ACCOUNTING

1.0 INTRODUCTION TO FINANCIAL ACCOUNTING
Accounting is a social science. The nature of accounting information has been dictated
from time immemorial by the needs of the users of the day. The history of accounting
reflects the pattern of social developments and the forces which necessitate the changes in
accounting system from time to time.
Over the years accountancy has made tremendous progress in the field of commerce and
industry. Accounting can be described as being concerned with measurement and
management. Measurement of recording transactions and management with the use of data
for making decisions are the two fundamental aspects.
Accounting function is vital for every entity of the society whether individuals, house
wives, business entity, nonprofit making organisations like municipalities, panchyats,
clubs, etc. All are required to maintain accounts.
Accounting is commonly referred to as the “language of the business” as it is effectively
employed to communicate the financial performance of business to various interested parties
or stakeholders. It is concerned with the measurement and communicating financial data.
Financial Accounting is based on double entry system of accounting which comprises of
(i) recording of business transactions in the books of prime entry,
(ii) posting into respective ledger accounts,
(iii) striking balance, and
(iv) preparing the performance statement (profit and loss statement) and position
statement (balance sheet).
Financial Accounting is concerned with the collection, recording, classification and
presentation of financial data to serve the purposes of the management, shareholders and
stakeholders, such as, creditors, bankers, Government, etc.
The nature and purpose of accounting
The basic aim of accounting in a business entity is to provide financial information for
making decisions on its activities. Managers of an economic entity at various levels require
analysed financial information for planning and programming, for controlling expenditure,
for ascertaining the extent of profitability or otherwise of a department – even of each
production item for undertaking new jobs, etc.
Financial information in tabular forms and with graphs and charts are also required by the
outsiders, namely, bankers, financial institutions, creditors, investors, government agencies
and even by the labour unions and the general public who have some interest in the particular
business concern.
Definition of Accounting
A widely accepted definition of accounting has been provided by the American Accounting
Association. According to this definition accounting is the process of identifying,
measuring and communicating information to permit judgement and decisions by the users
of accounts. This definition implies that –
(1) there should be users of accounts who need relevant information,
(2) the information should enable the users to make judgement and decisions, and
(3) transactions and events are measured and the data are processed and then
communicated to the users through accounting.
Objectives of Accounting
The basic objectives of accounting are to provide financial information to the managers,
owners and the stakeholders i.e. the parties who are interested in an organisation. To attain
such objectives various financial statements are prepared.
The users of financial statements may be broadly classified in the following groups –
(a) The investor – This group includes both existing and potential owners of shares in
companies. They are broadly interested in the performance of the entity and the
dividend declared by such entity. They also measure the social and economic policies
of the company to decide whether they will remain associated with such entity.
(b) The lender – This group includes both secured and unsecured lenders. Such creditors
may be financing long term or short term loans. The financial statements are analysed
to determine an organisation’s ability as to
(i) pay the interest on due date,
(ii) the growth and stability of the organisation,
(iii) capability of repaying the loan as agreed upon, and.
(iv) the book value of assets offered as security by the organisation.
(c) The customers and suppliers – While customers are interested in the ability of the
organisation to provide goods/services, the suppliers are interested in the capability
of the organisation to pay their dues as and when due.
(d) The government – This group includes various taxation authorities viz. Income
tax, Excise department, Sales tax department etc. and also various other government
authorities for statistical purposes and for framing various economic and planning
policies.
(e) The employee group – The employees are concerned with the capability of an
organisation to pay their present emoluments and future retirement benefits.
Moreover, financial statements help them to asses job security.
(f) The analyst – Advisors to the management, investors, employees or public at large
collect various data from financial statements to advise their clients.
(g) The Management – Financial statements provide required information to different
levels of management to assist them in making decisions at each appropriate level.
