Unit 1: Theoretical Framework

Chapter 1:Introduction to Accounting

1. Meaning and Definition of Accounting:

Meaning:- Accounting is a systematic process of identifying ,measuring
,recording ,classifying ,summarizing ,interpreting and communicating financial information.
Definitionby American Instituteof Certifiedpublic Accountants“Accounting isthe 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,”

Accounting is a medium of communication and is called as language of business.

2. Characteristics /Process of Accounting

(i) Identifying financial transactions and events

It means determining what transactions to record. It involves observing activities and selecting those
events that are of financial character and relate to the organization.

(ii) Measuring the transactions

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

(iii)Recording of transactions
Accounting involves recording the financial transactions in proper book of accounts such as
Journal or Subsidiary Books.

(iv) 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’.

(v) 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 .

(vi) 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.

(vii)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.
 3. Objectives of Accounting:

(i) 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. The recorded information enables verifiability and acts as an evidence.
(ii) 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, “Profit & Loss Account” is prepared
(iii) To determine the 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. For this purpose “Balance Sheet” is prepared
(iv)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.
(v)To assist the management
By analysing financial data and providing interpretations in the form of reports, accounting assists
management in handling business operations effectively.

4. Advantages of Accounting:

(i) Provide information about financial performance

Accounting provides factual information about financial performance during a given period of time. It
provide the information related to the profitability and financial position of the business over a period of
time.
(ii)Provide assistance to management
Accounting provide the financial information to the management in the form of various reports. It helps
management in business planning, decision making and in exercising control.
(iii)Facilitates comparative study
Keeping systematic records of financial transactions and preparation of reports at regular intervals helps in
making intra firm and inter firm comparison of the financial results over different time period.
(iv)Helps in settlement of tax liability
Systematic accounting records help in settlement of various tax liabilities. Such as – Income Tax, GST etc.
(v) 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.

5. Limitations Of Accounting:

(i) Accounting is not precise: Accounting is not completely free from personal bias or Judgment. Different
firm may have their own methods of estimations while presenting the financial performance of the business.

(ii)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

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

(iv) Ignore the qualitative information: Accounting records only those transactions which can be measured in
monetary terms. It ignores the qualitative aspects therefore certain important information does not find
place in accounting.

(v)Manipulation: Management may resort to window dressing and manipulate accounting to present a
favorable financial performance of the business than its actual position.
 6. Users of Accounting Information and their needs:
Users of Accounting Information 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 bonus.
(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. 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 for their research work.
• Consumers: They need information on the continued existence of the business and thus the
probability of a continued supply of products, parts and after sales service.

7.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 and users must be able to depend on the information.
• Relevance: Accounting information must be relevant. It must be available on time, help in
prediction and meet the decision-making requirements of the users.
• Understandability: Information should be disclosed in financial statements in such a manner
that these are easily understandable to the users and interpreted in the same sense at it was
conveyed to them.
• Comparability: The financial information and reports should be provided in such a way that both
intra-firm and inter-firm comparison is possible over different time periods.

7. Role of Accounting in Business:

Following points highlights the role of accounting in the field of business.

i. Maintainance of systematic records: The primary role of accounting is to maintain the

systematic records of financial transactions in order to ascertain the net profit or loss for
the accounting period and financial position of the business as on particular date.
ii. Assistance to Management: Accounting provides assistance to management
by providing financial information for its effective functioning and taking
rational and balanced decisions.
iii. Facilitates Comparative study: A systematic record of financial transactions enables a
business to compare one year’s results with others years and also locate the significant reasons to
changes,if any.
iv. Evidence in Court: Accounting records are often accepted by courts as good evidence.
v. Others:
• Facilitates raising loans
• Facilitates sale of business by ascertaining the proper purchase
price.
• Facilitates settlement of tax liabilities.

8. Types of Accounting Information :

i. Information relating to Profit or Surplus: The income statement makes available the
accounting information about the profit earned or loss incurred as a result of
business operations.
ii. Information relating to Financial Position: The balance sheet makes available the
information about the financial position of the business. It also provides the information
of various assets owned by the entity and the various liabilities owed by the entity.
iii. Information about Cash flow: Cash flow statement is a statement that shows both
inflows and outflow of cash during a specific period. It is of immense use as many
decisions such as payment of liabilities ,dividend and expansion of business, etc., are
based on availability of cash.

9. BASIC ACCOUNTING TERMS

(i) Entity:- It means a reality that has a definite individual existence. Business entity means a
specifically identifiable business enterprise like Tata motors, Reliance Industries etc.
(ii) Business Transactions: -The economic event that relates to the business entity and can be
measured in monetary terms is called Business Transaction. For example ,purchase of goods
,sale of goods, expenses incurred etc.
(iii) Assets:- These are properties or economic resources of an enterprise that can be expressed
in monetary terms. Assets are items of value used by the business in its operations. Assets
can be broadly classified into two types:
(a) Current assets: They are expected to be realized, or held for sale or for consumption
within 12 months. E.g debtors, stock, cash etc.
(b) Non-current assets : The assets other than current assets are termed as non-current
assets.

