UNIT – I
LESSON – 1.1
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ACCOUNTING – AN INTRODUCTION
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1.1.1 INTRODUCTION
Accounting is aptly called the language of business. This
designation is applied to accounting because it is the method of
communicating business information. The basic function of any
language is to serve as a means of communication. Accounting duly
serves this function. The task of learning accounting is essentially
the same as the task of learning a new language. But the
acceleration of change in business organization has contributed to
increasing the complexities in this language. Like other languages,
it is undergoing continuous change in an attempt to discover better
means of communications. To enable the accounting language to
convey the same meaning to all people as far as practicable it
should be made standard. To make it a standard language certain
accounting principles, concepts and standards have been developed
over a period of time. This lesson dwells upon the different
dimensions of accounting, accounting concepts, accounting
principles and the accounting standards.
1.1.2 OBJECTIVES
After reading this lesson, the reader should be able to:
• Know the evolution of accounting
• Understand the definition of accounting
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• Comprehend the scope and function of accounting
• Ascertain the users of accounting information
• Know the specialised accounting fields
• Understand the accounting concepts and conventions
• Realise the need for accounting standards
1.1.3 CONTENTS
1.1.3.1 Evolution of Accounting
1.1.3.2 Book Keeping and Accounting
1.1.3.3 Definition of Accounting
1.1.3.4 Scope and Functions of Accounting
1.1.3.5 Groups Interested in Accounting Information
1.1.3.6 The Profession of Accounting
1.1.3.7 Specialised Accounting Fields
1.1.3.8 Nature and Meaning of Accounting Principles
1.1.3.9 Accounting Concepts
1.1.3.10 Accounting Conventions
1.1.3.11 Accounting Standards
1.1.3.12 Summary
1.1.3.13 Key Words
1.1.3.14 Self Assessment Questions
1.1.3.15 Books for Further Reading
1.1.3.1 EVOLUTION OF ACCOUNTING
Accounting is as old as money itself. It has evolved, as have medicine,
law and most other fields of human activity in response to the social and
economic needs of society. People in all civilizations have maintained various
types of records of business activities. The oldest known are clay tablet records
of the payment of wages in Babylonia around 600 B.C. Accounting was
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practiced in India twenty-four centuries ago as is clear from Kautilya's book
`Arthshastra' which clearly indicates the existence and need of proper
accounting and audit.
For the most part, early accounting dealt only with limited aspects of the
financial operations of private or governmental enterprises. Complete
accounting system for an enterprise which came to be called as "Double Entry
System" was developed in Italy in the 15th century. The first known description
of the system was published there in 1494 by a Franciscan monk by the name
Luca Pacioli.
The expanded business operations initiated by the Industrial
Revolution required increasingly large amounts of money which in turn
resulted in the development of the corporation form of organisations. As
corporations became larger, an increasing number of individuals and
institutions looked to accountants to provide economic information about
these enterprises. For e.g. prospective investors and creditors sought
information about a corporation's financial status. Government agencies
required financial information for purposes of taxation and regulation.
Thus accounting began to expand its function of meeting the needs of
relatively few owners to a public role of meeting the needs of a variety
of interested parties.
1.1.3.2 BOOK KEEPING AND ACCOUNTING
Book-keeping is that branch of knowledge which tells us how to
keep a record of business transactions. It is considered as an art of
recording systematically the various types of transactions that occur in a
business concern in the books of accounts. According to Spicer and
Pegler, "book-keeping is the art of recording all money transactions, so
that the financial position of an undertaking and its relationship to both
its proprietors and to outside persons can be readily ascertained".
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Accounting is a term which refers to a systematic study of the principles
and methods of keeping accounts. Accountancy and book-keeping are
related terms; the former relates to the theoretical study and the latter
refers to the practical work.
1.1.3.3 DEFINITION OF ACCOUNTING
Before attempting to define accounting, it may be made clear that
there is no unanimity among accountants as to its precise definition.
Anyhow let us examine three popular definitions on the subject:
Accounting has been defined by the American Accounting
Association Committee as: ". . . the process of identifying, measuring
and communicating economic information to permit informed judgments
and decisions by users of the information". This may be considered as a
good definition because of its focus on accounting as an aid to decision
making.
