Unit 1: Theoretical Framework

CHAPTER 1

INTRODUCTION TO ACCOUNTING

MEANING OF ACCOUNTING

AMERICAN INSTITUTE OF CERTIFIED PUBLIC

ACCOUNTANTS

“Accounting is 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 a financial character, and interpreting the results thereof.”

Accounting is the process of recording financial transactions pertaining to a business. The accounting process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators, and tax collection entities. The financial statements used in accounting are a concise summary of financial transactions over an accounting period, summarizing a company's operations, financial position, and cash flows.

NEED FOR ACCOUNTING

•  In all activities and organizations (business or non-business) which require money and

other economic resources, accounting is required to account for these resources.

•  In other words, wherever money is involved, accounting is required to account for it.

•  Accounting is often called the language of business. The basic function of any language is

to serve as a means of communication. Accounting also serves this function.

Qualitative Characteristics of Accounting Information 

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. 

Relevance  

To be relevant, information must be available in time, must help in prediction and feedback, and must influence the decisions of users by : (a) helping them form prediction about the outcomes of past, present or future events; and/or (b) confirming or correcting their past evaluations. 

Understandability  

Understandability means decision-makers must interpret accounting information in the same sense as it is prepared and conveyed to them. The qualities that distinguish between good and bad communication in a message are fundamental to the understandability of the message. A message is said to be effectively communicated when it is interpreted by the receiver of the message in the same sense in which the sender has sent. Accountants should present the comparable information in the most intenlligible manner without sacrificing relevance and reliability. 

Comparability  

It is not sufficient that the financial information is relevant and reliable at a particular time, in a particular circumstance or for a particular reporting entity. But it is equally important that the users of the general-purpose financial reports are able to compare various aspects of an entity over different time period and with other entities. To be comparable, accounting reports must belong to a common period and use common unit of measurement and format of reporting. 

ACCOUNTING AS ASOURCE OF INFORMATION

Accounting is a definite process 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.

 

USERS OF ACCOUNTING INFORMATION 

 

 

Owners: The owners provide funds or capital for the organization. They possess curiosity in knowing whether the business is being conducted on sound lines or not, and 

whether the capital is being employed properly or not. Owners, being businessmen, always keep an eye on the returns from the investment. Comparing the accounts of various years helps in getting good pieces of information. 

 

Management: The management of the business is greatly interested in knowing the position of the firm. The accounts are the basis, the management can study the merits and 

demerits of the business activity. Thus, the management is interested in financial accounting to find whether the business carried on is profitable or not. The financial accounting is the “eyes and ears of management and facilitates in drawing future course of action, further 

expansion etc.” 

 

 

 

• Creditors: Creditors are the persons who supply goods on credit, or bankers or lenders of money. It is usual that these groups are interested to know the financial soundness before granting credit. The progress and prosperity of the firm, two which credits are extended, are largely watched by creditors from the point of view of security 

and further credit. Profit and Loss Account and Balance Sheet are nerve centers to know the soundness of the firm 

 

• Employees: Payment of bonus depends upon the size of profit earned by the firm. The more important point is that the workers expect regular income for the bread. The demand for wage rise, bonus, better working conditions etc. depend upon the profitability of the firm and in turn depends upon financial position. For these reasons, this group is interested in accounting. 

 

Investors: The prospective investors, who want to invest their money in a firm, of 

course wish to see the progress and prosperity of the firm, before investing their amount, by going through the financial statements of the firm. This is to safeguard the investment. For this, this group is eager to go through the accounting which enables them to know the safety of investment. 

 

Government: Government keeps a close watch on the firms which yield good amount of profits. The state and central Governments are interested in the financial statements to know the earnings for the purpose of taxation. To compile national accounting is essential. 

 

Consumers: These groups are interested in getting the goods at reduced price. Therefore, they wish to know the establishment of a proper accounting control, which in turn will reduce to cost of production, in turn less price to be paid by the consumers. 

Researchers are also interested in accounting for interpretation. 

 

Research Scholars: Accounting information, being a mirror of the financial performance 

of a business organization, is of immense value to the research scholar who wants to make a study into the financial operations of a particular firm as such study needs detailed accounting information relating to purchases, sales, expenses, cost of materials used, current assets, current liabilities, fixed assets, long-term liabilities and share-holders funds 

 

• The accounting system concerned only with the financial state of affairs and financial 

results of operations. 

• It is the original form of accounting. It is mainly concerned with the preparation of financial statements for the use of outsiders like creditors, debenture holders, investors and financial institutions. 

These users can be divided into two broad categories: internal users and external users.  

Internal users include: Chief Executive, Financial Officer, Vice President, Business Unit Managers, Plant Managers, Store Managers, Line Supervisors, etc.

