Accounting Concepts

Accounting for Business Activities

An individual, a group of individual or an institution like club or a local authority body (Calcutta Municipal Corporation), etc carries some kind of economic (or Business) activities, which can be expressed in terms of money.

The economic activities of an organization give rise to Financial Transactions and Events. Transactions mean some type of business work, the result of which can be expressed in terms of money. Event means an outcome or result of transactions.

Ex: A man purchased goods for Rs.20, 000 and Sold them for Rs.25, 000, the purchase and sale of the goods are Transactions, and the surplus of Rs.(25,000 -20,000) = Rs.5,000 is an Event.

Accounting helps us keeps records of all such Transactions and evaluate Events.

Book Keeping – The first step of Accounting

Book Keeping is the process of systemically recording of Financial transactions, in terms of Money. Book means Financial Records (Book in which Financial Records are kept). Keeping means systematic way of keeping the Financial records.

Book Keeping involves tasks like Recording of basic Financial transactions in original books (Journal & Subsidiary Books), Classifying & posting in ledger (and other books). Book Keeping is the first stage of Accounting. Accounting reports & statements are derived from the basic financial records maintained through Book Keeping

Lucas F. Pacioli, a resident of Venice (Italy), is regarded as the founder of book keeping. His book ‘De Computerised Script-rise, published in 1494, is regarded as the first book on Book Keeping.

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What is Accounting

Business entities for keeping records of their monetary or financial transactions. A businessman who has invested money in his business would like to know whether his business is making profit or incurring loss, the position of his assets and liabilities, and whether his capital in the business has increased or decreased during a particular period. The process of recording the business transactions to know the performance and status of business is known as Accounting

Accounting is a process comprising of Recording of transactions, Classifying, Summarizing, Analyzing, Interpreting & Communication of business activities & its results in a scientific & systematic way.

So, let us understand the meaning of each word in the sentence defining Accounting

  • Recording : Recording of Transaction. Each Business transaction is recorded in books of accounts, in a chronological manner, explaining the complete details of transaction (called Journal). For example, every business transaction like, sale, purchases, payment for expenses, salary & wages, receipt form debtors, etc must be recorded in books of accounts.
  • Classifying : The transactions are to be classified according to nature, purpose, into various account head and accounted for in proper account head. For example, Rent, Conveyance Expenses, sales, Purchase, etc. The purpose of classification is to compile and bring all transaction of similar nature, into one place (called Ledger) and compute the net amount of all the transactions for a specified period
  • Summarising : The Net of totals of each classified account head are compiled and a summary of the net transaction to be drawn up (called Trial Balance), to prepare the Accounts.
  • Analysis & Interpretation : The results are then analysed to assess the performance (Income, Expenses, Net Profit / Loss), and Financial Position (Assets – i.e what is owned, Liabilities – i.e what is owed), etc.
  • Communication : The results are then communicated to various stakeholders interested in the business like owners, partners, shareholders, lenders, Banks, Financial Institutions, Government, various statutory bodies

Definition of Accounting

  1. According to 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 of financial character, and interpreting the results thereof”.
  2. According to American Accounting Association “Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information”.

Let us further elaborate Definition of Accounting and the terms used

Significant Manner : The transactions are to be accounted for in proper heads and proper manner. In accounting, we record transactions in Double Entry System, Debiting & Crediting the respective accounts. The total of debits & credits for each transaction is always equal.

Transactions & Events: Transactions means actions involving money or which is measurable and expressed in terms of money. Events are results of actions and transactions.

Ex. X purchases an Item at Rs 1000. This is a transaction and is recorded in accounts. X sells the Item at Rs 1200. This is a transaction and is recorded in accounts. So, X makes a profit of Rs 200. This is event, as Profit of Rs 200 is result of the two transactions.

Ex. X gives an order to Y to supply  2 Pcs of TV @ Rs 15,000 each. Next day, Y delivers 2 TVs to X. After 2 days, X pays to the seller Rs 30,000 for the cost the 2 TVs. Here, placement of Order  by X to Y for supply of TV is not a transaction as there is no flow of money or money’s equivalent. Hence it is not recorded in Books of Accounts. Placement of order is an action not involving monetary transaction. Delivery of TVs by seller to X is a transaction, as materials worth Rs 30,000 has moved from Y to X. Payment of Rs 30,000 by X to Y is also a transaction, as money has moved from X to the seller.

So, it is said that all transactions are actions (like sale, purchase, delivery of goods), but all actions are not transactions (like placing an order is an action but not transaction). Events are results of transactions.

