What is Accounting?
Accounting defined as the process of identifying, measuring, recording and communicating the required information relating to the economic events of an organization to the interested users of such information.
Accounting refers to the system involved in making a financial record of business transactions and in the preparation of statements concerning the assets, liabilities, capital and operating results of the business.
Table of Contents
- 1 What is Accounting?
- 2 Accounting Definition
- 3 Difference Between Bookkeeping and Accounting
- 4 Objectives of Accounting
- 5 Scope of Accounting
- 6 Need of Accounting
- 7 Basics of Accounting
- 8 Double Entry System
- 9 Advantages of Accounting
- 10 Limitations of Accounting
- 11 Accounting Conventions
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.
Difference Between Bookkeeping and Accounting
|Objective||The objective of book-keeping is to prepare original books of accounts. It is restricted to journal, subsidiary books and ledger accounts only||The objective of accounting is to record, analyze and interpret the business transactions.|
|Scope||It has limited scope and is concerned with the recording of business transactions||It has wider scope as compared to book-keeping.|
|Level of work||It is restricted to low level of work. Clerical work is involved in it.||It is concerned with low level, medium level and even top level management. Low level clerks prepare the accounts, medium level report it and top level interpret it.|
|Mutual dependence||Book-keeping is only the art of recording transactions, so it has to depend upon accounting which makes it more meaningful and purposeful||Accounting is based upon bookkeeping which is its initial and vital part. It depends upon bookkeeping.|
|Results of business||It does not show the net result of the financial position of business.||Accounting shows the net result of the business. It tells us about the profit earned and also about the assets and liabilities of the business.|
|Principles of Accounting||In book-keeping, accounting concepts and conventions are followed||The methods of reporting and interpretation in accounting may vary from firm to firm.|
Objectives of Accounting
As an information system, the basic objective of accounting is to provide useful information to the interested group of users, both external and internal. The necessary information, particularly in case of external users, is provided in the form of financial statements, viz., profit and loss account and balance sheet.
Besides these, the management is provided with additional information from time to time from the accounting records of business.
The primary objectives of accounting include the following:
- Maintaining Accounting Records
- Ascertainment of Profit or Loss
- Ascertainment of Financial Position
- Communication of Information
Maintaining Accounting Records
Accounting maintains systematic record of the business relating to financial transactions, assets and liabilities. In the modern business organisations, due to increase in the volume of operations, it is always preferred to have written accounting records of the day to day affairs of the business.
Ascertainment of Profit or Loss
By preparing the income Statement which is also known as Profit and Loss Account, a business firm can calculate the profit earned or loss suffered during a particular period of time. For this, the business expenses are matched with the revenues during a particular accounting period.
Thus accounting helps the business firm to find out the result of operations (profit or loss) by maintaining a systematic record of incomes and expenses.
Ascertainment of Financial Position
With the help of the Balance Sheet which is also known as the Position Statement, accounting evaluates the financial strength and weakness of a business firm. The Balance Sheet comprises of the resources (assets) and the sources of financing those resources.
The business may be interested to know what it owns, what are the dues to outsiders and also the position of the capital employed. With the help of systematic records of assets, liabilities and capital a Balance Sheet can be prepared and the financial position of the business can be ascertained.
Communication of Information
The accounting information generated by the accounting process is communicated in the form of reports, statements, graphs and charts to the users who need it in different decision situations.
After preparation of necessary books of accounts and the position statement, accounting communicates those information to the appropriate users. The users can make use of the accounting information as per their requirements.
Scope of Accounting
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
- 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:
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:
- Accrual basis of accounting is not as simple as cash basis of accounting.
- 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.
- 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.
Advantages of Accounting
- Replacing Memory
- Assisting the Performance of Business
- Assessing the Financial Status of the Business
- Documentary Evidence
- Assisting in Realisation of Debts
- Facilitating the Sale of Business
- Preventing and Detecting Frauds
- Helpful to Management
Business transactions are innumerable, varied and complex, as such it is quite impossible to memorize each and every transaction. Accounting records these transactions in writing and thus it is not necessary that the businessman should memorise all the transactions.
Assisting the Performance of Business
Accounting keeps proper and systematic record of all business transactions. Income statements are prepared with these records and we are able to know the profit earned and the loss suffered by the business. Trading Account is prepared to find out gross profit or loss of the enterprise. Net profit or net loss can be known by preparing Profit and Loss Account.
Assessing the Financial Status of the Business
Financial position of the business is displayed through position statement i.e., Balance Sheet of the business. The statement is prepared at the end of the accounting year and reflects the true position of assets and liabilities of the business on particular date.
Accounting records can also be used as an evidence in the court of substantiate the claim of the business. These records are based on documentary proof. Every entry is supported by authentic vouches. That is why, the court accepts these records as evidence.
Assisting in Realisation of Debts
In ‘Accounts’ we prepare personal ledger accounts of all the parties. The personal account shows the exact amount due from the debtors. We can send the debtors their statement of accounts and thus enable them to verify entries and also to make early payment of the amount due. The account can also be used to prove the claim of the business against the debtors in the court.
Facilitating the Sale of Business
The position statement of the business shows the value of assets and liabilities of the business. We can calculate the ‘Net Worth’ of the business on the basis of these statements. Accounting facilitates in the calculation of the consideration for which the business should be sold.