The American Institute of Certified and Public Accountants
Committee on Terminology defined accounting as: "Accounting is the art
of recording classifying and summarising, 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". Of all
definitions available, this is the most acceptable one because it
encompasses all the functions which the modern accounting system
performs.
Another popular definition on accounting was given by American
Accounting Principles Board in 1970, which defined it as: "Accounting
is a service society. Its function is to provide quantitative information,
primarily financial in nature, about economic entities that is useful in
making economic decision, in making reasoned choices among
alternative courses of action". This is a very relevant definition in a
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present context of business units facing the situation of selecting the best
among the various alternatives available. The special feature of this
definition is that it has designated accounting as a service activity.
1.1.3.4 SCOPE AND FUNCTIONS OF ACCOUNTING
Individuals engaged in such areas of business as finance,
production, marketing, personnel and general management need not be
expert accountants but their effectiveness is no doubt increased if they
have a good understanding of accounting principles. Everyone engaged
in business activity, from the bottom level employee to the chief
executive and owner, comes into contact with accounting. The higher the
level of authority and responsibility, the greater is the need for an
understanding of accounting concepts and terminology.
A study conducted in United States revealed that the most
common background of chief executive officers in United States
Corporations was finance and accounting. Interviews with several
corporate executives drew the following comments:
"…… my training in accounting and auditing practice has been
extremely valuable to me throughout". "A knowledge of accounting
carried with it understanding of the establishment and maintenance of
sound financial controls- is an area which is absolutely essential to a
chief executive officer".
Though accounting is generally associated with business, it is not
only business people who make use of accounting but also many
individuals in non-business areas that make use of accounting data and
need to understand accounting principles and terminology. For e.g. an
engineer responsible for selecting the most desirable solution to a
technical manufacturing problem may consider cost accounting data to
be the decisive factor. Lawyers want accounting data in tax cases and
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damages from breach of contract. Governmental agencies rely on an
accounting data in evaluating the efficiency of government operations
and for approving the feasibility of proposed taxation and spending
programs. Accounting thus plays an important role in modern society
and broadly speaking all citizens are affected by accounting in some way
or the other.
Accounting which is so important to all, discharges the following vital
functions:
Keeping systematic records: This is the fundamental function of accounting.
The transactions of the business are properly recorded, classified and
summarised into final financial statements – income statement and the balance
sheet.
Protecting the business properties: The second function of accounting is to
protect the properties of the business by maintaining proper record of various
assets and thus enabling the management to exercise proper control over them.
Communicating the results: As accounting has been designated as the language
of business, its third function is to communicate financial information in respect
of net profits, assets, liabilities, etc., to the interested parties.
Meeting legal requirements: The fourth and last function of accounting is to
devise such a system as will meet the legal requirements. The provisions of
various laws such as the Companies Act, Income Tax Act, etc., require the
submission of various statements like Income Tax returns, Annual Accounts and
so on. Accounting system aims at fulfilling this requirement of law.
It may be noted that the functions stated above are those of
financial accounting alone. The other branches of accounting, about
which we are going to see later in this lesson, have their special
functions with the common objective of assisting the management in its
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task of planning, control and coordination of business activities. Of all
the branches of accounting, management accounting is the most
important from the management point of view.
As accounting is the language of business, the primary aim of
accounting, like any other language, is to serve as a means of
communication. Most of the world's work is done through organisations
– groups of people who work together to accomplish one or more
objectives. In doing its work, an organisation uses resources – men,
material, money and machine and various services. To work effectively,
the people in an organisation need information about these sources and
the results achieved through using them. People outside the organisation
need similar information to make judgments about the organisation.
Accounting is the system that provides such information.
Any system has three features viz. input, processes and output.
Accounting as a social science can be viewed as an information system
since it has all the three feature i.e., inputs (raw data), processes (men
and equipment) and outputs (reports and information). Accounting
information is composed principally of financial data about business
transactions. The mere records of transactions are of little use in making
"informed judgements and decisions". The recorded data must be sorted
and summarised before significant analysis can be prepared. Some of the
reports to the enterprise manager and to others who need economic
information may be made frequently: other reports are issued only at
longer intervals. The usefulness of reports is often enhanced by various
types of percentage and trend analyses. The "BASIC RAW
MATERIALS" of accounting are composed of business transactions
data. Its "primary end products" are composed of various summaries,
analyses and reports.
