Dept. of Management Studies, SSITS, Rayachoty. Page 1 UNIT – I INTRODUCTION TO ACCOUNTING INTRODUCTION Accounting is as old as money itself. The early stage of civilization where the number of transactions to be recorded were so small that the business man was able to record and check for himself all his transactions. But with the remarkable change in business such as scale of production, level of competition, change in technology etc., there is a need to give immense importance to the concept of Accounting. In our country, the system of Accounting was practiced 23 centuries ago as it is clear from the book named “Artha sasthra” written by Koutilya, Chandra Gupta‟s minister. In this book, he not only discussed the matters relating to politics and economics but also he discussed about the art of proper keeping of accounts. However, the modern system of accounting based on the principles of double entry system owes its origin to „Fra Luca Pacioli‟ (Father of Accounting) who first published the principles of double entry system in 1494 at Venice in Italy. MEANING OF ACCOUNTING The main purpose of accounting is to ascertain profit or loss made during a specific period, to know the financial condition of the organization and to have control over company‟s property. DEFINITIONS OF ACCOUNTING Accounting is an art of recording, classifying, summarizing and interpreting the financial information so as to take intelligent decisions. Accounting has been defined as: 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 financial character, and interpreting the results thereof.(AICPA)
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Dept. of Management Studies, SSITS, Rayachoty. Page 1
UNIT – I
INTRODUCTION TO ACCOUNTING
INTRODUCTION
Accounting is as old as money itself. The early stage of civilization where the number of
transactions to be recorded were so small that the business man was able to record and check for
himself all his transactions. But with the remarkable change in business such as scale of
production, level of competition, change in technology etc., there is a need to give immense
importance to the concept of Accounting. In our country, the system of Accounting was
practiced 23 centuries ago as it is clear from the book named “Artha sasthra” written by
Koutilya, Chandra Gupta‟s minister. In this book, he not only discussed the matters relating to
politics and economics but also he discussed about the art of proper keeping of accounts.
However, the modern system of accounting based on the principles of double entry system owes
its origin to „Fra Luca Pacioli‟ (Father of Accounting) who first published the principles of
double entry system in 1494 at Venice in Italy.
MEANING OF ACCOUNTING
The main purpose of accounting is to ascertain profit or loss made during a specific period, to
know the financial condition of the organization and to have control over company‟s property.
DEFINITIONS OF ACCOUNTING
Accounting is an art of recording, classifying, summarizing and interpreting the financial
information so as to take intelligent decisions.
Accounting has been defined as:
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 financial character, and interpreting
the results thereof.(AICPA)
Dept. of Management Studies, SSITS, Rayachoty. Page 2
Accountancy is the process of communicating financial information about a business entity to
users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and
reporting).
ACCOUNTING OBJECTIVES
1. To maintain a written record of business transactions
2. It is a record of income and expenses
3. It is a record of assets and liabilities
4. It is a record that communicates with the people, Government, customers etc.
ACCOUNTING FUNCTIONS
The main functions of Accounting can be given as follows.
1. It keeps a systematic permanent written record of business transactions of the
organization.
2. It keeps a record of incomes and expenses of the organization.
3. It maintains a record of assets and liabilities.
4. It provides information for meeting various legal requirements such as I.T returns, Sales
tax returns etc..
5. It communicates the results of the business to the various categories of persons such as
owners, creditors, Government etc..
6. It protects the property of the business
7. It keeps a track of all changes in the value of assets and liabilities.
8. It helps in managerial decision making.
9. It helps in optimum utilisation of resources.
10. It helps in meeting the competition in the market.
IMPORTANCE OF ACCOUNTING
Accounting is important in view of the following:
It provides legal information to stakeholders such as financial accounts in the form of
trading, profit and loss account and balance sheet.
It shows the mode of investment for shareholders.
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It provides business trade credit for suppliers.
It notifies the risks of loan in business for banks and lenders.
