CHAPTER-1.

INTRODUCTION

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

The definition given by the American Institute of Certified Public Accountants (‘AICPA’) clearly brings
out the meaning of accounting. According to it, accounting is “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 a financial character and interpreting the results thereof”.

The definition brings out the following as attributes of accounting:

1) Accounting is an art. Accounting is classified as an art, as it helps us in attaining our aim of

ascertaining the financial results, that is, operating profit and financial position through analysis
and interpretation of financial data which requires special knowledge, experience and judgment.
2) It involves recording, classifying and summarizing. Recording means systematically writing down
the transactions and events in account books soon after their occurrence. Classifying is the process
of grouping transactions or entries of the same type at one place. This is done by opening accounts
in a book called ledger. Summarizing involves the preparation of reports and statements from the
classified data (ledger), understandable and useful to management and other interested parties.
This involves preparation of final accounts namely profit and loss account and balance sheet.
3) It records transactions in terms of money. All transactions are recorded in terms of common
measure i.e. money which increases the understanding of the state of affairs of the business.
4) It records only those transactions and events which are of financial character. If an event has no
financial character then it will not be capable of being measured in terms of money; it will not be,
therefore, recorded.
5) It is the art of interpreting the results of operations to determine the financial position of the
enterprise, the progress it has made and how well it is getting along.

ACCOUNTING HAS THE FOLLOWING STAGES

1) The transactions of a business that have, at least in part, a financial character are identified and
recorded.
2) The recording is done in a manner which identifies the different classes and types of transactions.
3) The resulting records are summarized in such a way that the owners or other interested parties in
the business can see the overall effects of all the transactions. The statements prepared by the
summarizing process are known as financial statements which will show the profit or loss made
by the business over a period of time and the total capital employed in the business. Such financial
statements are used by management to make business decisions.
 BRANCHES OF ACCOUNTING
Accounting has three main forms or branches viz. financial accounting, cost accounting and
management accounting.

1) Financial Accounting: It is concerned with record-keeping directed towards the preparation of

trial balance, profit and loss account and balance sheet.
2) Cost Accounting: Cost accounting is the process of accounting for costs. It is a systematic
procedure for determining the unit cost of output produced or services rendered. The main
functions of cost accounting are to ascertain the cost of a product and to help the management
in the control of cost.
3) Management Accounting: Management accounting is primarily concerned with the supply of
information which is useful to the management in decision-making, increasing efficiency of
business and maximizing profits.

FUNCTIONS OF ACCOUNTING
The following are the main functions of accounting:

1) Keeping Systematic Records: Accounting is done to keep a systematic record of financial

transactions.
2) Protecting and Controlling Business Properties: Accounting helps to see that there is no
unauthorized use or disposal of any assets or property belonging to the firm, because proper
records are maintained. Accounting will furnish information about money due from various
persons and money due to various parties. The firm can see that all amounts due to it are
recovered in due time and that no amount is paid unnecessarily.
3) Ascertaining the Operational Profit/Loss: Accounting helps to determine the results of the
activities in a given period, usually a year, i.e. to show how much profit has been earned or how
much loss has been incurred. This is done by keeping a proper record of revenues and expenses
of a particular period and then matching the revenues with the corresponding costs.
4) Ascertaining the Financial Position of the Business: Balance sheet is prepared to ascertain the
financial position of the firm at the end of a particular period. It shows the values of the assets
and the liabilities of the business entity.
5) Facilitating Rational Decision Making: Accounting facilitates collection, analysis and reporting of
information at the required point of time to the required levels of authority in order to facilitate
rational decision making.

ADVANTAGES OF ACCOUNTING
The following are the advantages of accounting:

1) Maintenance of Business Records: All financial transactions are recorded in a systematic manner
in the books of accounts so that there is no need to depend upon on memory. It is impossible to
remember the business transactions which have grown in size and complexity.
2) Preparation of Financial Statements: Proper recording of transactions facilitates the preparation
of financial statements i.e. the trading and profit and loss account and balance sheet.
3) Comparison of Results: Accounting information when properly recorded can be used to compare
the results of one year with those of earlier years so that the significant changes can be analyzed.
4) Decision Making: Accounting information helps the management to plan its future activities by
preparing budgets and coordination of various activities in different departments.
5) Evidence in Legal Matters: Properly recorded accounting information can be produced as
evidence in a court of law.
6) Provides Information to Interested Parties: Interested parties like owners, creditors,
management, employees, customers, government, etc. can get financial information about the
organisation.
7) Helps in Taxation Matters: Income tax and/sales tax authorities depend for taxation matter on
the accounts maintained by the business.
8) Valuation of Business: When the business is to be sold, the accounting information can be utilized
to determine the proper value of business.

