Financial Accounting Chapter 01 – Introduction to Accounting

Introduction to Accounting

01.01. Introduction :

Accounting has rightly been termed as the language of the business. The basic
function of a language is to serve as a means of communication. Accounting also
serves this function. It records, classifies, analyses and communicates all the business
transactions that have taken place during a particular period. It is a system of
recording and reporting business transactions in financial terms, to interested
parties, viz., the proprietor, creditors, investors, Government and other agencies.

01.01.01.Need for Accounting:

The need for accounting is all the more great for a person who is running a business.
He must know:
(i) What he owns?
(ii) What he owes?
(iii) Whether he has earned a profit or suffered a loss on account of running a
business?
(iv) What is his financial position i.e. whether he will be in a position to meet
all his commitments in the near future or he is in the process of becoming
a bankrupt?

01.02. Origin of Accounting :

Accounting is as old as money itself. However, the act of accounting was not as
developed as it is today because in the early stages of civilisation, the numbers of
transactions to be recorded were so small that each businessman was able to record
and check for himself all his transactions. Accounting was practised in India twenty
three centuries ago as is clear from the book named "Arthashastra" written by
Kautilya, King Chandragupta's minister. This book not only relates to politics and
economics, but also explains the art of proper keeping of accounts.

However, the modern system of accounting based on the principles of double entry
system owes it origin to Luco Pacioli who first published the principles of Double
Entry System in 1494 at Venice in Italy.

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01.03. Meaning of Accounting :

 Accounting is a science because it has some definite objects to be fulfilled and

is an art as it prescribes the process through which the object can be achieved.
 Non-financial transactions cannot be recorded in accounting, i.e., only
transactions of financial nature are the subject–matter of accounting. To be
more clear, only those transactions which are expressed in terms of money
are recorded.
 Accounting is an art of recording transactions according to size, nature and
type of business transactions – cash transactions, credit transactions, frequent
transactions etc. When the recording in journal or subsidiary books is done,
they are to be classified by grouping the transactions or entries of one nature
at place. This is done by opening accounts in a book called ledger. Then such
ledgers are summarized in order to give useful information to the
management or interested parties. This is done by preparing trading and
profit and loss account and balance sheet of whole accounting record.
 Finally, it is an art of interpreting the result of the financial transactions and
communicating the result thereof. The aspect of interpretation falls under
management accounting.

01.04. Branches of Accounting :

Financial Determining the financial results for the Stewardship

1 Accounting period and the state of affairs on the last day Accounting
of the accounting period.

Cost Information generation for controlling Control

2 Accounting operations with a view to maximising Accounting
efficiency and profits.

Management Accounting to assist management in planning Decision

3
Accounting and decision making. Accounting

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01.05. Definition of Accounting :

The American Institute of Certified Public Accountants (AICPA) has defined the
Financial Accounting as "the art of recording, classifying and summarising in as
significant manner and in terms of money transactions and events which in part, at
least of a financial character, and interpreting the results thereof".

From the above the following attributes / functions of accounting emerge :

(i) Recording: It is concerned with the recording of financial transactions in an

orderly manner, soon after their occurrence in the proper books of
accounts.

(ii) Classifying: The classification takes the form of accounts in a separate

book called as Ledger. Separate ledger accounts are opened for each
expenses, income, property and liability. It useful for the segregation of
numerous business transactions into identifiable groups.

(iii) Summarising: It is concerned with the preparation and presentation of the

classified data in a manner useful to the users. This function involves the
preparation of Trial Balance and preparation of financial statements such
as Income Statement, Balance Sheet, Statement of Changes in Financial
Position, Statement of Cash Flow, and Statement of Fund Flow.

(iv) Interpreting: It is usually done through flow statements. They are useful in
evaluating past performance and providing guidance for future plans and
activities.

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01.06. Book-Keeping:

Book-keeping and accounting are often used interchangeably but they are different
from each other. Book-keeping may be defined as the art and science of correctly
and systematically recording in the books of account the business transactions of an
individual or a concern in a way to show clearly the monetary effect of each such
transactions. The work of book-keeping is usually entrusted to junior employees,
who maintain various books of accounts, journal, subsidiary books, ledgers etc, can
be called as book –keepers.

The books of original record, by themselves, do not give an idea of the company’s
financial position. When one has to make a judgment regarding the financial position
of the firm, the information contained in these books has to be analysed and
interpreted. Book-keeping provides basis for accounting.

01.06.01. Difference between Book-keeping and Accounting

Book-keeping Accounting

(i) It is concerned with the recording of (i) It is concerned with the summarizing of
transactions. the recorded transactions.

(ii) The work of book-keeping is mainly (ii) The work of accountant requires higher
routine and clerical in nature and is level of knowledge, conceptual
increasingly being done by computers. understanding and analytical skill.

(iii) Book-keeping constitutes the base (iii) Accounting starts where book-keeping
for accounting. ends.