Financial accounting generates some key documents, which includes profit and loss
account, patterning the method of business traded for a specific period and the balance
sheet that provides a statement, showing mode of trade in business for a specific period.
It records financial transactions showing both the inflows and outflows of money from
sales, wages etc.
Financial accounting empowers the managers and aids them in managing more efficiently
by preparing standard financial information, which includes monthly management report
tracing the costs and profits against budgets, sales and investigations of the cost.
***
BASIC TERMINOLOGY IN ACCOUNTING
Business transaction: Any transaction involving exchange of money or money‟s worth as
goods and services constitutes Business transaction.
Business: Any lawful and continuous economic activity carried on with a motive of
earning profit is called as Business. It includes production and distribution of goods and
services.
Goods: Articles either produced or purchased for the purpose of sale are called goods.
Capital: Amount invested by the proprietor to run the business is termed as capital.
Asset: Any physical thing that possesses money value can be called as an asset.
Fixed asset: The asset which cannot be converted in to cash within one year is called as
fixed asset. Ex: Land, buildings, machinery etc.
Current asset: The assets which can be convertible into cash within one year are called
current assets.
Debtor: The person who owes money to the firm is known as debtor.
Creditor: The person to whom money is owed is called as creditor.
Debt: The amount due from debtor is termed as debt.
Credit: The amount due to creditor is termed as credit.
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Debit and Credit in a transaction: There will be two aspects in every transaction
namely 1.Receiving aspect 2. Giving aspect. Receiving aspect is called as Debit and the
Giving aspect is called as Credit.
Drawings: Amount or goods withdrawn by the owner from the business for personal
purposes constitutes drawings.
Loss: Expenditure incurred without any benefit to the concern is termed as loss.
Income: Favorable change in owners‟ equity is called as income.
Profit: Excess of income over expenditure.
Industry: Group of companies engaged in similar kind of production is known as an
industry. Ex: sugar industry, steel industry etc.
Commerce: Commerce is the subject that is concerned with distribution of goods and
services.
***
BRANCHES OF ACCOUNTING
The financial literature classifies accounting into three broad categories, viz, Financial
Accounting, Cost Accounting and Management Accounting. Financial accounting is primarily
concerned with the preparation of financial statements. Cost accounting makes elaborate cost
records regarding various products, operations and functions. Management accounting covers
areas such as interpretation of financial statements, cost accounting, etc.
Financial Accounting
Financial accounting deals with the preparation of financial statements for the basic purpose of
providing information to various interested groups like creditors, banks, shareholders, financial
institutions, government, consumers, etc. Financial statements, i.e. the income statement and the
balance sheet indicate the way in which the activities of the business have been conducted during
a given period of time. The significance of financial accounting lies in the fact that it aids the
management in directing and controlling the activities of the firm and to frame relevant
managerial policies related to areas like production, sales, financing, etc.
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Cost Accounting
Cost Accounting is the process of determining and accumulating the cost of a particular product
or activity. Any product, function, job or process for which costs are determined and
accumulated, are called cost centres. The basic purpose of cost accounting is to provide a
detailed breakup of cost of different departments, processes, jobs, products, sales territories, etc.,
so that effective cost control can be exercised. Cost accounting also helps in making revenue
decisions such as those related to pricing, product-mix, profit-volume decisions, expansion of
business, replacement decisions, etc.
Management Accounting
The basic purpose of Management Accounting is to communicate the facts according to the
specific needs of decision-makers by presenting the information in a systematic and meaningful
manner. Management Accounting, therefore, specifically helps in planning and control. It helps
in setting standards and in case of variances between planned and actual performances, it helps in
deciding the corrective action. An important characteristic of management accounting is that it
is forward looking. Its basic focus is one future activity to be performed and not what has already
happened in the past.
SYSTEMS OF BOOK-KEEPING
There are two systems of book-keeping namely 1. Single entry system and 2. Double entry
system.