1.1 SUBDIVISION OF ACCOUNTING
Generally, accounting is subdivided as follows :
a) Book-keeping
b) Measuring working results and capital of the economic entity and reporting.
a) Book-Keeping : Book-keeping is the art and science of recording transactions of a
business enterprise or an organisation carrying out non-business activities in a systematic
and appropriate manner to measure the working results and capital at periodical interval
depending upon needs of an entity.
(b) Measuring working results and capital of the economic entity and reporting : The
most important aspect of accounting records is to measure the working results and the
capital of the economic entity and interpreting and reporting of results.
1.2 CONCEPTS AND CONVENTIONS IN ACCOUNTING
Basic concepts:
Accounting principles are built on a foundation of a few basic concepts. These concepts
are so basic that most accountants do not consciously think of them; they are regarded as
being self-evident. Non-accountants will not find these concepts to be self-evident. Some
accounting theorists argue that certain of the present concepts are wrong and should be
changed. But in order to understand accounting, as it now exists, one must understand
what the underlying concepts currently are. The different aspects are :—
1. Business Entity Concept
2. Money Measurement Concept
3. Cost Concept
4. Going Concern Concept
5. Dual-aspect Concept
6. Realisation Concept
7. Accrual Concept
8. Accounting Period Concept
1. Business Entity Concept:
The business is treated as a distinct (and separate) entity from the individuals who own it
and accordingly accountants record transactions. For example, if the owner of a shop
withdraws Rs. 10,000 for personal use, from the business entity point of view, the entity
has less cash though it belongs to the owners. Therefore, this amount is shown as a reduction
in owner’s capital, which in view of business entity concept appears as a liability in the
balance sheet of the business. Without such a distinction the affairs of the shop will be
mixed with the personal affairs of the owner. For a company the distinction is easier as
legally the company is a distinct entity from the persons who own it. Therefore, an entity is
a business organisation or activity in relation to which accounting reports are compiled. It
may include universities, voluntary organisations, government and non-business units. What
we have stated above is just a superficial discussion of the concept, though the central point
has been brought out clearly. But we have to go at least a little deeper because out of this
basic concept, a large number of very important sub-concepts emerge, dealing with
ownership equities, without which we cannot understand properly many of the modern
accounting practices.
Pure Accounting Viewpoint : We will start from the fundamental accounting equation, that is:
Debit = Credit (i)
And, Assets = Liabilities (ii)
And, Assets = Internal Liabilities + External Liabilities (iii)
And finally, Assets = Capital + Liabilities; or A = C + L (iv)
2. Money Measurement Concept:
A record is made only of the information that can be expressed in monetary terms for
accounting purposes. The advantage of doing this is that money provides common
denominators by means of which variety of facts can be expressed as numbers that can be
added and subtracted. This enables addition and subtraction of varied items since money
provides the common denominator. An event even though important like the loyalty of the
workers will not be recorded unless it can be expressed in monetary terms. The changing
price level also creates difficulties in the monetary value.
If we look at financial accounting purely from the point of view of Fundamental Accounting
Equation:
Assets = Capital + Liabilities,
then it would be evident that it had virtually no option but to adopt monetary values of assets
and liabilities and capital to apply the equation in day-to-day business affairs. This concept
is basically concerned with the problem of measuring items of the accounting equation.
Such items may be plant and machinery (assets), liability for loan taken – all these are object
of some kind of the other. Other items represent events (transactions) such as expenses
and income. Basically, double entry system is additive (say, when finding the aggregate of
assets) or subtractive (say when total liabilities are deducted from total assets to find capital,
or deducting expenses from income to estimate profit). But only the "like" can be added
with the "like" and the "like" can be deducted from the "like", when the word "like" means
that the items involved are expressed in the same unit. But in real-world affairs, physical
assets may have to be expressed in several ways, like numbers of units, weight, volume,
etc. Likewise wages may have to be expressed in man-hours or simply in hours. Apart
from ensuring feasibility of making addition and subtraction, which is inherent in the
accounting equation, the sign of equality (actually the sign of "identity") needs use of the
same units in describing such items. In accounting the description is finally expressed
quantitatively in terms of money. In modern business it is essential link to accounting to a
market system in an exchange economy a valuable source of quantitative data. Since goods
and service are generally exchanged in terms of money, a monetary measurement of
economics data can be assumed to be useful in decision-making, particularly for that decision
relating to wealth and the production of goods and services.