 

External users include: present and potential Investors (shareholders), Creditors (Banks and other Financial Institutions, Debenture holders and other Lenders), Tax Authorities, Regulatory Agencies (Department of Company Affairs, Registrar of Companies, Securities Exchange Board of India, Labour Unions, Trade Associations, Stock Exchange and Customers, etc.

OBJECTIVES OF ACCOUNTING

Objective of accounting may differ from business to business depending upon their specific requirements. However, the following are the general objectives of accounting.

• Keeping systematic record.

          Accounting is used for the maintenance of a systematic record of all financial transactions in book of accounts. A proper and complete records of all business transactions are kept regularly. Moreover, the recorded information enables verifiability and acts as an evidence.

• Ascertain the results of the operation.

         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 profitsor 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.

• Ascertain the financial position of the business.

              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) and claims against such resources (Liabilities) facilitates the preparation of a statement known as balance sheet position statement.

• Portray the liquidity position.

             Accounting liquidity measures the company’s debtor’s ability concerning their debt payments. The same is usually expressed in terms of the percentage of the current liabilities.

• To provide information to various parties.

             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).

• To facilitate rational decision – making.

            Accounting records andfinancial statements provide financial information which help thebusiness in making rational decisions about the steps to be taken inrespect of various aspects of business.

         

• To satisfy the requirements of law

            entities such as companies, societies, public trusts , are compulsorily required to maintain accounts as per the law governing their operations such as companies act, trust act, societies act etc. Maintenance of Accounts is also compulsory under sales tax act and income tax act. 

ROLE OF ACCOUNTING

For centuries, the role of accounting has been changing with the changes in economic development and increasing societal demands.

1.  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.
2. It also performs the service activity by providing quantitative financial information that helps the users in various ways.
3. 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 non-financial information. These limitations of accounting must be kept in view while making use of the accounting information.

 

MEANING AND DEFINITION OF BOOKKEEPING

• Definition: “The art keeping permanent record of business transactions is book keeping.”
• J. R. Batliboi: “book-keeping is an art of recording business dealings in a set of books”.
• R. N. Carter: “Book-keeping is the science and art of correctly recording in the books

          of accounts, all those business transactions that results in transfer of money’s worth”.

FEATURES OF BOOK-KEEPING

• It is the process of recording business transactions.
• Monetary transactions are only recorded.
• Recording is made in given set of books of accounts.
• Record is prepared for a specific period but presented for future references.
• It is an art of recording business transactions scientifically.

DIFFERENCE B/W BOOK-KEEPING AND ACCOUNTING

BOOK-KEEPING

• The object of book-keeping is to prepare original books of accounts, trial balance and to maintain systematic record of financial results.

 *  It has a limited scope .

• Level of work is restricted to clerical work

ACCOUNTING

• The object of accounting is to record, classify, summarize, analyze, and interpret the business transactions and ascertain financial results and to communicate to various parties.
• It has a wider scope.
• It is concerned with all levels of Management.

ADVANTAGES OF ACCOUNTING

• Replacement of memory
• Evidence court
• Assessment of taxation liability
• Comparative study
• Sale of business
• Assistance to the insolvent person
• Assistance to various parties
• Facilities in raising loans
• Information regarding financial position.

LIMITATIONS OF ACCOUNTING

• Records only monetary transactions.
• Unsuitable for forecasting.
• No realistic information
• Personal bias of the accountant affects the accounting statements .
• Incomplete information.
• Profit no real test of managerial performance .
• Historical in nature.
• Window dressing in balance sheet.

BASIC TERMS USED IN ACCOUNTING

Entity

• An entity means an economic unit which performs economic activities e.g., Bajaj Auto,
• Maruti, TISCO.

 Account

• It is a summarized record of
• relevant transactions at one place
• relating to a particular head. It records not only the amount of transactions
•  but also reflect the direction of the account.

• ENTRY

• A transaction and event when recorded in the books of accounts is known as an Entry

• Transaction

• It is a financial happening entered into by two or more willing parties.
• It effects a change in the asset, liability, or net worth account.
• It is recorded first in journal and then posted into the ledger Examples of a transaction are sale of goods, purchases of goods, receipt from debtors, payment made to creditors,
• purchase or sale of fixed assets, payment of dividend, etc.

• Proprietor

• is the person who makes the investment and bears all the risks and rewards of the business

Debtor is

•  a person or firm or company which owes amount to the enterprise on account of credit sale of goods or services.
•  The amount due from him is a debt.
•  The amount due from a person as per the books of the account is called a book debt.

• Drawings

• It is the amount of money or the value of goods which the proprietor or a partner takes for his domestic or personal use.
•  Drawing reduces the investment (or capital) of the owners.
•  It appears only in the accounts of sole proprietorship firms and partnership firms.