Single entry system: It is the age old unscientific method of accounting which records only one
aspect of the transaction i.e., either debit or credit. Usually sole trader (single seller) keeps his
books of accounts under this method. This method of accounting is not helpful in any way to the
organizations in the preparation of final accounts. Moreover it doesn‟t provide sufficient
information for managerial decision making.
Double Entry System: This system was stated by Fra Luca Pacioli in the year 1494. He hails
from Venice in Italy. This is the scientific method of accounting where the two aspects of
transaction are taken into consideration. Therefore one can find that, for every debit there is an
equal and corresponding credit for every transaction in this method. It is helpful not only in
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preparing final accounts but also in taking important financial decisions. In our country as per
the Companies Act 1956 and the Income Tax Act 1962 all the companies are supposed to
maintain their books of accounting under this method.
BOOK-KEEPING Vs ACCOUNTING
Book-keeping and accounting are two different departments dealing with the accounts of
company. Book-keeping is the initial stage, in which we keep the record of income and
expenditure, whereas in Accounting department, accountants analyze the company‟s financial
activity and prepare reports. Both are very important for the proper management and financial
success of a business.
Book-keeping
In simple words, recording the financial dealings of a company or individual is
bookkeeping, like sales, purchase, revenues and expenses. Traditionally, it is called as book-
keeping since records were kept in books; now there is specific software for this purpose, but the
old name is still in use. Usually, book-keepers are appointed to keep the record in accurate and
precise manner. This activity is very important for the financial health of a company, as it
informs the management about up to date financial condition of their company. Commonly used
books are, daybook, ledger, cashbook and many others are also used, according to the nature of
business. A bookkeeper enters a particular financial activity in its respective book and post to the
ledger as well. Single entry and double entry are two types of bookkeeping. As the name suggest,
in single entry a transaction is either recorded in debit or in credit column of the same account,
but in case of double entry, two entries of each transaction are carried to ledger, one in debit
column and other under credit heading.
Accounting
Accounting deals with organized recording, reporting and analysis of financial activity of
a company. Making statements regarding assets and liabilities also come under the jurisdiction of
accounting. Accountants are also responsible for making monthly fiscal statements and yearly
tax returns. The accounting departments also do preparation of company‟s budgets and plan loan
proposals. Moreover, they analyze the cost of company‟s products or services. Now-a-days,
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Accounting Principles
Accounting Concepts Accounting Conventions i. Business Entity concept i. consistency ii. Money Measurement concept ii. Full Disclosure iii. Going Concern concept iii. Conservatism iv. Cost concept iv. Materiality v. Dual Aspect concept vi. Accounting Period concept vii. Matching concept viii. Realization concept ix. Accrual concept
The concepts and conventions are explained below:
I) Business Entity Concept
This concept implies that a business unit is separate and distinct from the persons who
supply capital to it. Irrespective of the form of organization, a business unit has got its own
individuality as distinguished from the persons who own or control it. In case this concept is not
followed, affairs of the business will be mixed up with the private affairs of the proprietor and
the true picture of the business will not be available.
II) Money Measurement Concept
Money is the only practical unit of measurement that can be employed to achieve
homogeneity of financial data, so accounting records only those transactions which can be
expressed in terms of money though quantitative records are also kept. The advantage of
expressing business transactions in terms of money is that money serves a common denominator
by means of which heterogeneous (different) facts about a business can be expressed in terms of
numbers (i.e. money) which are capable of additions and subtractions.
III) Going Concern Concept
It is assumed that a business unit has a reasonable expectation of continuing business at a
profit for an indefinite period of time. A business unit is deemed to be a going concern and not a
gone concern. It will continue to operate in the future. Transactions are recorded in the books
keeping in view the going concern aspect of the business unit. It is because of this concept that
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suppliers supply goods and services and other business firms enter into business transactions
with the business unit.