3. Cost Concept :
The cost concept and the money measurement concept go hand in hand. Transactions are
recorded in the books at the price paid that is the cost. This avoids an arbitrary value being
placed on the asset and all subsequent accounting is in relation to the cost. Therefore, the
recording of the assets is at cost figures and this may not reflect the current market value
especially in the case of the older assets. The value of an asset in the accounting records
does not remain at the original cost because it is diminished systematically by virtue of its
use called expired cost and then shown at its depreciated value e.g. an asset of Rs. 1,00,000
is depreciated at 10%. Therefore, closing value will be Rs. 90,000 in the Balance Sheet. An
expired cost is an expenditure of money, the economic value of which has been made use
of during a particular year (or lost without accruing any benefit to the entity, like machinery
destroyed by flood). Every cost has to be recovered from the market through sales, otherwise,
the entity will suffer loss, that is, lose its capital. Depreciation, looked at from this viewpoint,
is nothing but gradual recovery of cost incurred, that is, money paid at a time during a
particular year for acquiring a fixed asset, during the subsequent years (during which the
asset is assumed to remain serviceable) on some estimated basis, by treating the expired
cost pertaining to a particular year, calculated on some approved and selected estimated
basis, by including such expired cost, called an expense, in the cost of production of that
particular accounting year. Linking annual depreciation with the expected service life of a
fixed asset does not endow any scientific logic on any estimated basis of depreciation. In
accounting, depreciation is nothing more and nothing less than a process of allocation of
some specific costs (cost of acquiring fixed assets) on some generally accepted (may or
may not be legally approved) estimated basis. An expired cost is not a money measure of
the wear and tear obsolescence (passage of time) etc. of any fixed assets. It is just a
reasonable basis for recovery of cost of fixed asset in a gradual manner. Money value of
wear and tear would need engineering analysis, which is not the domain of financial
accounting.
In essence, in a little more technical sense, cost represents the exchange price agreed upon
by the buyer and the seller in a relatively free economy. Cost has been the most common
valuation concept in the traditional accounting structure.
Therefore, cost is the exchange price of goods and services at the time they are acquired.
So, cost is also the economic sacrifice expressed in monetary terms required to obtain a
specific asset or a group of assets. Very often cost is not represented by a single exchange
price, but it includes many sacrifices of economic resources necessary to obtain the asset
in the form, location and time in which it can be useful to the operating activities of the firm.
4. Going Concern Concept :
Accounting assumes that the business will exist indefinitely into future and accordingly
transactions are recorded. If however, there is evidence that the firm will be liquidated then
market value of the assets and liabilities will be ascertained and necessary accounting
considered. In other cases where the business is an on-going activity resale value of assets
is irrelevant. The whole accounting is done based on this assumption.
The present concept as well as the earlier Business Entity concept belongs to the category
of "Environmental Postulates of Accounting". It is important to know the precise meaning
of this expression, for which purpose we have to know what an accounting postulate is and
what is environmental in accounting. In order to avoid a lengthy discussion, we may
summarise, by stating that postulates are basic assumption or fundamental propositions
concerning the economic, political and sociological environment in which accounting must
operate. Thus, it is clear that certain economic, political and sociological events do affect
the thinking and actions of accountants and we must also clearly understand that every
such event does not affect accounting concepts and practice. The basic criteria for any
such postulates are:
(1) They must be relevant to the development of accounting logic, that is, they must
serve as a foundation for the logical derivation of further propositions; and
(2) They must be accepted as valid by the participants in the discussion as either being
true or providing a useful starting point as an assumption in the development of
accounting logic.