Monetary Transactions : Only transactions which can be expressed in terms of money, are to be recorded in books of accounts. Non monetary transactions are not recorded.

The transactions must be recorded in chronological manner. Chronological means in sequence of time. So, the transactions must be recorded as they occur. The transaction of Date 1 must be recorded first, followed by transactions of next date.

Judgments & Decisions : The purpose of accounting is to enable the users of Financial Information (who studies and analyses the result) to interpret the financial results (of what has happened and what is the position) to take prudent business decisions. For example, for manager  /  owner to take decision about how to manage efficiently, investor to decide about investment in the business, etc.

System of Accounting

There are three major systems of Accounting

Cash System: Transactions are recorded as and when actual cash is received or paid.

Single Entry System: Only one aspect is recorded, or sometimes no transactions are recorded at all.

Double Entry System: Both aspects (Debit and Credit) are fully and completely recorded.

5-1 Cash System of Accounting

In Cash System, The transaction is recorded only when payment is made.

Ex. X sells goods to Y for Rs 10000 on credit on 1st Jan. Y pays to X  on 20th April. So, under Cash Accounting System, X would record the Sale of Rs 10000 on 20th April only (no records would be made on 1st Jan as no payment (money flow) was made on 1st Jan. Similarly, under Cash Accounting System, Y would record the Purchase of Rs 10000 on 20th April only.

Cash basis of accounting do not follow the matching principle of Accounting & Income determination. So, the financial statements prepared under this system do not present a true and fair view of operating results and financial position of the organization.

However, cash system of accounting is suitable in the following cases:

  • Where the organization is very small or in case of individuals, where it is difficult to allocate small amounts between accounting periods
  • Where credit transactions are almost negligible and collections are uncertain, like Accounting of professionals. Such financial statement prepared are termed as Receipts and Payments Account.

Accrual System of Accounting

 In Accrual System, transactions are recorded on the basis of happening of the transaction, i.e amounts becoming due for payment or receipt, in the period in which they occur irrespective of the period in which cash is received or paid.

So, under Accrual System (also called Mercantile System), for the example cited, X would record the Sales on 1st Jan and would record the payment on 20th April. Between, 1st Jan and 20th April, X would show the amount of Rs 10000 in the name of Y as Receivable (Y is debtor). In the same way, Y would record the Purchase on 1st Jan and would record the payment on 20th April. Between, 1st Jan and 20th April,  Y would show the amount of Rs 10000 in the name of X as Payable (X is creditor).

Accrual System is based on following principles :

  • Revenue is recognised as earned, irrespective of whether cash is received or not
  • Costs are matched against revenues on the basis of relevant time period to determine periodic income
  • Costs not charged to income are carried forward to next period.
  • Cost that appears to have lost its utility or its power to generate future revenue, is written off as loss.

Single Entry System

Single Entry System is not proper System of Accounting. Only one side of entry (like Sale / Purchase) or Receivable / Payable is kept and the accounts are constructed by finding the balancing figures for missing information. So, we will not follow or discuss about Single Entry System. All discussions would be according with Accrual System.

Book Keeping vs Accounting

  • Book keeping involves recording of transactions. Accounting involves summarising of recorded transactions.
  • Book-keeping involves routine and clerical work. Most of it is increasingly being done by computers. Accounting requires higher level of knowledge, and analytical skill.
  • Book-keeping constitutes the first stage and base for accounting. Accounting starts after Book Keeping.
  • Book-keeping is done in accordance with basic and fundamental accounting concepts and conventions, uniformly applicable for all organisations.  Accounting methods, policies and procedures may vary from firm to firm.
  • Business Performance & Financial position cannot be ascertained through book-keeping records. Business Performance & Financial position can be ascertained from Accounting Statements.

Objectives of Accounting

The objective of Accounting is to get the Financial State of Affairs, Operational Results, Financial Forecasting, Financial Decision making, Compliance of Taxation & Statutory Requirements etc.

  • Financial Position: To  reveal  State of Affairs (What is owned & what is owed), like Balance Sheet
  • Operational Results:  To reveal Operational Results, like Profit & Loss Statement
  • Budgeting : To plan activities ahead & review the actual results vis a vis the plan
  • Decision Making: For Analysis and reporting of information, facilitates decision-making.
  • Communicating the Results: To communicate the results to Government investors, creditors, employee etc.
  • Regulation & Taxation:  To comply the Statutory, legal & Taxrequirements

Let us elaborate each Term of the Objectives of Accounting

  • Financial Position : The Balance Sheet shows the Financial Position of the Organisation on the Balance Sheet Date . It shows Assets owned by the firm with details of each Asset (details of Fixed Asset, Investments, Current Assets (further showing details of Cash & Bank Balances, Debtors and other Assets) etc. It also shows the Liabilities (Amounts Payable by the organisation). The organisation can find the liquidity position how it would pay up the liabilities out of the assets.