Preventing and Detecting Frauds
The proper accounting system and effective arrangement of internal check prevents leakage of goods and cash. In case, cheating takes place, theft or embezzlement is made and fraud is committed, accounting helps in detection of these losses and also fixes responsibility for it. Proper accounting prevents employees from committing fraud.
Helpful to Management
Accounting is useful to the management in various ways. It enables the management to assess the achievements of its performance. Actual performance can be compared with the desired performance or with the performance of previous years. The weaknesses of the business can be identified and corrective measures can be applied to remove them.
Various profitability, sales and liquidity ratios can be calculated, the actual performance can be evaluated and effective line of action can be decided for the future. Funds flow statement can also be prepared to understand the additional funds earned during the year and their application.
Limitations of Accounting
The limitations of accounting can be understood in the following points:
- Qualitative Assessment not Possible
- Influenced by Personal Judgement
- Shows Estimated Position
- Inflation is Ignored
- Risk of Window Dressing
Qualitative Assessment not Possible
Accounting deals with the monetary events only. In the process, many important qualitative matters like efficient management, good public relations, efficient labour force do not find its place in the accounting records.
Influenced by Personal Judgement
In some cases of accounting records, personal judgement plays an important role. Again, personal judgement may vary person to person. Hence, the profit disclosed by accounting may end up as an approximation only.
Shows Estimated Position
Accounting does not show the real position. It shows the estimated position only since it is prepared on going concern basis.
Inflation is Ignored
lnflation is an important factor in the economy. But accounting information ignores the impact of inflation. It is so because of the fact that accounting records are historical in nature.
Risk of Window Dressing
By entering false figures, the value of assets, liabilities, profits or loss can be increased or decreased. Hence, sometimes the income statement and the balance sheet fail to provide the true and fair view of the business.
The Oxford Advanced Learner’s Dictionary has defined the word ‘Convention’ as practice or custom based on general consent.
Kohler has observed that convention is ‘a statement or rule of practice which, by common consent, is implied in the solution of a given class of problems or guides behavior in a certain kind of situation’.
An axiom and convention may be indistinguishable, thus, the use of straight line depreciation for long is regarded as a convention, has tended to take on the character of an axiom. A convention dictates many of the activities of the public accountant, such as measures of materially, style and content of financial statements, the features of audit reports etc.
In International Accounting Standards, the conventions have been termed as accounting policies. In practice the generally accepted accounting policies are known as accounting conventions, which have been adopted by accountants for a long time.
The Accounting conventions are mainly of four types:
- Convention of Consistency
- Convention of Full Disclosure
- Convention of Conservatism
- Convention of Materiality
Convention of Consistency
The Consistency convention implies that same accounting policies will be used for similar items over the year. In this way more meaningful inter-period comparisons can be made. If the income statement for the current period shows higher earnings than the preceding period, the user is entitled to assume that business operations have been more profitable provided there is no change in the accounting policies adopted by the enterprises.
The business entity should be consistent in the accounting practices or principles in respect of the assets, equities, revenues and expenses.
Convention of Full Disclosure
Every business enterprise prepare its final accounts at the end of each financial year. The final accounts contain income statement and balance sheet. Quite a number of persons are interested in studying these statements. They include owners, employees,
debtors, investors, Government, and consumers. Hence, it is necessary that the financial information as contained in these statements is reported objectively so that these statements may present a true and fair view of an enterprise.
Convention of Conservatism
Conservatism is a policy of playing safe in the world of uncertainties. It is a quality of judgement to be exercised in evaluating risks and uncertainties present in the business to ensure that reasonable provisions are made for anticipated losses in the realisation of recorded assets and settlement of obligations.
The working rule is: “anticipate no gains but provide for all possible losses, and if in doubt write it off.” When applied to business income this convention results in the recognition of all losses that have been incurred or are likely to occur and to admit the gains only when they have been realized.
According to this convention, care should be taken in valuing the current assets like closing stock which should be valued at lower of the cost or market price. If the value of closing stock has gone down in the market, it should be written down to the extent of reduction in value.
But no ‘write ups’ should be followed if the market shows an upward trend, unless the goods are sold and the gain is actually realized. The convention of conservatism is based on the plea that the understatement of earnings and assets is less dangerously misleading than the overstatement.
Convention of Materiality
There may be a great deal of financial information which can be provided for any business, but in order to make financial statements more meaningful and to minimize costs, accountants should report only such information which is material.
Materiality is an implicit guide for the accountants in deciding what should be disclosed in the financial statements. There is, however, some difficulty in defining materiality because this convention lacks operational definition.
Most definitions of materiality stress the role of accountants’ judgement in interpreting what is and what is not material. While at the same time stressing its importance, materiality is essentially a matter of professional judgement. An individual item should be judged material if the knowledge of that item could reasonably be deemed to have influence on the users of the financial statements.
For example, suppose a waste paper basket is purchased in a business. Technically it is a fixed asset of the business as its life is likely to last for more than one accounting period.
Therefore, annual depreciation should be provided on this asset. But, the amount spent on this purchase is so insignificant that the accountant may treat it as revenue expenditure and charge the whole amount to profit and loss account in the year of purchase.