IV) Cost Concept
According to this concept the asset is recorded at cost at the time of its purchase but is
systematically reduced in its value by charging deprecation. The cost concept has the advantage
of bringing objectivity in the accounts. Information given in the financial statements is not
influenced by the personal bias or judgment of those who furnish such statements. In the absence
of cost concept, assets will be shown at their market values which will depend on the subjective
views of persons who furnish financial statements.
V) Dual Aspect Concept
This is the basic concept of accounting. According to this concept, every financial
transaction involves a two-fold aspect, (a) yielding of a benefit and (b) the giving of that benefit.
VI) Accounting Period Concept
Normally accounting period adopted is one year as it helps to take any corrective action,
to pay income-tax, to absorb the seasonal fluctuations and for reporting to the outsiders. A period
of more than one year reduces the utility of accounting data. The principle of segregating capital
expenditure from revenue expenditure is based on the accounting period concept. The revenue
expenditure for a particular period is transferred to the Profit and Loss Account of that period
whereas capital expenditure is carried forward to the extent its benefit will be utilized in future
accounting periods. Thus, the accounting period concept plays a very important role in
determining the income of a particular accounting period. It is also helpful in ascertaining the
true and fair financial position of a business entity on a particular date at a particular point of
time.
VII) Matching Concept
This concept is based on the accounting period concept. The most important objective of
running a business is to ascertain profit periodically. The determination of profit of a particular
accounting period is essentially a process of catching the revenue recognized during the period
and the costs to be allocated to the period to obtain the revenue. The matching concept stands on
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firm footing and should be followed while preparing financial statements to have a true and fair
view of the profitability and financial position of a business entity.
VIII) Realization Concept
According to this concept revenue is considered as being earned on the date at which it is
realized, i.e., on the date when the property in goods passes to the buyer and he becomes legally
liable to pay.
IX) Accrual Concept
The essence of the accrual concept is that revenue is recognized when it is realized, that
is when sale is complete or services are given and it is immaterial whether cash is received or
not. Similarly, according to this concept, expenses are recognized in the accounting period in
which they help in earning the revenue whether cash is paid or not. Thus, to ascertain correct
profit or loss for an accounting period and to show the true and fair financial position of the
business at the end of the accounting period, we make record of all expenses and incomes
relating to the accounting period whether actual cash has been paid or received or not. Therefore,
as a result of the accrual concept, outstanding expenses and outstanding incomes are taken into
consideration while preparing final accounts of a business entity.
Accounting Conventions
The term „conventions‟ denotes customs or traditions which guide the accountant while
preparing the accounting statements. The following are the important accounting conventions:-
1. Convention of consistency
2. Convention of full disclosure.
3. Convention of conservatism.
4. Convention of materiality.
1. Convention of Consistency
Accounting rules and conventions should be continuously observed and applied i.e., these
should not change from one year to another. The results of different years will be comparable
only when accounting rules are continuously adhered to from year to year. Consistency also
implies external consistency, i.e., the financial statements of one enterprise should be comparable
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with another. It means that every enterprise should follow same accounting methods and
procedures of recording and reporting business transactions. The development of international
and national accounting standards is due to the convention of consistency.
2. Convention of Full Disclosure
According to this convention, all accounting statements should be honestly prepared and
to that end full disclosure of all significant information should be made. All information which is
of material interest to proprietors, creditors and investors should be disclosed in accounting
statements. An obligation is placed on the accounting profession to see that the books of
accounts prepared on behalf of others are as reliable and informative as circumstances permit.
3. Convention of Conservatism or Prudence
Literally speaking, conservatism means taking the gloomy view of a situation. It is a
policy of caution or playing safe and had its origin as a safeguard against possible losses in a
world of uncertainty. It compels the businessman to wear a “risk-proof” jacket, for the working
rule is: anticipate no-profits, but provide for all possible losses.”