LIMITATIONS OF ACCOUNTING
The following are the limitations of accounting:

1) Accounting information is expressed in terms of money: The accountant measures only those
events that are of financial nature i.e. capable of being expressed in terms of money. Non-
monetary items or events which cannot be measured are not recorded in accounting.
2) Accounting information is based on estimates: Some accounting data are based on estimates and
some estimates may be inaccurate.
3) Accounting information may be biased: Accounting information is not without personal influence
or bias of the accountant. In measuring income, accountant has a choice between different
methods of inventory valuation, deprecation methods, treatment of capital and revenue items
etc. Hence, due to the lack of objectivity income arrived at may not be correct in certain cases.
4) Fixed assets are recorded at the original cost: The values of fixed assets change over time and so
there may be a great difference between the original cost and current replacement cost. Balance
sheet may not show true and fair view of the financial position on a particular date.
5) Accounting can be manipulated: Accounting information may not be used as the only test of
managerial performance as profits can be manipulated or misrepresented.
6) Money as a measurement unit changes in value: The value of money does not remain stable.
Unless price level changes are considered in measurement of income, the accounting information
will not show true financial results.

BOOK KEEPING
Book-keeping is mainly concerned with recording of financial data relating to the business operations
in a significant and orderly manner. It is concerned with the permanent record of all transactions in a
systematic manner to show its financial effect on the business. It covers procedural aspects of
accounting work and includes record keeping function. It is the science and art of correctly recording
in books of account all those business transactions that result in the transfer of money or money’s
worth. It is mechanical and repetitive. This work of book–keeping is of clerical nature and usually
entrusted to junior employees of accounts section of a business house. Now-a-days, most of the book-
keeping work is done through computers and other electronic devices. In fact, accounting is based on
a systematic and efficient book-keeping system. The main purpose behind book-keeping is to show
correct position regarding each head of income and expenditure as well as assets and liabilities.
Further, book-keeping is meant to show the effect of all the transactions made during the accounting
period on the financial position of the business.

BOOK-KEEPING AND ACCOUNTING

Book-keeping and accounting are often used interchangeably but they are different from each other.
Accounting is a broader and more analytical subject. It includes the design of accounting systems
which the book-keepers use, preparation of financial statements, audits, cost studies, income-tax
work and analysis and interpretation of accounting information for internal and external end-users as
an aid to making business decisions. This work requires more skill, experience and imagination. The
larger the firm, the greater is the responsibility of the accountant. It can be said that accounting begins
where book-keeping ends. Book- keeping provides the basis for accounting.

DIFFERNCE BETWEEN BOOK-KEEPING AND ACCOUNTING

Book-keeping Accounting

(i) It is concerned with the recording of (i) It is concerned with the summarizing of the
transactions. recorded transactions.

(ii) The work of book-keeping is mainly routine (ii) The work of accountant requires higher level of
and clerical in nature and is increasingly being knowledge, conceptual understanding and
done by computers. analytical skill.

(iii) Book-keeping constitutes the base for (iii) Accounting starts where book keeping ends.
accounting.

(iv) Book-keeping is done in accordance with (iv) The methods and procedures for accounting for
basic accounting concepts and conventions. analysis and interpretations for financial reports
may vary from firm to firm.

(v) Financial statements do not form part of book- (v) Financial statements are prepared in accounting
keeping. process from the book-keeping records.

(vi) Financial position of the business cannot be (vi) Financial position of the business is ascertained
ascertained through book-keeping records. on the basis of accounting reports.

SYSTEMS OF ACCOUNTING
Basically there are two systems of accounting:
 Cash System of Accounting
It is a system in which accounting entries are made only when cash is received or paid. No entry is
made when a payment or receipt is merely due. In other words, it is a system of accounting in which
revenues and costs and assets and liabilities are reflected in the accounts in the period in which actual
payments or actual receipts are made in cash. It may not treat any revenue to have been earned or
even sales to have taken place unless cash is actually paid by customers. It has no relevance whether
the receipts pertain to previous period or future period. Similarly, expenses are restricted to the actual
payments in cash during the current year and it is immaterial whether the payments have been made
for previous period or future period.

Cash basis of accounting is incompatible with the matching principle of income determination. Hence,
the financial statements prepared under this system do not present a true and fair view of operating
results and financial position of the organization. However, cash system of accounting is suitable in
the following cases:

1) Where the organization is very small or in the case of individuals, where it is difficult to allocate
small amounts between accounting periods; and
2) Where credit transactions are almost negligible and collections are uncertain e.g. accounting in
case of professionals i.e. doctors, lawyers, firms of chartered accountants/company secretaries.
But while recording expenses, they take into account the outstanding expenses also. In such a
case, the financial statement prepared by them for determination of their income is termed as
Receipts and Expenditure Account.