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The information needs of a business enterprise can be outlined
and illustrated with the help of the following chart:
CHART SHOWING TYPES OF INFORMATION
Information
Nonquantitative Quantitative
Information Information
Accounting Non accounting
Information Information
Operating Financial Management Cost
Information Accounting Accounting Accounting
The chart clearly presents the different types of information that
might be useful to all sorts of individuals interested in the business
enterprise. As seen from the chart, accounting supplies the quantitative
information. The special feature of accounting as a kind of a quantitative
information and as distinguished from other types of quantitative
information is that it usually is expressed in monetary terms. In this
connection it is worthwhile to recall the definitions of accounting as
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given by the American Institute of Certified and Public Accountants and
by the American Accounting Principles Board.
The types of accounting information may be classified into four
categories: (1) Operating information, (2) Financial accounting
information (3) Management accounting information and (4) Cost
accounting information.
Operating Information: By operating information, we mean the information
which is required to conduct the day-to-day activities. Examples of operating
information are: Amount of wages paid and payable to employees, information
about the stock of finished goods available for sale and each one's cost and
selling price, information about amounts owed to and owing by the business
enterprise, information about stock of raw materials, spare parts and accessories
and so on. By far the largest quantity of accounting information provides the raw
data (input) for financial accounting, management accounting and cost
accounting.
Financial Accounting: Financial accounting information is intended both for
owners and managers and also for the use of individuals and agencies external to
the business. This accounting is concerned with the recording of transactions for
a business enterprise and the periodic preparation of various reports from such
records. The records may be for general purpose or for a special purpose. A
detailed account of the function of financial accounting has been given earlier in
this lesson.
Management Accounting: Management accounting employs both historical and
estimated data in assisting management in daily operations and in planning for
future operations. It deals with specific problems that confront enterprise
managers at various organisational levels. The management accountant is
frequently concerned with identifying alternative courses of action and then
helping to select the best one. For e.g. the accountant may help the finance
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manager in preparing plans for future financing or may help the sales manager
in determining the selling price to be fixed on a new product by providing
suitable data. Generally management accounting information is used in three
important management functions: (1) control (2) co-ordination and (3) planning.
Marginal costing is an important technique of management accounting which
provides multi dimensional information that facilitates decision making. More
about it can be had in the Unit IV.
Cost Accounting: The Industrial Revolution in England posed a challenge to the
development of accounting as a tool of industrial management. This necessitated
the development of costing techniques as guides to management action. Cost
accounting emphasizes the determination and the control of costs. It is
concerned primarily with the cost of manufacturing processes. In addition one of
the principal functions of cost accounting is to assemble and interpret cost data,
both actual and prospective, for the use of management in controlling current
operations and in planning for the future.
All of the activities described above are related to accounting and
in all of them the focus is on providing accounting information to enable
decisions to be made. More about cost accounting can be gained in
unit V
1.1.3.5 GROUPS INTERESTED IN ACCOUNTING INFORMATION
There are several groups of people who are interested in the accounting
information relating to the business enterprise. Following are some of them:
Shareholders: Shareholders as owners are interested in knowing the profitability
of the business transactions and the distribution of capital in the form of assets
and liabilities. In fact, accounting developed several centuries ago to supply
information to those who had invested their funds in business enterprise.
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Management: With the advent of joint stock company form of organisation the
gap between ownership and management widened. In most cases the
shareholders act merely as renters of capital and the management of the
company passes into the hands of professional managers. The accounting
disclosures greatly help them in knowing about what has happened and what
should be done to improve the profitability and financial position of the
enterprise.
Potential Investors: An individual who is planning to make an investment in a
business would like to know about its profitability and financial position. An
analysis of the financial statements would help him in this respect.
Creditors: As creditors have extended credit to the company, they are much
worried about the repaying capacity of the company. For this purpose they
require its financial statements, an analysis of which will tell about the solvency
position of the company.
