Accounting Definition

Accounting is an art of recording, classifying, and summarising in a significant manner and in terms of money transactions and events which in part, at least of a financial character, and interpreting the results thereofAmerican Institute of Certified Public Accountants
the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.American Accounting Association

the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.

Thus, accounting is not merely concerned with recording, classifying or summarising the transactions but also an important tool for providing appropriate information to the management for decision making.

The analysis of the above definitions brings out the following as attributes of accounting:

  • It is the art of recording and classifying business transactions and events.
  • The events and transactions of a financial nature must be recorded in monetary terms, while the events and transactions of a non-financial nature cannot be recorded.

  • The record should reflect the importance of the transactions so recorded both individually and collectively, which includes summarization, thereby making it amenable to analysis.

  • The users of the financial statements should be able to obtain the message encompassed in such financial statements, and it is the knowledge of accounting, which enables the user to understand the contents of the financial statements.

  • It is an art of making summarisation, analysis, and interpretation of the events and transactions.

  • The results of such analysis must be communicated to the persons who are to make decisions or form judgments.

Objectives of Accounting

Accounting is required to keep and maintain systematic records of a business

Accounting is a means of recording the monetary transactions and events. Accounting is done to keep and maintain a systematic record of financial transactions and events. In the absence of accounting there would have been terrific burden on human memory which, inmost cases would have been impossible to bear.

In accounting, systematic record of monetary aspects of business transactions and events are maintained, the first step in preparation of financial statements. This is referred to as book-keeping. After recording daily business transactions and events in an orderly manner, recorded information is classified and then, summaries are prepared.

Thus, accounting is a wider term and includes, besides book-keeping, preparation of financial statements and their analysis and interpretation.

To protect business properties

Accounting provides protection to business properties from unjustified and unwarranted use. This is possible on account of accounting supplying the following information to the manager or the proprietor:

  • The amount of the proprietor’s fund invested in the business.
  • How much the business have to pay to others?
  • How much the business has to recover from others?
  • How much the business has in the form of
    • fixed-assets
    • cash in hand
    • cash at bank
    • stock of raw-materials, work-in-progress and finished goods?

Information about the above matters helps the proprietor in assuring that the funds of the business are not unnecessarily kept idle or under utilized.

To ascertain the operational profit or loss

Accounting is required to ascertain the earning of the business concerns, which is achieved by preparation of profit and loss account. To ascertain profit earned or losses suffered during a period of time, a business organization prepares an income statement.

It is also referred to as trading and profit & loss account. To calculate operational profit or loss for a period of time, revenues and other incomes are aggregated and expenses incurred during that period are subtracted from the aggregate of revenue and other incomes. Revenue refers to the value of goods sold or services rendered.

Other incomes include rent, interest, dividend and/ or royalty received from the parties who use business properties, fund, rights etc.

Expenses mean the amount of resources used or lost to earn revenue and other incomes. Excess of revenue and other incomes over expenses is termed as profit.

However, if expenses are more than the aggregate of revenues and other incomes then the loss is suffered by the business organization. Hence, it essentially involves recognising revenues and expenses and matching them to establish the results of the business.

Thus, Profit (or Loss) = Revenues and other incomes – Expenses

Accounting is required to identify the obligations (Liabilities) and resources (asset)

In addition to profit (or loss), sound decision-making requires information about the financial position of a business organization.

To depict financial position of a business, financial position statement is prepared. On one hand, it gives details of resources owned by the business organization. Resources owned are termed as assets. On the other hand, it contains information about obligations of business. Obligations of the business towards outsiders and the owner are referred to as liabilities and capital respectively.

Financial position statement is also termed as balance sheet which provides information about sources of finance (e.g. outside liabilities and owner’s equity) and the resources (e.g. assets) of the business.

Accounting records are required to portray the liquidity position

Financial reporting should provide information about how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing, about its capital transactions, cash dividends and other distributions of resources by the organization to owners, and about other factors that may affect an enterprise’s liquidity and solvency.

Accounting records are required to control over the property and assets of the firm

Accounting provides up-to-date information about the various assets that the firm possesses and the liabilities the firm owes so that nobody can claim a payment which is not due to him.

Accounting records are required to file tax returns

This is the objective which hardly needs emphasis. The credible accounting records provide the best bases for filing returns of both, direct as well as indirect taxes.

Accounting records are required to be maintained statutorily by central government and regulatory bodies.

Accounting records are required to make financial information available to various groups and users. Accounting is called the language of business. It aims to communicate information about financial results and financial position of a business enterprise to decision-makers. Various groups like owners, investors, management, creditors, financial institutions, employees, government, researchers, customers, public etc. need this information for sound decision-making.

Thus, accounting aims to meet the information needs of the decision-makers and helps them in rational decision-making. This is done through financial statements, namely, “Income Statements” and “Position Statement”.

It must be understood properly that there are general purpose statement designed to cater primarily to external user groups.

