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. In
order 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
• 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 in order to ascertain the
company’s strengths and weaknesses. Management is also concerned with ensuring
that the money invested in the company/organisation is generating an adequate
return and that the company/organisation 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/organisation 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/organisation.
• 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 imposed by the Companies Act 1956 and SEBI from
time-to time.
Accounting as a Source of Information
Accounting as a Source of Information
As
discussed earlier, accounting is a definite processes 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 in 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 utilize resources effectively
in meeting goals;
•
provide factual and interpretative information by disclosing underlying assumptions
on matters subject to interpretation, evaluation, prediction, or estimation;
and
•
provide information on activities affecting the society.
Qualitative
characteristics are the attributes of accounting information which tend to
enhance its understandability and usefulness. In order to assess whether
accounting information is decision useful, it must possess the characteristics
of reliability, relevance, understandability and comparability.
Reliability
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.
The
economic development and technological improvements have resulted in an increase
in the scale of operations and the advent of the company form of business organisation.
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:
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 analyses 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 decisions and actions.
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:
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 amount 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
an evidence.
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 Rs 6,00,000 and total expenses are Rs. 5,40,000 the profit will
be equal to Rs. 60,000(Rs. 6,00,000 – Rs. 5,40,000). If however, the total expenses
exceed the total revenue, the difference reflects the loss.
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 organisation (Assets)
Qualitative Characteristic
of Accounting Information
Decision
Makers (Users of Accounting Information) Understandability Decision Usefulness Relevance,
Reliability, Timeliness, Dedicative Feedback, Verifiability Faithfulness Value,
Neutrality Comparability.
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 returns on
investments;
•
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.
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 nonfinancial information.
These limitations of accounting must be kept in view while making use of the
accounting information.
As a language – it is perceived as the language
of business which is used to communicate information on enterprises;
As a historical record- it is viewed as
chronological record of financial transactions of an organisation at actual
amounts involved;
As current economic reality- it is viewed as the
means of determining the true income of an entity namely the change of wealth
over time;
As an information system – it is viewed as a
process that links an information source (the accountant) to a set of receivers
(external users) by means of a channel of communication;
As a commodity- specialized information is viewed
as a service which is in demand in society, with accountants being willing to
and capable of providing it.
Basic Terms in Accounting
Entity
Entity
means a thing 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
A 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.
This item will be shown on the asset side of the balance sheet of Super Bazaar.
Assets can be broadly classified into two types: Fixed Assets and Current
Assets.
Fixed Assets are assets held on a
long-term basis, such as land, buildings, machinery, plant, furniture and
fixtures. These assets are used for the normal operations of the business.
Current Assets are assets held on a
short-term basis such as debtors (accounts receivable), bills receivable (notes
receivable), stock (inventory), temporary marketable securities, cash and bank
balances.
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. Super Bazar, for example, purchases goods for Rs.
10,000 on credit for a month from Fast Food Products on March 25, 2005. If the
balance sheet of Super Bazaar is prepared as at March 31, 2005, Fast Food
Products will be shown as creditors on the liabilities side of the balance
sheet. If Super Bazaar takes a loan for a period of three years from Delhi
State Co-operative Bank, this will also be shown as a liability in the balance
sheet of Super Bazaar. Liabilities are classified as long-term liabilities and
short-term liabilities (also known as short-term liabilities). Long-term
liabilities are those that are usually payable after a period of one year, for
example, a term loan from a financial institution or debentures (bonds) issued
by a company.
Short-term
liabilities are obligations that are payable within a period of one year, for
example, creditors, bills payable, bank overdraft.
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.
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, royalties, rent received,
etc. Revenue is also called income.
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.
Spending
money or incurring a liability for some benefit, service or property received
is called expenditure. Payment of rent, salary, 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.
The
excess of revenues of a period over its related expenses during an accounting
year profit. Profit increases the investment of the owners.
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.
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 whole sellers and by whole sellers 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.
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.
It
refers to the products in which the business units 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)
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 have to 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.
The Profit & Loss
Account aims to monitor profit. It has three parts.
This records the money
in (revenue) and out (costs) of the business as a result of the business’
‘trading’ ie buying and selling. This might be buying raw materials and selling
finished goods; it might be buying goods wholesale and selling them retail. The
figure at the end of this section is the Gross Profit.
This starts with the
Gross Profit and adds to it any further costs and revenues, including
overheads. These further costs and revenues are from any other activities not
directly related to trading. An example is income received from investments.
The Appropriation Account. This shows how the
profit is ‘appropriated’ or divided between the three uses mentioned above.
Uses of the Profit and
Loss Account.
The main use is to
monitor and measure profit, as discussed above. This assumes that the
information recording is accurate. Significant problems can arise if the
information is inaccurate, either through incompetence or deliberate fraud.
Once the profit(loss)
has been accurately calculated, this can then be used for comparison ie judging
how well the business is doing compared to itself in the past, compared to the
managers’ plans and compared to other businesses.
There are ways to ‘fix’
accounts. Internal accounts are rarely ‘fixed’, because there is little point
in the managers fooling themselves (unless fraud is going on) but public
accounts are routinely ‘fixed’ to create a good impression out to the outside
world. If you understand accounts, you can usually (not always) spot these
‘fixes’ and take them out to get a true picture.
Example Profit and Loss
Account:
An example profit and loss account is provided below:
A trial balance is a list of all the nominal ledger (general ledger) accounts contained in the ledger of a business. This list will contain the name of the nominal ledger account and the value of that nominal ledger account. The value of the nominal ledger will hold either a debit balance value or a credit value balance. The debit balance values will be listed in the debit column of the trial balance and the credit value balance will be listed in the credit column. The profit and loss statement and balance sheet and other financial reports can then be produced using the ledger accounts listed on the trial balance.