5. Dual Aspect Concept :
The economic resources of an entity are assets and the acquisition of an asset must be on
account of : –
(a) some other assets being sold ; or
(b) the creation of an obligation to pay ; or
(c) there has been a profit owed to proprietor ; or
(d) the owner has contributed.
On the other hand, an increase in liability is on account of an increase in asset or a loss.
Therefore, at any time –
Assets = Liabilities + Capital
Capital = Assets – Liabilities
The owner’s share is what is left after paying outsiders. This is the accounting equation.
Every transaction has dual impact and accounting systems record both the aspects and are
called the double entry system. e.g. X starts a business with a capital of Rs.20,000. There
are two aspects of the transaction. On the one hand the business has assets of Rs. 20,000
while on the other hand it has to pay the proprietor Rs. 20,000, therefore: –
Capital (Equities) = Assets (Cash)
Rs. 20,000 = Rs. 20,000
What has been stated above is an oversimplified version of the concept and its application,
since this is the form of the concept with which we are familiar as beginners. But we have
to go a little deeper in order to have a more meaningful understanding of the concept
because it is the bedrock on which double entry book keeping has built its gigantic edifice
and is still flourishing as a very important discipline all over the world. There must be
something deeper than what has been stated above which caught the imagination of an
Italian priest and mathematician and prompted him to codify if not invent the double-entry
system in 1495 which explained logically and systematically what happens in the economic
world, in terms of money when goods are manufactured and sold at the market place
through financial transactions. This could be applied to sale of services equally logically,
and systematically. In course of time it also exposed other related concepts, especially the
first two concepts already discussed, namely the Business Entity concept and the Money
Measurement concept.
6. Realisation Concept :
The realisation concept indicates the amount of revenue that should be considered from a
given transaction. Realization refers to inflows of cash or claims to cash. It states that the
amount recognized as revenue is the amount that is reasonably certain to be realised.
Sometimes there is scope for difference of judgement as to how to ascertain "reasonably
certain". A situation arises when a company makes a credit sale and expects that the customer
will pay their bill. Experience shows that not all customers pay their bill. In measuring the
revenue for a period, the amount of credit sales that will not be realised should be reduced
by the estimated amount of credit sales that will never be realised i.e. by estimated amount
of bad debts. Example: If a company makes a credit sale of Rs 100,000 during a period and
experience indicates that 2% of credit sales will become bad debt, the amount of revenue
for the period is Rs 98,000 and not Rs 100,000. It does not anticipate events and stops the
business from inflating their profits by recording sales and incomes likely to accrue. Unless
money has been realised as cash or legal obligation to pay on sale, profit or income is
considered e.g. M places an order with N for supply of certain goods yet to be manufactured.
On receipt of order N purchases raw materials, employs workers, produces goods and
delivers to M. M makes payment on receipt of goods. In this case the sale is not at the time
of receipt of order but at the time when goods are delivered to M.
7. Accrual Concept :
Profit arises only out of business operation when there is an increase in the owner’s share
of the business and not due to his contribution to the business. Any increase in owner’s
equity is called revenue and any reduction in it termed as a loan. In fact, it is the direct
outcome of Realisation Concept (already discussed) and the Accounting Period concept (to
be discussed). In a way, realisation concept has been split up into two parts, namely,
production of economic goods or rendering of economic services, and realisation of due
revenue. Any uncertainty about any of the two elements beyond what is considered
uncontrollable will not permit the accountant to treat the money value or cash equivalent of
the sale price to be considered as realised income. Another very vital element is involved in
between, that is, a third one, namely acquiring legal right to claim the price of the goods
delivered or fees for services rendered. Acquiring the legal right to claim the consideration
for goods/services is called accrual of revenue, which usually precedes collection. However,
in case of cash transactions, under the accrual method P/L A/c and Balance Sheet are
prepared on the accrual basis, in the absence of any uncertainty about collection. This does
not mean that collection has been given less importance than economic value adding and the
right to claim the purchase consideration. With uncertainty about collection, it is meaningless
and dangerous to take income into account as having been realised. In fact, ability to pay, is
considered by the supplier of goods and services before one decides to sell his products or
render his services to another. Then after the deal is finalised, goods have been delivered or
services rendered and legal right to claim the purchase consideration has been acquired,
collection is taken up as a specialised process to ensure return of capital and earning of
profit. The other pressure comes from the Accounting Period convention. Production is a
continuous process. True profit is cash profit during the entire lifetime of an enterprise.