Thus, the Balance sheet shows the complete and overall status of the financial position of the organisation for a specified Date.

  • Operational Results : The Profit & Loss Account shows the Income & Expenses and the net Profit / loss for the specified period. It shows the details of Income & Expenses (Direct & Indirect) for each head, the amount of gross profit (net of Direct Income & Direct Expenses) and net Profit / Loss (net of Indirect Income & Indirect Expenses). This helps the organisation to plan the operations to optimize its performance
  • Budgeting : Accounts are based on past transactions. They reveal the performance and state of affairs of the organisation. These information are useful and form the basis to plan the future operations. So, accounts statements are used to make the Budget, the financial plan for the next period. Without Accounts of the immediate past period in hand, there would be no guidance to prepare Budget for next period.
  • Decision Making : Accounting Statements reveal the performance and state of affairs of the organisation. So, they help to make the decisions for  managers based on the facts and figures revealed by the Accounting reports.
  • Communication to users : Accounting Statements are used as means &  media to communicate the information to interested bodies like shareholders, creditors, investors, employees, customers and other government & statutory bodies. They get the information by studying and interpreting the accounts reports made available to them.
  • Regulation & taxation : Government  Regulatory bodies, like import, export, licensing and taxation bodies compile the Accounting information of the organisations, or a particular class of organisation to prepare the policy about control, regulation & taxation.

Branches of Accounting

According to purpose & objective, Accounting process may be classified as Financial Accounting, Management Accounting, Cost Accounting, Social Accounting etc.

  • Financial Accounting: It deals with the preparation, interpretation of financial statements.
  • Management Accounting: It deals with the accounting data for management decision.
  • Cost Accounting: It deals with the classification, recording, allocation and summarization of cost or products & services.
  • Social Accounting: It deals with the application of accounting to socio-economic analysis and preparation, estimation and interpretation of national and international accounting data.

In recent years, there has been various development in accounting policies, rules and regulations, guidelines, principles and method to set up global uniformity in accounting practices.

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Users of Accounting Information

The financial statements are prepared primarily to serve various stakeholders:

  • Investors: To determine whether they should buy, hold or sell and to assess the ability of the enterprise to pay dividends.
  • Employees: Employees and their representative groups are interested in information to assess the stability, profitability and the ability of the enterprise to provide remuneration, retirement benefits and employment opportunities.
  • Lenders: Lenders are interested in information, to determine whether their loans, and interest will be paid when due.
  • Suppliers and Creditors: They are interested in information to determine whether amounts owing to them will be paid when due.
  • Customers: Customers have an interest in information about supply and fulfillment of their desired products & services and the continuance of an enterprise.
  • Governments: Government and their agencies are interested in the information about allocation of resources of enterprises to determine taxation and other national policies.
  • Public: Public are interested in information about trends and recent developments of the enterprise, activities and its contribution to the society.

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Necessity of Accounting

Accounting records & statements are required for following purposes

  • Management: It records all the business transactions systematically and helps the management in planning, decision-making and controlling the business to function properly.
  • Business performance: It reveals the performance (Profit / Loss) & Financial Status (position of assets and liabilities)  of the business.
  • Information: Owners, creditors, management, employees, government and consumers get the financial information.
  • Financing: To raise money for business, like bank loan, private loan from market, Funds from Investors, Financial Institutions etc.
  • Comparative Study: Comparative study & analysis between successive years and other companies in similar trade.
  • Statutory : To comply the Statutory, legal & Taxrequirements, provide evidence to substantiate claim of the business
  • Valuation of Business : In case of sale, acquisition, merger of business, accounting information helps to determine the value of business.

Role of Accountant

Role of accountants is Important in areas like Maintenance of Books of Accounts, Evidence in court, proving insolvency, Valuation of Business, Audit of Accounts, fraud detection etc, Financial, Taxation & Management Consultancy services.

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Accounting & Other Disciplines

There is close relationship between some specific disciplines with accounts. That is why, professional Accountants are to study these disciplines also, for their professional work. The most Important disciplines related to accounts are :

  • Economics : Accounting is about recording compiling, analysing and presentation of financial data, while economics is about management of resources. 