• Purchases

•  The term purchases are used only for purchases of goods.
•  Goods are those items which are purchased for resale or
•  for manufacture of products which are also to be sold.
•  It includes both cash and credit purchases

• Depreciation

•  It is a fall in the value of an asset
•  because of usage; or
•  with passage of time; or
•  obsolescence; or
•  accident

• Purchases Return:

•  Goods purchased may be returned due to any reason, say, they are not as per specifications or are defective.
•  Goods returned are termed as Purchases Return or Returns Outward.

• Sale

•  This term is used for the sale of goods dealt by the enterprise.
•  The term ‘Sales’ includes both Cash and Credit Sales.
•  When goods are sold for cash, they are cash sales
•  When goods are sold and payment is to be received at a later date, they are credit sales.

• Sales Return or Returns Inwards

•  It means Goods sold returned by the purchaser.

Discount

• A reduction in the price of goods is Discount.

           Trade Discount

• It is a discount allowed to a customer on the basis of quantity of goods purchased.

           Cash Discount

•  It is a discount allowed to a customer for making prompt or timely payment.

• Capital

•  It means the amount (in terms of money or assets having money value)
•  Which the proprietor has invested in the business
•  and can claim from it.
•  It is a liability of the business towards the owner.
• It is so because of Business Entity Concept.
• Capital = Assets – Liabilities

• Gain

•  It is a profit that arises from transactions which are incidental to business such as
•  sale of investments or fixed assets
•  at more than their book values.
• Gain may be operating gain or non-operating gain.

• Cost

• It is the amount of expenditure
•  incurred on or
•  attributable to
•  a specified article, product or activity.

• Creditor is

•  a person or firm or company to whom the enterprise owes amount on account of Credit purchase of goods or services.

• Assets:

•  Assets are property or legal rights
•  owned by an individual or business
•  to which money value can be attached.
•  In other words, anything which will enable the firm to get cash or a benefit in the future,

• Bad Debt

•  It is the amount that has become irrecoverable
•  It is a business loss, and
•  Thus, is debited to Profit and Loss Account.

• Insolvent

• Insolvent is a person or an enterprise which is not in a position to pay its debts.

• Liabilities

•  Liabilities means the amount
•  which the business owes to outsiders,
•  excepting the proprietors.
•  Liabilities can be classified in
•  (i) Long-Term Liabilities (ii) Current Liabilities,
•  This can be expressed as: Liabilities = Assets – Capital

• Goods

•  They refer to items forming part of the stock-in-trade of an enterprise,
•  which are purchased or manufactured with a purpose of selling.
•  In other words, they refer to the products in which an enterprise is dealing.

• Stock or Inventory

•  Stock is the tangible property held by an enterprise
•  for the purpose of sale in the ordinary course of business or
•  for the purpose of using it in the production of goods
•  meant for sale or services to be rendered.
•  Stock may be opening stock or closing stock.

• Profit

•  Profit is the surplus of revenues of a business over its costs.
•  Profit is categorized into:

1. Gross Profit: Gross Profit is the difference between sales revenue or the proceeds of goods sold and/or services rendered over its direct cost.
2. Net Profit: Net Profit is the profit made after allowing for all expenses. In case expenses are more than the revenue; it is Net  Loss.

• Loss

•  Loss is excess of expenses over its related revenues which may arise from normal business activities.
•  It decreases the owner’s equity.
• It also refers to money or money’s worth lost (or cost incurred) against which the enterprise receives no benefit, e.g., cash or goods lost in theft.
•  It also arises from events of non-recurring nature, e.g., loss on sale of fixed assets

• Expense

• An expense is the amount spent in order to produce and sell the goods and services which produce the revenue.
•  Expense is the cost of the use of things or services for the purpose of generating revenue.
•  Expense is that part of the expenditure which has been consumed during the current accounting period.
•  Examples of expense are payment of salaries, wages, rent, etc.

• Expenditure:

• An expenditure is the amount spent or liability incurred for the value received
•  Expenditure may be categorised into: (i) Capital Expenditure (ii) Revenue Expenditure
•  An expenditure is a payment (or a money sacrifice) for a benefit received.

• Capital Expenditure

•  It is the amount spent in purchasing assets which will give benefit over more than one accounting period.
•  It means expenditure incurred to acquire fixed assets or its improvement.
•  Capital expenditure is debited to particular asset account.
•  They appear at the assets side of the Balance Sheet.