The trial balance is
usually prepared by a bookkeeper who has used daybooks to record
financial transactions and then post them to the nominal ledgers and personal
ledger accounts. The trial balance is a part of the double-entry
bookkeeping system and uses the classic 'T' account format for
presenting values.
Summary with Reference to Learning
Objectives
1. Meaning of Accounting :
Accounting is
a process of identifying, measuring, recording the business transactions and
communicating thereof the required information to the interested users.
2. Accounting as a source of information : Accounting as a source
of information system is the process of identifying, measuring, recording and
communicating the economic events of an organisation to interested users of the
information.
3. Users of accounting information :
Accounting plays a significant role in society by providing information to
management at all levels and to those having a direct financial interest in the
enterprise, such as present and potential investors and creditors. Accounting
information is also important to those having indirect financial interest, such
as regulatory agencies, tax authorities, customers, labour unions, trade
associations, stock exchanges and others.
4. Qualitative characteristics of
Accounting : To make accounting information decision
useful, it should possess the following qualitative characteristics.
•
Reliability • Understandability
•
Relevance • Comparability
5. Objective of accounting :
The primary objectives of accounting are to:
•
maintain records of business;
•
calculate profit or loss;
•
depict the financial position; and
•
make information available to various groups and users.
6. Role of accounting :
Accounting is not an end in itself. It is a means to an end.
It
plays the role of a:
•
Language of a business
•
Historical record
•
Current economic reality
•
Information system
•
Service to users
Provisions and Reserve
Provisions
There are certain expenses/losses which are related to the current accounting period but amount of which is not known with certainty because they are not yet incurred. It is necessary to make provision for such items for ascertaining true net profit. For example, a trader who sells on credit basis knows that some of the debtors of the current period would default and would not pay or would pay only partially. It is necessary to take into account such an expected loss while calculating true and fair profit/loss according to the principle of Prudence or Conservatism.
Provisions
There are certain expenses/losses which are related to the current accounting period but amount of which is not known with certainty because they are not yet incurred. It is necessary to make provision for such items for ascertaining true net profit. For example, a trader who sells on credit basis knows that some of the debtors of the current period would default and would not pay or would pay only partially. It is necessary to take into account such an expected loss while calculating true and fair profit/loss according to the principle of Prudence or Conservatism.
Reserves
A part of the profit may be set aside and retained in the business to provide for certain future needs like growth and expansion or to meet future contingencies such as workmen compensation. Unlike provisions, reserves are the appropriations of profit to strengthen the financial position of the business. Reserve is not a charge against profit as it is not meant to cover any known liability or expected loss in future. However, retention of profits in the form of reserves reduces the amount of profits available for distribution among the owners of the business. It is shown under the head Reserves and Surpluses on the liabilities side of the balance sheet after capital. Examples of reserves
are:
Types of Reserves
A reserve is created by retention of profit of the business can be for either a
general or a specific purpose.
1. General reserve: When the purpose for which reserve is created is not specified, it is called General Reserve. It is also termed as free reserve because the management can freely utilize it for any purpose. General strengthens the financial position of the business.
2. Specific reserve: Specific reserve is the reserve, which is created for some specific purpose and can be utilized only for that purpose. Examples of specific reserves are given below :
(i) Dividend equalization reserve: This reserve is created to stabilize or maintain dividend rate. In the year of high profit, amount is transferred to Dividend Equalization reserve. In the year of low profit, this reserve amount is used to maintain the rate of dividend.
(ii) Workmen compensation fund: It is created to provide for claims of the workers due to accident, etc.
(iii) Investment fluctuation fund: It is created to make for decline in the value of investment due to market fluctuations.
(iv) Debenture redemption reserve: It is created to provide funds for
The
Accounting rule for Real Account is
Debit
What Comes In and Credit What Goes out All Asset Accounts It Includes both
Tangible assets like Cash, car, Furniture and Intangible assets Like Goodwill,
Patents.
Accounting
Rule for Personal Account is Credit the Benefit Giver and Debit the Benefit
Receiver, All Accounts which can be attached to an individual or Organisation.
It can be either an Asset or Liability
Say
an organisation buys goods on Credit from Mr. X for 1000 $ so here the Account
of Mr. X is a Personal Account and will be a Creditor i.e. Liability.
Debit
All Losses and Expenses and Credit all Incomes and Profits.
All
Income, Expense, Profit, Losses accounts are Nominal Account.
Questions for Practice
Short Answers
1. Define
accounting.
2. State what
is end product of financial accounting.
3. Enumerate
main objectives of accounting.
4. List any
five users who have indirect interest in accounting.
5. State the
nature of accounting information required by long-term lenders.
6. Who are the
external users of information?
7. Enumerate
informational needs of management.
8. Give any
three examples of revenues.
9.
Distinguish between debtors and creditors.
10.
‘Accounting information should be comparable’. Do you agree with this Statement?
Give two reasons.
11. If the
accounting information is not clearly presented, which of the qualitative
Characteristic
of the accounting information is violated?
12. “The role
of accounting has changed over the period of time”- Do you agree?
Explain.
13. Giving
examples, explain each of the following accounting terms:
• Fixed
assets • Gain • Profit
• Revenue •
Expenses • Short-term liability
• Capital
14. How will
you define revenues and expenses?
15. What is
the primary reason for the business students and others to Familiarise
themselves with the accounting discipline?