There is lot of common elements between Economics and Accounts, as both of them deal on information, management  and deployment of resources. However, the object and meaning of these terms in their respective discipline vary, Economics theories and conclusions are often based supported on accounting data and information. Management decisions for optimum control & deployment of critical resources and future action are often based both on economic and financial data. So, Economics and Accounting are closely inter related

  • Statistics : Accounts provide factual precise data, while Statistics is about probable outcome. However, many areas of Financial Management, Inventory control and optimisation methods use statistical theories. On the other hand, Statistical Data on financial areas are based on financial results. 

A large area of auditing of accounts is based on statistical sampling. Theories of Probability & statistics are applied to evaluate contingencies.  In fact, there is a branch called Business Statistics, applied in Business & Accounts. So, Statistics and Accounting are closely inter related.

  • Law : Every business organisation is a separate legal entity. A number of legal, economical and social laws, rules & procedures apply to business enterprises (like  various Mercantile Laws, Company Law, Labour Laws, Taxation rules etc).

Organisations have to comply plethora of rules and regulations. The application of Law is so extensive to business organisations, that  many organisation have to establish a separate cell (like Accounts and Finance) for compliance of various statutes, rules & regulations of law, which mostly derive data from accounts. So, naturally,  Law and Accounting are closely inter related.

  • Mathematics : Accounts is intimately related with Mathematics, as Accounts are based on numerical data, which require lot of mathematical computation.

The Accounting theories are based on Accounting Equation, a concept based on mathematical foundation & concept. Various computation of Inventory Control & Management, Depreciation, Interest, Annuity, Present & Future Value, etc. are based on Mathematics. In fact, there a branch of mathematics called Business Mathematics, applied in Accounts.

  • Management : Management is all about planning, effective and optimum use of resources (e.g the most Important 4 M’s- Money, Materials, Manpower, Machineries).

Accounts deal with all these resources and their optimum deployment. So, management and Accounts go hand to hand with each other.

Accounting – key points

We now summarise the key points of Accounting discussed so far

Accounting Transactions & Events

Economic activities may be classified as Transactions and Events. Transaction means activity of Business, performance of act, Event means the happening or outcome of Business transactions.  For example, X buys goods worth of Rs 1000 (transaction), sells goods costing Rs 800 at Rs 1100 (transaction).  The results of these transactions are : X earns profit of  1100-800=Rs 300 (event), the cash increases by Rs 1100-1000=100 (event), stock increases by Rs 1000-800=200 (event).

Definition of Accounting

According to 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 of financial character, and interpreting the results thereof”. This definition lays stress on recording of Accounting Transaction and preparation of Accounting Books & Financial Reports.

However modern approach leans towards the aspect of Interpretation and communication of accounting Information, to motivate making informed & prudent business decisions. This view is reflected in the modern definition of Accounting by American Accounting Association, as “Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information”.

Accounting Functions

Accounting Functions may be categorised as :

  • Preparation of Accounting Books and Statements

a) Recording (writing the Journal Books), b) Classifying (Posting in Ledger), c) Summarising (Trial Balance, P L statement, Balance Sheet, Cash Flow Statement), d) Analysing (Grouping of similar financial data)

  • Use of Financial Statements

a). Interpretation (significance & relationship of Financial data like Ratio Analysis, Working Capital) b) Communication (transmission of Financial Statements to Internal User like Directors, Partners, Managers, & External Users like Investors, Lenders, Buyers, Suppliers, Government regulators & Agencies.

Objectives of Accounting

a) Systematic Recording of Transactions in Primary Books of Accounts.

b) Evaluating the performance of Business (preparation of Profit & Loss Account),

c) Ascertainment of State of Affairs (preparation of Balance Sheet).

d) Communicating Information to Users of Financial Statements for informed decision making; Internal Users like Directors, Partners, Managers; External Users like Investors, Lenders, Buyers, Suppliers, Government regulators & Agencies.

e) To evaluate liquidity (in short run) and solvency position (in long run)

Functions of Accounting

a) Measurement of past performance and activities.

b) Forecasting of future activities and financial position based on past performance data and anticipated future plans & actions.

c) Interpreting and analysing the Accounting information for informed decision making.

d) Comparing and evaluating the achievements  relation to plans & targets.

e) Identify weakness and take required corrective control measures.

f) Provides information to Government Agencies & Regulators for policy formulation by Government.