Government: Any popular Government has to keep a watch on big businesses
regarding the manner in which they build business empires without regard to the
interests of the community. Restricting monopolies is something that is common
even in capitalist countries. For this, it is necessary that proper accounts are
made available to the Government. Also, accounting data are required for
collection of sale-tax, income-tax, excise duty etc.
Employees: Like creditors, employees are interested in the financial statements
in view of various profit sharing and bonus schemes. Their interest may further
increase when they hold shares of the companies in which they are employed.
Researchers: Researchers are interested in interpreting the financial statements
of the concern for a given objective.
Citizens: Any citizen may be interested in the accounting records of business
enterprises including public utilities and Government companies as a voter and
tax payer.
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1.1.3.6 THE PROFESSION OF ACCOUNTING
Accountancy can very well be viewed as a profession with stature
comparable to that of law or medicine or engineering. The rapid
development of accounting theory and techniques especially after the
late thirties of 20th century has been accompanied by an expansion of
the career opportunities in accounting and an increasing number of
professionally trained accountants. Among the factors contributing to
this growth have been the increase in number, size and complexity of
business enterprises, the imposition of new and increasingly complex
taxes and other governmental restrictions on business operations.
Coming to the nature of accounting function, it is no doubt a
service function. The chief of accounting department holds a staff
position which is quite in contra distinction to the roles played by
production or marketing executives who hold line authority. The role of
the accountant is advisory in character. Although accounting is a staff
function performed by professionals within an organization, the ultimate
responsibility for the generation of accounting information, whether
financial or managerial, rests with management. That is why one of the
top officers of many businesses is the Financial Controller. The
controller is the person responsible for satisfying other managers'
demands for management accounting information and for complying
with the regulatory demands of financial reporting. With these ends in
view, the controller employs accounting professionals in both
management and financial accounting. These accounting professionals
employed in a particular business firm are said to be engaged in private
accounting. Besides these there are also accountants who render
accounting services on a fee basis through staff accountants employed by
them. These accountants are said to be engaged in public accounting.
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1.1.3.7 SPECIALISED ACCOUNTING FIELDS
As in many other areas of human activity, a number of specialised
fields in accounting also have evolved besides financial accounting.
Management accounting and Cost accounting are the result of rapid
technological advances and accelerated economic growth. The most
important among them are explained below:
Tax Accounting: Tax accounting covers the preparation of tax returns and the
consideration of the tax implications of proposed business transactions or
alternative courses of action. Accountants specialising in this branch of
accounting are familiar with the tax laws affecting their employer or clients and
are upto date on administrative regulations and court decisions on tax cases.
International Accounting: This accounting is concerned with the special
problems associated with the international trade of multinational business
organisations. Accountants specialising in this area must be familiar with the
influences that custom, law and taxation of various countries bring to bear on
international operations and accounting principles.
Social Responsibility Accounting: This branch is the newest field of accounting
and is the most difficult to describe concisely. It owes its birth to increasing
social awareness which has been particularly noticeable over the last three
decades or so. Social responsibility accounting is so called because it not only
measures the economic effects of business decisions but also their social effects,
which have previously been considered to be unmeasurable. Social
responsibilities of business can no longer remain as a passive chapter in the text
books of commerce but are increasingly coming under greater scrutiny. Social
workers and people's welfare organisations are drawing the attention of all
concerned towards the social effects of business decisions. The management is
being held responsible not only for the efficient conduct of business as reflected
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by increased profitability but also for what it contributes to social well-being and
progress.
Inflation Accounting: Inflation has now become a world-wide phenomenon.
The consequences of inflation are dire in case of developing and underdeveloped
countries. At this juncture when financial statements or reports are
based on historical costs, they would fail to reflect the effect of changes in
purchasing power or the financial position and profitability of the firm. Thus the
utility of the accounting records, not taking care of price level changes is
seriously lost. This imposes a demand on the accountants for adjusting financial
accounting for inflation to know the real financial position and profitability of a
concern and thus emerged a future branch of accounting called Inflation
accounting or Accounting for price level changes. It is a system of accounting
which regularly records all items in financial statements at their current values.
Human Resources Accounting: Human Resources Accounting is yet another
new field of accounting which seeks to report and emphasise the importance of
human resources in a company's earning process and total assets. It is based on
the general agreement that the only real long lasting asset which an organisation
possesses is the quality and calibre of the people working in it. This system of
accounting is concerned with, "the process of identifying and measuring data
about human resources and communicating this information to interested
parties".