(iv) Fixed Assets: These are the non current assets which are held for long term use and
increases the earning capacity of business. It can be classified into:

(a)Tangible Assets: Assets which have physical existence and can be seen and touched are
termed as Tangible Assets. E.g Building, furniture, machinery etc.
(b) Intangible Assets: These assets cannot be seen or touched and not available for sale or
purchase in open market. E.g goodwill, patents, copyright etc.
(v) Liabilities:- Liabilities are obligations or debts that an enterprise has to pay at some time in the
future. Liabilities are classified as:

(a) Current liabilities :The liabilities which are due for payment or to be settled within 12
months are termed as current liabilities. E.g creditors, outstanding expenses, short term
borrowings etc.
(b)Non-current liabilities : The liabilities other than current liabilities are termed as non-
current liabilities.
(vi) 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.
(vii) 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 and his claim over the
assets of business.
(viii) Income/Revenue:- The amount earned by business by selling goods or providing services to
customers is called sales revenue. Other items of income common to many businesses are
commission received , interest received , dividend received , rent received, etc.
(ix) 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. For example depreciation, rent, wages, salaries, interest etc.
(x) Expenditure:-Spending money or incurring liability for some benefit is called expenditure .
If the benefit of expenditure is exhausted within a year, it is called revenue expenditure(expense)
e.g rent, salary ,electricity charges etc. On the other hand, if the benefit of an expenditure lasts for
more than a year, it is called capital expenditure(assets) e.g purchase of machinery, furniture,
etc.
(xi) Profit: - The excess of revenues/Income of over its related expenses during an accounting year
is profit.
(xii) 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 etc.
(xiii) Loss: - The excess of expenses over its related revenues its termed as loss.
(xiv)Voucher:- The documentary evidence in support of a transaction is known as voucher. For
example, cash memo, invoice, cash receipt etc.
(xv) Goods: - It refers to the product/article purchased for sale or for use in the manufacturing of
certain other products. 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.
(xvi) Purchase: Purchases are total amount of goods procured by a business on credit and on cash
for sale, or further processing or manufacturing other goods.

(xvii) Sales: It is total revenue from goods sold or services provided to customers. Sales may be
cash sales or credit sales

(xviii) Stock(Inventory): In a trading concern, the stock on hand is the amount of goods which are
lying unsold at a particular time . In a manufacturing company, stock comprises of raw materials,
semi-finished goods and finished goods on hand at a particular time .

(xix) Debtors: There are persons/entities who owe to an enterprise an amount for buying goods
and services on credit.
(xx)Creditors: These are persons/entities who have to be paid by an enterprise an amount for
providing the enterprise goods and services on credit.
(xxi) Discount: Discount is the deduction in the price of the goods sold. It is offered in two ways.
 (a) Trade discount : It is given to promote sales by offering deduction in the list price of goods
(b) Cash Discount: This discount is given to the customers/debtors who make prompt payment
or pay within stipulated period.

Do it yourself:

1. Explain the meaning of Accounting.

2. What are the steps involved in the process of accounting?
3. Explain any two objectives of accounting.
4. What are advantages of accounting?
5. Enlist the various external users of accounting information.
6. Discuss the role of Accounting in business.(any two points)
7. Explain the various types of Accounting Information.
8. Qualitative characteristics of Accounting includes
(a) Reliability and relevance
(b) Understandability and comparability
(c) Both (a) and (b)
(d) None of the above
9. Basic function of accounting is to :
(a) Record all business transactions
(b) Interpret financial data
(c) Assist to management
(d) None of the above
10. Which of the following is not of a financial character?
(a) Purchase of asset
(b) Purchase of asset for cash
(c) Withdrawing money by proprietor from business
(d) Strike by employees.
11. Which of the following is not an internal user of financial statements?
(a) Board of Directors
(b) Managers
(c) Employees
(d) Lenders

12.The long term assets that have no physical existence but, possess a value is known as ,
A)Current assets
B)Fixed assets
C)Intangible assets
D) Investments

13. The assets that can be easily converted into cash within a short period (i.e., 1 year or less is known
as,
A)Current assets
B)Fixed assets
C)Intangible assets
D) Investments
14. Which of these best explains fixed assets?
A) Are bought to be used in the business
B) Are expensive items bought for the business
C) Are items which will not wear out quickly
D) Are of long life and are not purchased specifically for resale

Q.15 Which of the following is the first step in accounting?

a. Communicating to the interested parties.
b. Analysing
c. Measurement of transactions
d. Identification & recording of Financial transactions and events

Q.16 Which of the following is not a business transaction?

a. Purchases of goods from Amit of `5,000
b. Paid salaries `250.
c. Purchase a Car of `5,25,000 from his personal account.
d. Purchase a Laptop of `50,500 for Business.

17.Give 2 examples of Tangible assets.

18. The amount which the proprietor has invested in a business is known as____________