4. Convention of Materiality
Whether something should be disclosed or not in the financial statements will depend on
whether it is material or not. Materiality depends on the amount involved in the transaction. For
example, minor expenditure of Rs. 10 for the purchase of a waste basket may be treated as an
expense of the period rather than as asset. Custom also influence materiality. For example, only
round figures (to the nearest rupee) may be shown in the financial statements to make the figures
manageable without affecting the accuracy of the accounting data. Similarly, for income tax
purposes the income has to be rounded to nearest ten rupees. The term “materiality” is a
subjective term. The accountant should record an item as material even though it is of small
amount if its knowledge seems to influence the decision of the proprietors or auditors or
investors.
***
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ROLE OF ACCOUNTANTS IN MODERN BUSINESS ORGANIZATION
Accounting is an age-old profession. In old days of accounting, the main function of an
accountant was to maintain the records of the business. However over the years, the role of an
accountant has undergone a sea change. With the inception of joint stock company form of an
organization, the profession of accountancy has come to be recognized as one of the lucrative
professions. Accountants can be broadly divided into two categories namely, Accountants in
public practice and Accountants in employment. Accountants in public practice (practicing
chartered accountants) are members of the Institutes of Chartered Accountants of India. The
accountant renders valuable service to the society in the following manner:
1. Writing up Accounts for Preparing Financial Statements: Professional accountants
offer services for writing up accounts and preparing financial statements. By maintaining
proper books of accounts and records he assists management to a great extent in the field
of planning, decision-making and controlling. A systematic record also enables the
business to compare one year‟s results with those of other years.
2. Audit of Accounts: Conducting of audit is one of the most important functions of a
professional accountant where his specialized training, skills and judgement are most
often called into play. Audit satisfies the users of financial statements that the accounting
information contained in these statements is true and reliable and that accounts have been
prepared in accordance with the accounting standards. It, thus, adds credibility to
financial statements prepared by the business. He also points out the shortcoming and
suggests ways to overcome them.
3. Role as Management Accountant: A management accountant helps the management in
planning and control of organizational activities and their performance evaluation.
4. Help to government, Revenue Department and Tax Payer: Chartered accountant
plays an important role in ensuring that the Government gets its proper share of taxes and
at the same time the tax payer is not exploited. Chartered accountant is instrumental in
preparing the financial statements of the enterprise. He also prepares the returns for tax
purposes. He also appears before the tax authorities on behalf of the taxpayer. He also
does the work of certification of documents in many cases.
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5. Role as Cost Accountant: As a cost accountant, he maintains the costing records and
ascertains the cost of product or service. He provides costing information introduces cost
control and cost reduction methods and assists the management in fixing appropriate
selling prices.
6. Role in Merger, Liquidation, etc: The services or advice of chartered accountants are
frequently sought in the formation, merger or liquidation of limited companies. They are
called upon to undertake investigation for achieving greater efficiency in management and
find out the reasons for increase of decrease in profits. They act as executors and trustees
under a will or trust deed to carry out the administration of the estate or settlements.
***
ADVANTAGES OF ACCOUNTING
Accounting gives businesses many advantages which can be summarized as under-
Maintaining systematic records
It is a primary function of accounting to keep a proper and chronological record of
transactions and events, which provides a base for further processing and proof for checking and
verification purposes. It involves writing in the original/subsidiary books of entry, posting to
ledger, preparation of trial balance and final accounts.
Meeting legal requirements
Accounting helps to comply with the various legal requirements. It is mandatory for joint
stock companies to prepare and present their accounts in a prescribed form. Various returns such
as income tax, sales tax are prepared with the help of the financial accounts.
Protecting and safeguarding business assets
Records serve a dual purpose as evidence in the event of any dispute regarding ownership
title of any property or assets of the business. It also helps prevent unwarranted and unjustified
use. This function is of paramount importance, for it makes the best use of available resources.
Facilitates rational decision-making
Accounting is the key to success for any decision making process. Managerial decisions
based on facts and figures take the organisation to heights of success. An effective price policy,
satisfied wage structure, collective bargaining decisions, competing with rivals, advertisement
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and sales promotion policy etc all owe it to well set accounting structure. Accounting provides
the necessary database on which a range of alternatives can be considered to make managerial
decision-making process a rational one.