Scope of Accounting

Accounting plays a key role in serving a systematic and up-to-date record of varied and numerous business transactions. Its target is to analyse the financial transactions as they take place, to record them in orderly fashion, to group and arrange the information in terms of useful and understandable financial report (Balance Sheet, Income Statement) and to assist in the process of interpretation.

Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is useful in making economic decisions, in making reasoned choices among alternative course of action.

To be more useful, accounting should provide various information in an integral information system. The primary objective of accounting is to take decision on various matters based on accounting data provided through different financial statements.

Accounting is thus not an end itself but a means to an end. It is mainly a service function. In broad perspective an accounting system should concern itself with the following information:

  • Analysis of past financial data to find out the reasons for bad condition of the concern and corrective measures for improvement of the business.
  • Accounting is an art, on the other hand, it is the application of knowledge comprising of some accepted theories, rules, concepts and conventions. It helps us to achieve our goals and tells us the manner in which we may attain our objectives in the best possible way. The more we practice an art the more expert we become in it.
  • Accounting is a science because recording, classifying and summarising of business transactions is done on the basis of certain principles of double entry system which are universally applicable.
  • Accounting seems to be very important in financial forecasting and financial forecasting helps in estimating the profitable projects and out of these profitable projects accountant chooses the one which is more profitable for the concern.
  • For decision-making accounting is useful. Accounting helps the accountants to take decision about capital structures, cost of capital, an ideal capital gearing ratio, capital budgeting, working capital, cash, budget, cost control, inventory management etc.
  • Accounting is a technique which compares the cost of various departments and thus find out which department is efficient than the other.
  • As is common with physicians, engineers, lawyers, and architects, accountants (including CPAs) commonly are engaged in professional practice or are employed by business, government entities, non-profit organisations and so on.
  • Accounting can be classified into the following categories:
    • Financial accounting
    • Management accounting (including Cost accounting
    • Auditing
    • Others like Price level changes accounting, Social cost accounting, Social auditing, Human resource accounting, Forensic accounting, Creative accounting, Value added accounting etc.

Need of Accounting

Accounting, being a man-made system, has evolved over a period of time to provide financial information of a business enterprise to users of accounting information.

A large number of groups with varied interests in affairs of business enterprise have emerged over a period of time, especially after emergence of corporate form of organisation involving separation of ownership and management.

The main points of need of accounting are as follows:

  • Accounting information needs of shareholders have assumed great significance in the corporate business world because of separation of ownership and management in case of joint stock companies. Owners are interested in the financial information, to know about safety of amount invested and return on amount invested.

  • For managing business profitably, information about financial results and financial position is needed by management. By providing this information accounting helps managers in efficient and smooth running of a business organization.

  • Prospective investors would like to know about the past performance of the business organization before making investment in that concern. By analysing historical information provided by accounting records, they can arrive at a decision about the return and the risk involved in investing in a particular business organization.

  • Creditors and Financial institutions, whosoever is extending credit or loan to a business organization would like to have information about its repaying capacity, credit worthiness etc. The required information can be obtained by analysing and interpreting the financial statements of the business organization.

  • Employees are concerned about job security and future prospects. Both of these are intimately related with the performance of the business concern. Thus, by analysing financial statements they can draw conclusions about their job-security and future prospects.

  • Government policies relating to taxation, providing subsidies etc. are guided by relevance of the industry in the economic development of the country and the past performance of the industry. Information about past performance is provided by the accounting system. Collection of taxes is also based on accounting records.

  • Researchers need financial information for testing hypothesis and development of theories and models. The financial statements provide the required information.

  • Customers who have developed loyalties to a business are certainly interested in the continuance of the business. They certainly want to know about the future directions of the organization with which they are associating themselves. The way to information about the organization is through their financial statements.

  • An enterprise affects the public at large in many ways, such as a provider of employment to a number of persons, being a customer to many suppliers, a provider of amenities in the locality, a cause of concern to the public due to pollution etc. Hence, public at large is interested in knowing the future directions of organization and the only window to peep inside the organization is their financial statements.

  • Members of non-profit organizations such as schools, colleges, hospitals, clubs, charitable institution to know how their contributed funds are being utilised and to ascertain if the organization deserves continued support or support should be withdrawn keeping in view the bad performance depicted by the accounting information and diverted to another organization.

    In knowing the performance of such organizations, criterion will not be the profit made but the chief criterion will be the service provided to the society.

Above mentioned points of need of accounting and accounting information are not exhaustive. Anyone having an interest in the business enterprise can use information for decision-making.

Basics of Accounting

For recording business transactions of business organization, there are three approaches of accounting which are widely accepted:

  • Cash basis of accounting
  • Accrual basis of accounting
  • hybrid or Mixed basis of accounting

As you know, all business transactions ultimately result into realisation of revenue or incurring of expense. Truely speaking, the approaches to accounting which are to be discussed here tell how revenues and expenses are to be recognised.

Cash Basis of Accounting

Under the cash basis of accounting actual cash receipts and actual cash payments are recorded. Credit transactions are not recorded at all and are ignored till the cash is actually received or paid.