• Revenue Expenditure

•  It is the amount spent to purchase goods and services that are consumed during the accounting period.
•  It is shown in the debit side of the Profit and Loss Account

• Revenue

•  It is the gross inflow of cash, receivables or other consideration
•  arising in the ordinary course of business activities
•  from the sale of goods, rendering of services,
•  and use by others of enterprise resources yielding interest, royalties and dividends

• Income:

•  Income is the profit earned during an accounting period.
•  In other words, the difference between revenue and expense is called income.
•  Income = Revenue – Expense

Basis of Accounting:1. Cash Basis of Accounting 2. Accrual Basis of Accounting

 Cash Basis of Accounting:

 Under this method only cash transactions are recorded in the books of accounts. Entries are made only if cash is received or paid.

Accrual Basis of Accounting:

Under this method all transactions are recorded in the books of accounts (Cash and Non-Cash). Entries are made on the Accrual basis, it means cash and Non-cash both transactions are recorded in the books of accounts.

Source of Documents

All financial transactions are recorded in the books of accounts on the basis of source document or on the basis of some evidence. Source documents are helpful to prove that a transaction is actually made or not.

Cash Memo: Cash Memo is A bill of sale, it is a written document by a 'seller' to a purchaser,

reporting that on a specific date, a particular sum of money or other "value received",

Invoice or Bill : When goods are sold on credit, An invoice or bill is issued on the name of the buyer, indicating the products, quantities, and agreed prices for products or services, the seller has provided the buyer.

Receipt : A receipt is a written acknowledgment that a specified a sum of money has been received from the customer as an exchange for goods or services. The receipt is evidence of purchase of the goods or service.

Pay-in-Slip : Pay in slip is a form that is filled when the money is deposited by a customer in to his bank account.

Cheque: A cheque is a document (usually a piece of paper) that orders a payment of money. The

person writing the cheque, the drawer, usually has a account where the money is deposited.

Debit Note : When we return goods back to the supplier, a debit not is made on the name of

supplier, it means his account his debited. Debit Note proves that a debit entry has been made to a

debtor's or creditor's account.

Credit Note: When we receive goods back from our customer, then a credit not is made on the

name of the customer, it means customer’s account is credited.

Meaning of Voucher : Voucher is the documentary proof or evidence in support of a transaction.

For example when we purchase goods for cash, we get cash memo, and when we purchase goods

on credit, we get an invoice, when we make payment we get Receipt.

Types of Vouchers

There are two types of vouchers a) Cash Voucher b) Non Cash Voucher

Cash Vouchers: Cash vouchers are prepared for cash transactions only, when cash is received or

paid. There are two types of cash vouchers: a) Debit Vouchers b) Credit Vouchers

Debit Vouchers: Debit vouchers are prepared only for cash payments

Credit Vouchers : Credit vouchers are the opposite side of debit vouchers, Credit vouchers are prepared when we receive cash

Preparation of accounting vouchers: All business transactions recorded in the books of

accounts can be compared with the source documents. Accounts are debited or credited on the

basis of these source documents. After deciding, that what to be debited or credited, the next step

is the preparation of the vouchers.

Meaning of Accounting Equation

The Accounting Equation' is based on the double-entry book keeping system. For every debit there must be a credit. The accounting equation states that the sum of the Total assets must be equal to the sum of the liabilities.

Assets = Liabilities + Capital

Or

 Capital = Assets - Liabilities

 Or

 Liabilities = Assets - Capital

 Or

 Assets = Total Liabilities or Total Equity

 Or

 Total Assets = Internal Liabilities + External Liabilities

 

Accounting Standards

History and Development of Accounting Standards

The International Accounting Standards Committee (IASC) came into existence on 29th June 1973.

The main objectives of IASC are to develop the accounting standards. In India the Institute of

Charted Accountants of India (ICAI) had constituted the ‘Accounting Standards Board’ in April

1977 for developing the Accounting Standards

Meaning of Accounting Standards:

Accounting standards are the rules in written form that ensure the uniformity of accounting Standards, and provide guidance for the preparation, presentation and reporting of accounting information.

Features/Characteristics/Nature of Accounting Standards:

a) Provide Guidance to the Accountants ;

b) Brings Uniformity;

c) Accounting Standards are flexible ;

d) Provide information

Advantages of Accounting Standards

a) Helpful in bringing the uniformity

b) Helpful in improving the reliability of financial statements

c) Helpful in resolving the conflicts among the users of financial information.

Accounting Standards issued by the ICAI: Amendment is made recently in the section 211 of

companies act 1956. According to this amendment, the financial statements (Profit and Loss

Account and Balance Sheet) of a company should comply with the Accounting Standards. The

Council of the Institute of Charted Accountants of India has so far issued the following 32

Accounting Standards (AS).

Process of Accounting:

(1) Collecting and identifying financial transactions

(2) Recording

(3) Classifying

(4) Summarizing

(5) Deals with financial transactions

(6) Analysis and Interpretation

(7) Communicates