1.1.3.8 NATURE AND MEANING OF ACCOUNTING PRINCIPLES
What is an accounting principle or concept or convention or
standard? Do they mean the same thing? Or does each one have its own
meaning? These are all questions for which there is no definite answer
because there is ample confusion and controversy as to the meaning and
nature of accounting principles. We do not want to enter into this
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controversial discussion because the reader may fall a prey to the
controversies and confusions and lose the spirit of the subject.
The rules and conventions of accounting are commonly referred to
as principles. The American Institute of Certified Public Accountants
have defined the accounting principle as, "a general law or rule adopted
or professed as a guide to action; a settled ground or basis of conduct or
practice". It may be noted that the definition describes the accounting
principle as a general law or rule that is to be used as a guide to action.
The Canadian Institute of Chartered Accountants has defined accounting
principles as, "the body of doctrines commonly associated with the
theory and procedure of accounting, serving as explanation of current
practices and as a guide for the selection of conventions or procedures
where alternatives exist". This definition also makes it clear that
accounting principles serve as a guide to action.
The peculiar nature of accounting principles is that they are manmade.
Unlike the principles of physics, chemistry etc. they were not
deducted from basic axiom. Instead they have evolved. This has been
clearly brought out by the Canadian Institute of Chartered Accountants
in the second part of their definition on accounting principles: "Rules
governing the foundation of accounting actions and the principles
derived from them have arisen from common experiences, historical
precedent, statements by individuals and professional bodies and
regulation of governmental agencies". Since the accounting principles
are man made they cannot be static and are bound to change in response
to the changing needs of the society. It may be stated that accounting
principles are changing but the change in them is permanent.
Accounting principles are judged on their general acceptability to
the makers and users of financial statements and reports. They present a
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generally accepted and uniform view of the accounting profession in
relation to good accounting practice and procedures. Hence the name
generally accepted accounting principles.
Accounting principles, rules of conduct and action are described
by various terms such as concepts, conventions, doctrines, tenets,
assumptions, axioms, postulates, etc. But for our purpose we shall use all
these terms synonymously except for a little difference between the two
terms – concepts and conventions. The term "concept" is used to connote
accounting postulates i.e. necessary assumptions or conditions upon
which accounting is based. The term convention is used to signify
customs or traditions as a guide to the preparation of accounting
statements.
1.1.3.9 ACCOUNTING CONCEPTS
The important accounting concepts are discussed hereunder:
Business Entity Concept: It is generally accepted that the moment a business
enterprise is started it attains a separate entity as distinct from the persons who
own it. In recording the transactions of the business the important question is:
How do these transactions affect the business enterprise? The question as
to how these transactions affect the proprietors is quite irrelevant. This concept
is extremely useful in keeping business affairs strictly free from the effect of
private affairs of the proprietors. In the absence of this concept the private
affairs and business affairs are mingled together in such a way that the true
profit or loss of the business enterprise cannot be ascertained nor its financial
position. To quote an example, if the proprietor has taken Rs.5000/- from the
business for paying house tax for his residence, the amount should be deducted
from the capital contributed by him. Instead if it is added to the other business
expenses then the profit will be reduced by Rs.5000/- and also his capital more
by the same amount. This affects the results of the business and also its financial
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position. Not only this, since the profit is lowered, the consequential tax
payment also will be less which is against the provisions of the Income-tax Act.
Going Concern Concept: This concept assumes that the business enterprise will
continue to operate for a fairly long period in the future. The significance of this
concept is that the accountant while valuing the assets of the enterprise does not
take into account their current resale values as there is no immediate expectation
of selling it. Moreover, depreciation on fixed assets is charged on the basis of
their expected life rather than on their market values. When there is conclusive
evidence that the business enterprise has a limited life the accounting procedures
should be appropriate to the expected terminal date of the enterprise. In such
cases, the financial statements could clearly disclose the limited life of the
enterprise and should be prepared from the `quitting concern' point of view
rather than from a `going concern' point of view.