Income is merely the difference between the cash receipts and cash payments. The Receipts and Payments Account prepared in case of non-trading concerns such as a charitable institution, a club, a school, a college etc. and professional men like lawyer, doctor, a chartered accountant etc. can be cited as the best example of cash basic of accounting.

Advantages of cash basis of accounting

The main advantages of cash basis of accounting are as follows:

  • Cash basis of accounting has considerable appeal to many people because it is so simple, appears to be so realistic, is verifiable and satisfies the conservative instinct.

  • Cash basis of accounting approach is more objective as very few estimates and judgments are required.

  • Cash basis of accounting is suitable for those enterprises where most of the transactions are on cash basis.

Disadvantages of cash basis of accounting

The main disadvantages of cash basis of accounting are as follows:

  • Cash basis of accounting does not give a true and fair view of profit and loss and financial position of the organization because it ignores outstanding and prepaid expenses and accrued income and income received in advance.

  • Cash basis of accounting does not follow matching principle of accounting.

  • Cash basis of accounting does not distinguish between capital and revenue items and as a result there is no consistency in the profits of the two years.

  • In cash basis of accounting actual cash inflows and outflows are considered, there is great possibility of profit manipulation e.g., payments may be delayed or proposed, similarly incomes may be postponed or collected early.

Accrual Basis of Accounting

Due to disadvantages of the cash basis of accounting, the accrual basis of accounting has been developed by accountants. In this accounting approach every cash receipt cannot be treated income for determining the true profit of the accounting entity of the period. Accrual basis of accounting rejects the circumstances of receipt or payment of cash as criteria for associating either income or expense with a period.

Rather this basic of accounting is based on concept of realisation and expiration and follows two basic accounting principles viz. the revenue recognition and the matching principle.

On the accrual basis of accounting, the income whether received or not but has been earned or accrued during the period forms past of the total income of that period e.g., sales made on credit will be included in the total sales of the period irrespective of the fact when cash is actually realised.

Similarly, if the firm has taken benefit of a particular service, but has not paid within that period, the expense will relate to the period in which the service has been utilised and not to the period in which the payment for it is made, e.g., rent due to the landlord but not paid will be taken as an expense for the period when it is due and not in the period when it is paid.

Thus, under accrual basis of accounting net income for a period is the result of matching of revenue realised in the period and costs expired during the period.

Advantages of Accrual basis of accounting

The main advantages of accrual basis of accounting are as follows:

  • Accrual basis of accounting is preferred by accountants as it is more scientific as compared to cash basis of accounting.

  • The accrual basis of accounting gives a complete picture of the financial transactions of the business as it makes a record of all transactions relating to a period and takes into account adjustments like outstanding expenses, prepaid expenses, income received in advance and income earned but not received etc.

  • The accrual basis of accounting discloses correct profit or loss for a particular period and also exhibit true financial position of the business on a particular day.

  • Accrual basis of accounting has wide acceptability as the Companies Act, 1988 has amended section 209 of the companies Act, 1956 with effect from 15th June 1988 requiring companies to maintain their accounts on accrual basic of accounting so that fairest possible periodic net income and the financial position may be reported to the public.

Disadvantages of accrual basis of accounting:

The main disadvantages of accrual basic of accounting are as follows:

  1. Accrual basis of accounting is not as simple as cash basis of accounting.

  2. In accrual basis of accounting a quick appraisal of the profit or loss is not possible as a lot of adjustments are required for finding the true financial position of the business.

  3. The accrual basis of accounting is too elaborative.

Mixed or Hybrid Basis of Accounting

Cash basis of accounting is by far the simplest system whereas the accrual basis of accounting is scientific and reliable. So accountants have tried to club these advantages of the two systems and have come up mixed or hybrid basis of accounting.

Under mixed basis of accounting both cash basis and accrual basis are followed. Incomes are recorded on cash basis whereas expenses are taken on accrual basis. The net income is ascertained by matching expenses on accrual basis with income on cash basis.

This is the most conservative basis of ascertaining income because all possible expenses relating to the period whether actually paid or not are considered whereas income only received in cash is taken into consideration.

When all the expenses are taken into account, there is reduction in taxable income and hence this system is popular among professionals like advocates, doctors, lawyers, chartered accountants etc.

Double Entry System

Double entry system owes its origin to an Italian merchant named Lucas Pacioli who wrote the first book entitles ‘De Computis et Scripturis’ on double entry accounting in the year 1494. We have seen earlier that every business transaction has two aspects. i.e., when we receive something, we give something else in return.

For example, when we purchase goods for cash, we receive goods and give cash in return; similarly in a credit sale of goods, goods are given to the customer and the customer becomes debtor for the amount of goods sold to him. This method of writing every transaction in two accounts is known as

Double Entry System of Accounting. Of the two accounts, one account is given debit while the other account is given credit with an equal amount. Thus, on any date, the total of all debits must be equal to the total of all credits because every debit has a corresponding credit.

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