(iv) Book-keeping is done in accordance (iv) The methods and procedures for
with basic accounting concepts and accounting for analysis and interpretations
conventions. for financial reports may vary from firm to
firm.

(v) Financial statements do not form (v) Financial statements are prepared in
part of book-keeping. accounting process from the book-keeping
records.

(vi) Financial position of the business (vi) Financial position of the business is
cannot be ascertained through book- ascertained on the basis of accounting
keeping records. reports.

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01.07. Objectives of Accounting :

(i) Providing Information to the Users for Rational Decision-making: The primary
objective of accounting is to provide useful information for decision-making to
stakeholders such as owners, management, creditors, investors, etc. Various
outcomes of business activities such as costs, prices, sales volume, value under
ownership, return of investment, etc. are measured in the accounting process. All
these accounting measurements are used by stakeholders in course of business
operation. Hence, accounting is identified as ‘language of business’.

(ii) Systematic Recording of Transactions: To ensure reliability and precision for the
accounting measurements, it is necessary to keep a systematic record of all financial
transactions of a business enterprise which is ensured by bookkeeping. These
financial records are classified, summarized and reposted in the form of accounting
measurements to the users of accounting information i.e., stakeholder.

(iii) Ascertainment of results of the Transactions: ‘Profit/loss’ is a core accounting

measurement. It is measured by preparing profit and loss account for a particular
period. Various other accounting measurements such as different types of revenue
expenses and revenue incomes are considered for preparing this profit and loss
account. Difference between these revenue incomes and revenue expenses is known
as result of business transactions identified as profit/loss. As this measure is used
very frequently by stockholders for rational decision-making, it has become the
objective of accounting.

(iv) Ascertain the Financial Position of Business: ‘Financial position’ is another core
accounting measurement. Financial position is identified by preparing a statement of
ownership i.e., Assets and Owings i.e., liabilities of the business as on a certain date.
This statement is popularly known as balance sheet. Various other accounting
measurements such as different types of assets and different types of liabilities as
existed at a particular date are considered for preparing the balance sheet. This
statement may be used by various stakeholders for financing and investment
decision.

(v) To Know the Solvency Position: Balance sheet and profit and loss account
prepared as above give useful information to stockholders regarding concerns
potential to meet its obligations in the short run as well as in the long run.

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01.08. Users / Groups Interested in Accounting :

Accounting information helps users to make better financial decisions. Users of

financial information may be both internal and external to the organization.

(A) Internal users (Primary Users) of accounting information include the following:
(i) Management: for analyzing the organization's performance and position
and taking appropriate measures to improve the company results.
(ii) Employees: for assessing company's profitability and its consequence on
their future remuneration and job security.
(iii) Owners: for analyzing the viability and profitability of their investment and
determining any future course of action.
Accounting information is presented to internal users usually in the form of
management accounts, budgets, forecasts and financial statements.

(B) External users (Secondary Users) of accounting information include the

following:

(i) Creditors: for determining the credit worthiness of the organization. Terms
of credit are set by creditors according to the assessment of their
customers' financial health. Creditors include suppliers as well as lenders
of finance such as banks.
(ii) Tax Authorities: for determining the credibility of the tax returns filed on
behalf of the company.
(iii) Investors: for analyzing the feasibility of investing in the company.
Investors want to make sure they can earn a reasonable return on their
investment before they commit any financial resources to the company.
(iv) Customers: for assessing the financial position of its suppliers which is
necessary for them to maintain a stable source of supply in the long term.
(v) Regulatory Authorities: for ensuring that the company's disclosure of
accounting information is in accordance with the rules and regulations set
in order to protect the interests of the stakeholders who rely on such
information in forming their decisions.
External users are communicated accounting information usually in the form of
financial statements.

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01.09. Advantages of Accounting :

1. Useful to the Management: The accounting information is useful to the

management in the following ways:
(i) In the preparation of budget;
(ii) In planning the future course of action;
(iii) In co-ordinating the different departments;
(iv) In controlling the managerial activities.

2. Comparison of results: Intra-comparison that is comparison of results within

the enterprises over a period of time can be possible.

3. Evidence for Taxation: Written records serve as a reliable source for taxation
purposes. Taxes cannot be levied arbitrarily.

4. Legal Evidence: Written accounting information acts as an evidence in the

court of law, which will be binding everyone.

5. Determination of the Price: The accounting information is an important tool

to determine the price of the enterprises, in a situation of selling process.

01.10. Disadvantages of Accounting :

1. Financial accounting is of historical nature

Net effect of transactions are recorded in financial accounting which has happened in
past. These accounts is just post mortem of all events of business in past .These
record does not help for future planning and other managerial decisions. Financial
accounting shows the profitability of business but it is failure to tell that is it good or
bad. Financial accounting is also failure to know the reasons of low profitability
position.

2. Financial accounting deals with overall profitability

Accounts of business are made by a way which shows only overall profitability .It
does not shows net profit per product , or per department or according to job . Thus
to find difficult to all activities which do not give profit. So, it creates inefficiency in
business activities.