Money Measurement Concept: Accounting records only those transactions
which can be expressed in monetary terms. This feature is well emphasized in
the two definitions on accounting as given by the American Institute of Certified
Public Accountants and the American Accounting Principles Board. The
importance of this concept is that money provides a common denomination by
means of which heterogeneous facts about a business enterprise can be
expressed and measured in a much better way. For e.g. when it is stated that a
business owns Rs.1,00,000 cash, 500 tons of raw material, 10 machinery items,
3000 square meters of land and building etc., these amounts cannot be added
together to produce a meaningful total of what the business owns. However, by
expressing these items in monetary terms Rs.1,00,000 cash, Rs.5,00,000 worth
of raw materials, Rs,10,00,000 worth of machinery items and Rs.30,00,000
worth of land and building – such an addition is possible.
A serious limitation of this concept is that accounting does not
take into account pertinent non-monetary items which may significantly
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affect the enterprise. For instance, accounting does not give information
about the poor health of the Chairman, serious misunderstanding
between the production and sales manager etc., which have serious
bearing on the prospects of the enterprise. Another limitation of this
concept is that money is expressed in terms of its value at the time a
transaction is recorded in the accounts. Subsequent changes in the
purchasing power of moneys are not taken into account.
Cost Concept: This concept is yet another fundamental concept of accounting
which is closely related to the going-concern concept. As per this concept: (i) an
asset is ordinarily entered in the accounting records at the price paid to acquire it
i.e., at its cost and (ii) this cost is the basis for all subsequent accounting for the
asset.
The implication of this concept is that the purchase of an asset is
recorded in the books at the price actually paid for it irrespective of its
market value. For e.g. if a business buys a building for Rs.3,00,000, the
asset would be recorded in the books at Rs.3,00,000 even if its market
value at that time happens to be Rs.4,00,000. However, this concept does
not mean that the asset will always be shown at cost. This cost becomes
the basis for all future accounting for the asset. It means that the asset
may systematically be reduced in its value by changing depreciation. The
significant advantage of this concept is that it brings in objectivity in the
preparations and presentation of financial statements. But like the money
measurement concept this concept also does not take into account
subsequent changes in the purchasing power of money due to
inflationary pressures. This is the reason for the growing importance of
inflation accounting.
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Dual Aspect Concept (Double Entry System): This concept is the core of
accounting. According to this concept every business transaction has a dual
aspect. This concept is explained in detail below:
The properties owned by a business enterprise are referred to as
assets and the rights or claims to the various parties against the assets are
referred to as equities. The relationship between the two may be
expressed in the form of an equation as follows:
Equities = Assets
Equities may be subdivided into two principal types: the rights of
creditors and the rights of owners. The rights of creditors represent debts of the
business and are called liabilities. The rights of the owners are called capital.
Expansion of the equation to give recognition to the two types of equities results
in the following which is known as the accounting equation:
Liabilities + Capital = Assets
It is customary to place `liabilities' before `capital' because creditors
have priority in the repayment of their claims as compared to that of owners.
Sometimes greater emphasis is given to the residual claim of the owners by
transferring liabilities to the other side of the equation as:
Capital = Assets – Liabilities
All business transactions, however simple or complex they are, result in
a change in the three basic elements of the equation. This is well explained with
the help of the following series of examples:
(i) Mr.Prasad commenced business with a capital of Rs.3,000: The
result of this transaction is that the business, being a separate
entity, gets cash-asset of Rs.30,000 and has to pay to Mr.Prasad
Rs.30,000 his capital. This transaction can be expressed in the
form of the equation as follows:
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Capital = Assets
Prasad Cash
30,000 30,000
(ii) Purchased furniture for Rs.5,000: The effect of this transaction is
that cash is reduced by Rs.5,000 and a new asset viz. furniture
worth Rs.5,000 comes in thereby rendering no change in the total
assets of the business. The equation after this transaction will be:
Capital = Assets
Prasad Cash + Furniture
30,000 25,000 5,000
(iii) Borrowed Rs.20,000 from Mr.Gopal: As a result of this
transaction both the sides of the equation increase by Rs.20,000;
cash balance is increased and a liability to Mr.Gopal is created.
The equation will appear as follows:
Liabilities + Capital =Assets
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