Then and then only we know total money collected and spent by it during its lifetime. But
the way our culture has bound us up with annual profit, annual income and other periodic
results, we have divided the entire life-span of our organisation into several chapters, each
chapter being an accounting period or an accounting year. A year consists of 12 months.
This is very significant, because each period being equal in terms of time frame, it facilitates
comparison of performances. Because of this Cost Accountants divide a year in 13 months,
each period consisting of 4 weeks. The process of dividing the life span of a company into
time–chapters which is an artificial man-made process, though production follows a
continuous flow, gives rise to certain accounting problems. For example, at the time of
closing of period/annual accounts, production and sale might have been completed, local
right to claim the sales value have been acquired, but payment has not yet come through.
8. Accounting Period Concept :
The accounting reports measure activities for a specified interval of time called the accounting
period, which is usually one year and therefore termed as annual reports. Interim reports in
between may be compiled especially for internal users. Except for those ventures which are
predetermined to end on the completion of a specific task or a specific time-frame, every
enterprise, profit-oriented or not, desires to enjoy perpetual existence as a going (running)
concern, making profits, grow and distribute profits judiciously. This calls for recognition
and measurement of incomes and expenses and to match them to ascertain profit. But, the
concept of profit is time-related. Hence, the question: profit for what length of time?
Theoretically, the most correct reply would be the entire life–time of an enterprise. That
means no measurement of income until an enterprise is wound up. But human beings
inherently, desire to know, periodic performances mainly for the purpose of comparison,
which would not be possible, different firms wind up after different lengths of time. Moreover,
from the practical point of view, some firms may not close down during a number of
successive generations. Hence no income tax for ages, too. Let us not extend the list of
such fanciful but important (academically) possibilities. Thus, out of practical considerations,
businessmen, sided by accountants, divide the life span of an entity into a number of chapters
of equal duration, usually a twelve-month period. Thus one phase of activities of an enterprise
is deemed to have passed – one chapter is closed. Such a 12-month chapter is called
accounting period. And financial accountants prepare a P/L A/c. for that period to estimate
its operating result, that is, profit or loss and the financial position as at the end of the period
in terms of assets, liabilities (external) and owners’ equity (internal liability).
Conventions:
The term "accounting conventions" refer to the customs or traditions, which are used as a
guide in the preparation of meaningful financial records in the form of the income statement
(Profit and Loss Account) and the position statement (Balance Sheet).
These are as follows.
1. Conservatism :
Financial statements are drawn on a conservatism basis where better evidence is required
of losses. This is necessary as Management and ownership are in different hands and a cut
is needed on management to show overoptimistic, favourable performance results. For
example, inventories are valued at the cost or market price whichever is lower. Revenues
are recognised when they are certain but expenses as soon as they are reasonably possible
e.g. it encourages the accountant to create provisions for bad and doubtful debts.
Since inception, it has come to mean the following:
a) delay in recognition of income;
b) expedite recognition of income;
Note : This obviously affects the reliability of the process of matching cost against
revenue.
c ) if in doubt, understate assets and income;
d) if in doubt, overstate liabilities and expenses.
Note : (c) and (d) above violate the postulates of consistency and therefore
comparability.