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3. Absence of full disclosure of facts

In financial accounting we record only those activities and transactions which we can
show or describe in money. There are many other facts of business which are non
financial and non monetary like efficient management, demand of products of firm,
good relations in industry, good working environments which cannot be known by
financial accounting.

4. Financial reports are interim report of business

Financial statements made by financial accounting is the interim report of firm’s all
business work but financial position and profitability which are shown in it is not fully
true. Due to adopting cost concept, all transactions are recorded on it real cost but
by changing in the time; it is the need of time to adjust cost of assets and liabilities
according to inflation of market. Because, financial accounting does not records
according to inflation so its result does not show true position of business.

5. Incomplete knowledge of costs

From cost point of view, financial accounting is incomplete. In financial
accounting, accountant does not calculate each and every product’s total cost. So,
financial accounting does not help to determine the price of product of business.

6. No provision of cost control

Financial accounting does not help business organization for controlling the cost.
Because, there is no provision of controlling cost in it. In financial accounting, we
write cost, if we paid any expenses. Thus there is no provision of improvement in
financial accounting. Except this, there is no any other way to inspect all expenses.

7. Financial statements are affected from personal judgment

Many events of financial statements are affected from personal judgement of
accountant. Method of calculating depreciation, rate of provision of doubtful debts
and stock valuation method are decided by accountant. Thus, financial statements
do not show true and fair view of business.

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01.11. Basis of Accounting :

Financial statements are to be prepared in accordance with Generally Accepted

Accounting Principles (GAAP). The following are the basis of accounting, which are
generally accepted, in calculating profit or loss of an enterprise.

(a) Cash Basis

(b) Accrual or Mercantile Basis
(c) Hybrid or Mixed Basis

(a) Cash Basis of Accounting:

Under this method, all incomes are considered to be earned when they are actually
received in cash. Similarly, expenses are deemed to be incurred only when they are
actually paid in cash. In other words, importance is attached to cash receipts and
payments but non-cash items, such as outstanding, pre-paid expenses, accrued
incomes or income received in advance are ignored. This method is adopted in those
concerns where only cash transactions take place. Generally this system is followed
by individuals like Doctors, Lawyers, Auditors, Engineers, Brokers, and Small Traders
etc.

(b) Accrual or Mercantile Basis of Accounting:

This method is commonly adopted by business concerns. Incomes are recorded or
credited to the period in which they are earned irrespective of the fact whether the
same has actually been received or not. Similarly, expenses are charged to the period
in which they relate irrespective of the fact that they have actually been paid or not.
In other words, all items of incomes and expenditures, both cash items as well as non
– cash items such as pre- paid expenses, accrued incomes or income received in
advance etc, are taken into account.

(c) Hybrid or Mixed Basis of Accounting:

Under this method, both cash basis and accrual basis are followed. Incomes are
recorded on cash basis whereas expenses are taken on accrual basis. The net income
is ascertained by matching expenses on accrual basis with income on cash basis. This
is the most conservative basis of ascertaining income because all possible expenses
relating to the period whether actually paid or not are considered whereas income
only received in cash in taken into consideration. This system is followed by
professional like Doctors, Lawyers, and Chartered Accountants etc.,

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01.12. System of Accounting :

There are two systems of accounting namely Single Entry System and Double Entry
System.

Single Entry System: The single entry system is not a really a system because in some
cases record may be one – sided; and in some other cases no record is maintained at
all. It is more appropriate to call it an incomplete system of recording transactions.
Double effect of every transaction is ignored and only the accounts relating to
suppliers and customers and cash account are found. Thus, the system is incomplete,
inaccurate and unscientific system of recording business transactions.

Double Entry System: The modern system of accounting is based on what is known
as double entry principle. It refers to that system of book keeping where each
transaction is recorded in both of its aspects. viz.

i. receiving of the benefit of the transaction and

ii. Giving away of the benefit of the transaction.

For a complete record of transactions, it should be presented in both the accounts.

Business transactions affect two aspects of the accounts in the opposite direction. If
are account receives a benefit there must be another account to give the benefit. It is
like the two sides of a coin. Thus, every transaction involves two accounts, one which
gives the benefit of the transactions and another which receives the same.

01.12.01. Steps involved in Double entry system

(a) Preparation of Journal: Journal is called the book of original entry. It records the
effect of all transactions for the first time. Here the job of recording takes place.

(b) Preparation of Ledger: Ledger is the collection of all accounts used by a business.
Here the grouping of accounts is performed. Journal is posted to ledger.

(c) Trial Balance preparation: Summarizing. It is a summary of ledger balances

prepared in the form of a list.

(d) Preparation of Final Account: At the end of the accounting period to know the
achievements of the organization and its financial state of affairs, the final accounts
are prepared.

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01.12.02. Accounting Process in Double entry system :

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