the general needs of the users.

a) Investors : They provide risk capital to the enterprise. As, providers of

the risk capital, they are keen to know their profit from their
investments. Investors need accounting information to decide
whether they should buy, hold or sell shares of a certain company
they also need the info for assessing that whether the company is in
the state of paying dividends or not.

b) Lenders : Lenders provide Loan to the enterprise. They are banks,

development financial institutions & debenture holders.

Long term lenders are mainly interested in knowing the solvency position and
the short term lenders are interested in knowing the liquidity and profitability
of the enterprise.

c) Managers : Managers prepare & present the financial statements.

They need information for taking various policy decisions and to plan
and control the working of the enterprise.
 d) Employees and trade unions : Employees are interested to know the
stability and profitability of the enterprise as their salaries, wages &
other benefits are dependent on the financial position of the
enterprise.

Qualitative characteristics of financial statements :

1) Understandability : The financial info presented in the financial

statements should be understandable by the users. In other words, users
should be able to understand the info provided in the financial
statements & its significance.

2) Relevance : Accounting information communicated must be relevant to

the users. The information is relevant when it can meet the requirements
of the users….Information has the quality of relevance when it can
influence the economic decisions of the user by helping him to evaluate
his past, present & future evaluation.

3) Reliability : The information should be reliable. Reliability gives trust and

confidence that the reported information is based on facts. The
information can be considered as liable when it is free from any material
error or personal biasness.

4) Comparability : Accounting information of an enterprise should be

comparable with similar information of the same/other enterprise for
different/particular years. To achieve comparability, an enterprise should
follow the same accounting policies over the year, consistency in
accounting policies is necessary.

Functions of accounting :
 a) Maintaining systematic accounting records : One of the main
functions of accounting is to identify transactions and entering them
into appropriate books of accounts and maintaining a system record of
all the transactions as, the no. of transactions are usually very large.

b) Calculation of Profit or loss : At the end of the accounting period, the

income statement i.e the profit & loss a/c is prepared to calculate the
net profit or net loss. Excess of income over expenses is termed as net
profit and excess of expenses over income is termed as net loss.

c) Ascertainment of financial position : At the last date of the

accounting period, balance sheet is prepared, to find out the financial
position of the enterprise. The balance sheet shows assets, liabilities
and equity.

d) Determination of the cash flows : Apart from preparing the p&l a/c
and the balance sheet, Cash flow statement is also prepared in order to
find out the inflows and outflows of cash and cash equivalents from
operating, investing and financing activities.

e) Forecasting : Using the current and past financial statements, projected

financial statements for the coming years can be prepared.

Advantages & Disadvantages of Accounting :

Apart from the general purpose Transactions and events are recorded
financial statements which are which can only be expressed in the
prepared for all the users, specific monetory terms, there are certain
purpose financial statements are also events which affect the business but
prepared, which can only be used by are in non-monetory terms.
the management, which assists them
in making policy decisions etc and
work accordingly.
A systematic record of all the Financial statements are prepared
transactions are kept in the books ofonce a year for external users.
accounts, therefore it isn’t necessary
However incase of listed companies,
to memorise the transactions. quarterly results are also published.
Thus, the timely info. Is not made
available to the external users.
Systematic accounting records can While calculating the profit, the
be used as an evidence in the court enterprise takes into consideration
of law. Accounting records are kept the revenues and expenses as per
on double entry basis can be relied the accounting principles. Certain
upon by the income tax and sales tax type of social costs like water or air
authorities. pollution caused by the enterprise
are ignored.

Branches of Accounting :
Financial Cost Management Tax HR National
Accounting Accounting Accounting Accounting Accounting Accounting

Basis of accounting :

a) Cash basis of Accounting :

Cash basis accounting is a method of keeping track of finances where you

record income and expenses when actual money changes hands. In simpler
terms, it means you record transactions only when cash is received or paid
out, without considering when the transaction was made or when goods or
services were delivered. It's a straightforward way of tracking money based on
actual cash flow.

b) Accrual basis of accounting :

The accrual basis of accounting is a method that records financial transactions

when they occur, regardless of when the cash is exchanged. This means
revenues and expenses are recognized when they are earned or incurred,
rather than when the money is actually received or paid out. It gives a more
accurate picture of a company's financial health by matching revenues with
expenses in the same accounting period.