Users of Accounting Information

The financial statements are prepared primarily to serve various stakeholders, like :

a) Investors need to assess the ability of the enterprise to pay dividends.

b) Employees and their representative groups are interested to assess the stability, profitability and ability of the enterprise to provide remuneration, retirement benefits and employment opportunities.

c) Lenders need to determine whether their loans, and interest will be paid when due.

d) Creditorsare need to determine whether they would be paid when due.

e) Customers need to know about supply and fulfillment of their desired products & services, and the continuance of an enterprise.

f) Government and their agencies need to determine taxation and other national policies.

g) GeneralPublic is also interested about trends and recent developments of the enterprise, activities and its contribution to the society.

h) Internal management as a  whole is intimately interested for management, control and decision making.

Accounting Terminologies

Book Keeping : Involves tasks like Recording of basic Financial transactions in original books (Journal & Subsidiary Books), Classifying & posting in ledger (and other books) and preparation of summarized balance of ledger Accounts (Trial Balance).

Accounting : Process comprising of Recording of transactions, Classifying, Summarizing, Analyzing, Interpreting & Communication of business activities & its results in a scientific & systematic way.

Accounting Principles, Concepts & Conventions :  Set of basic rules, perceptions, principles, and methods that are universally accepted and assumed.

Accounting Standards (AS) : Written policy documents covering the aspects of recognition, measurement, presentation and disclosure of accounting transactions in the financial statements, in the respective country

International Financial Reporting Standards (IFRS)  : Specify a Accounting global standard all over the world.

Generally Accepted Accounting principles (GAAP) :  Constitutes concepts, conventions, principles, etc, used to describe rules for preparation of Financial Statements

Accounting Concepts : Set of  basic assumptions or conditions of a Business Enterprise & its operations, like (i) Separate Entity Concept: Business is treated as a separate entity from its owners; (ii) Going Concern Concept: A business will continue an indefinite long economical life; (iii) Money Measurement Concept: Business Transactions in terms of money only are recorded (iv) Accounting Period Concept: Business life is segmented in uniform period over its life to get correct position for each segmented period. (v) Matching Concept: Revenues and associated Costs are matched. (vi) Accrual Concept: Revenues and Expenses are recognized as they are earned or incurred, irrespective of the date of receipt or payment of money. (vii) Cost Concept: Assets are shown in cost price (i.e. in acquisition price). (viii) Realization Concept: Revenue is recorded only when it is realized. (ix) Dual Aspect Concept: Every transaction is recorded under double entry system (equal Debit & Credit)

Accounting Convention: Customs or traditions pursued by the accountant, while preparing the accounting statement, like : (i) Conservatism: Provides for future losses but not  anticipated profit  (ii) Materiality:  Recording of all material transactions (iii)  Prudence : Caution in making the estimates under conditions of uncertainty. (iv) Disclosure : All material information which might influence the decisions of the user of the financial statements must be disclosed.

Accounting Policies : Specific principles, rules and procedures implemented by a company’s management team to prepare its financial statements.

Revenue Income & Expenses

  • Revenue Income : Income fully earned for the period of the respective financial year.
  • Revenue Expenses : Expenses fully consumed for the period of the respective financial year
  • Capital Income & Expenses
  • Capital Income : Sudden unusual Income not resulting from regular operations of the business. Hence not taken into the Profit & Loss Account of the current year but are carried in the Balance Sheet as Reserves
  • Capital Expenses : Expenses incurred during the year whose benefit would extend to subsequent Financial Year. So, unexpired amount of Capital Expenses are carried to Balance Sheet to written over subsequent periods

Deferred Revenue Expenses : Exceptional revenue expenses, or loss, not borne fully in the year in which it is spent or loss incurred, but is spread over a period in future.

Revenue Expenditure treated as Capital Expenditure : Revenue expenses  closely associated to a Capital Expenditure to become a part of Capital Expenditure, or to put a Capital Asset into use, recognized as Capital Expenses.

Accounting Estimates : An approximated amount in a financial statement for which there is no precise means of measurement.

Valuation Principles : Specific principles, adopted by a company for valuation of its assets & liabilities to prepare its financial statements.

Double Entry System : Conforming to Accounting equation, ensuring that Total Liabilities must be equal to Total Assets, each accounting transaction are recorded in terms of equal debits & credits.

Classification of Accounts

  • Personal Accounts: Representing Persons (real, artificial or representative)
  • Real Accounts: Representing tangible & intangible assets
  • Nominal Accounts: Representing Expenses and Income

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