Communicating and reporting
The individual events and transactions recorded and processed are given a concrete form
to convey information to others. This economic information derived from financial statements
and various reports is intended to be used by different groups who are directly or indirectly
involved or associated with the business enterprise.
Comparison of results
Systematic maintenance of business records enables to compare profit of one year with those of
earlier years to know the facts about the changes. This helps the business to plan its future
affairs.
Decision making
The accountant helps the management by providing the relevant information for solving the day-
to-day problems of business.
LIMITATIONS OF FINANCIAL ACCOUNTING
The following limitations of financial accounting have led to the development of cost
accounting:
1. No clear idea of operating efficiency:. Financial accounting does not give a clear picture of
operating efficiency when prices are rising or decreasing on account of inflation or trade
depression.
2. Not helpful in the price fixation: In financial accounting costs are not available as an aid in
determining prices of the products, services, production order and lines of products.
3. No classification of expenses and accounts: In financial accounting there is no such system
by which accounts are classified so as to give data regarding costs by departments, processes,
products in the manufacturing divisions; by units of product lines and sales territories; by
departments, services and functions in the administrative divisions. Further expenses are not
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classified as to direct and indirect items and are not assigned to the products at each stage of
production to show the controllable and uncontrollable items of overhead costs.
4. No data for comparison and decision making: It does not supply useful data to
management for comparison with previous period and for taking various financial decisions as
introduction of a new product, replacement of labour by machines, price in normal or special
circumstances, producing a part in the factory or buying it from outside market , production of a
product to be continued or given up, priority accorded to different products, investment to be
made in new products are not etc.
5. No control on cost: It does not provide for a proper control of materials and supplies, wages,
labour and overheads.
6. No standards to assess the performance: In financial accounting there is no well-developed
system of standards to appraise the efficiency of the organizations in the use of materials, labour
and overhead cost by comparing the work of labours, clerks, salesmen and executives which
should have been accomplished in producing and selling a given number of product in an allotted
period of time. It does not provide information to assess the performance of various persons and
departments and to see that the costs do not exceed a reasonable limit for given quantum of work
of the requisite quality.
7. Provides only historical information: Financial accounting is mainly historical and tells
about the cost already incurred. It does not provide day to day cost information to management
for making effective plans for the coming year and period after that as financial data is
summarized at the end of the accounting period.
8. No analysis of losses: It does not provide complete analysis of losses due to defective
material, idle time, idle plant and equipment. In other words, no distinction is made between
available and un available wastage.
9. Inadequate information for reports: I t does not provide adequate information for reports to
outside agencies such as banks, government, insurance companies and trade associations.
***
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USERS OF ACCOUNTING INFORMATION
Accounting is the language of business. It is the system of recording, summarizing, and
analyzing an economic entity's financial transactions. Effectively communicating this
information is key to the success of every business. Those who rely on financial information
include internal users, such as a company's managers and employees, and external users, such as
banks, investors, governmental agencies, financial analysts, and labor unions.
Accounting information helps users to make better financial decisions. Users of financial
information may be both internal and external to the organization.
Internal users of accounting information include the following:
Management: for analyzing the organization's performance and position and taking
appropriate measures to improve the company results.
Employees: for assessing company's profitability and its consequence on their future
remuneration and job security.
Owners: for analyzing the viability and profitability of their investment and determining
any future course of action.
Accounting information is presented to internal users usually in the form of management
accounts, budgets, forecasts and financial statements.
External users of accounting information include the following:
Creditors: for determining the credit worthiness of the organization. Terms of credit are
set according to the assessment of their customers' financial health. Creditors include
suppliers as well as lenders of finance such as banks.
Tax Authorities: for determining the credibility of the tax returns filed on behalf of the
company.
Investors: for analyzing the feasibility of investing in the company. Investors want to
make sure they can earn a reasonable return on their investment before they commit any