Accrual System of Accounting

This is also known as mercantile system of accounting. It is a system in which transactions are recorded
on the basis of amounts having become due for payment or receipt. Accrual basis of accounting
attempts to record the financial effects of the transactions, events, and circumstances of an enterprise
in the period in which they occur rather than recording them in period(s) in which cash is received or
paid by the enterprise. It recognizes that the buying, selling and other economic events that affect
enterprise’s performance often do not coincide with the cash receipts and payments of the period.
The purpose of accrual basis accounting is to relate the revenue earned to cost incurred so that
reported net income measures an enterprise’s performance during a period instead of merely listing
its cash receipts and payments. Accrual basis of accounting recognizes assets, liabilities or components
of revenues and expenses received or paid in cash in past and expected to be received or paid in cash
in the future. The following are the essential features of accrual basis:

1) Revenue is recognized as it is earned irrespective of whether cash is received or not;

2) Costs are matched against revenues on the basis of relevant time period to determine periodic
income, and
3) Costs which are not charged to income are carried forward and are kept under continuous review.
Any cost that appears to have lost its utility or its power to generate future revenue is written off
as a loss.
 ACCOUNTING AS INFORMATION SYSTEM
Accounting, being the language of business, is used to communicate financial and other information
to individuals, organizations, governments etc. about various aspects of business and non-business
entities. For example, when a firm applies for a loan from a bank, it will have to submit details of its
business activities in terms of operating results (profit or loss) and the financial position (assets and
liabilities). Similarly, the shareholders or prospective investors must have financial information in
order to evaluate the performance of the management. Many laws require that extensive financial
information be reported to various government departments such as income-tax department, sales
tax department, and company law board and so on. Accounting is a discipline that collects reports and
interprets financial information about the activities of different organizations. Hence, actual
accounting is concerned with communicating the results of an organization.

USERS OF ACCOUNTING INFORMATION

Accounting is of primary importance to the proprietors and the managers. However, other persons
such as creditors, prospective investors, etc. are also interested in the accounting information.

1) Owners/Shareholders: The primary aim of accounting is to provide necessary information to the

owners related to their business.
2) Managers: In large business organizations and in corporations, there is a separation of ownership
and management functions. The managers of such business houses are more concerned with the
accounting information because they are answerable to the owners.
3) Prospective Investors: The persons who are contemplating an investment in a business will like
to know about its profitability and financial position. They derive this information from the
accounting reports of the concern.
4) Creditors, Bankers and other Lending Institutions: Trade creditors, bankers and other lending
institutions would like to be satisfied that they will be paid on time. The financial statements help
them in judging such position. Banks and other lending agencies rely heavily upon accounting
statements for determining the acceptability of a loan application.
5) Government: The Government is interested in the financial statements of business enterprise on
account of taxation, labour and corporate laws.
6) Employees: Employees are interested in financial statements because increase in their salaries
and wages and payment of bonus depends on the size of the profit earned.
7) Regulatory Agencies: Various Government departments and agencies such as Company Law
Board, Registrar of Companies, Tax Authorities etc. use accounting reports not only as a basis for
tax assessment but also in evaluating how well various businesses are operating under regulatory
legislation.
8) Researchers: Accounting data are also used by the research scholars in their research in
accounting theory as well as business affairs and practices.
9) Customers: Customers may also have either short-term or long-term interest in the business
entity to know the profitability, liquidity and solvency position of the company.

CHARACTERISTICS OF ACCOUNTING INFORMATION

The various characteristics of accounting information are as follows:

1) Relevance: The information should be relevant in order to influence the economic decisions of
users by helping them to evaluate the events at all times. Accounting information has a bearing
on decision making by helping investors, creditors and other users to evaluate past and future
events. It confirms or corrects prior expectations. The relevance of information is affected by its
nature and materiality.
2) Reliability: Reliability relates to the confidence in the accounting information in the sense that the
information must faithfully represent what it intends to present; it must be factual. Information
should be free from material errors and bias. The key aspects of reliability are faithful
representation, substance over form, neutrality, prudence and completeness.
3) Comparability: Accounting information of an enterprise is useful when it is comparable with
similar information for the same enterprise in other periods of time and similar information
regarding other enterprises at the same time. Thus, the information should be presented in a
consistent manner over time and consistent between entities to evolve users to make significant
comparisons.
4) Understandability: Information should be readily understandable by users who are expected to
have a reasonable knowledge of business, economics and accounting and a willingness to study
the information with reasonable diligence.
5) Timeliness: The more quickly the information is communicated or provided to the users, the more
likely it is to influence their decisions. Hence, for prompt decision-making accounting information
should be made available at appropriate time without delays.
6) Cost-benefit: The accounting information must be useful to most of the people who want to use
it and preparation of that useful information must not be a costly and time consuming process.
The emphasis is on cost-benefit consideration and the benefit derived from information should
normally exceed the cost of providing it.
7) Verifiability: Verifiability ensures the truthfulness of the recorded transactions, which can be
checked by persons other than the accountant himself.
8) Neutrality: Accounting information is neutral in the sense that it should be free from bias and it
should not favour one group over another. Neutrality is significant especially for the external users
of accounting information.
9) Completeness: Completeness means that all material information that is necessary to investors,
creditors or other users for assessing the financial position and operating results of the
organization has been disclosed in the financial statements.

DOUBLE ENTRY SYSTEM

There are two systems of keeping records- Single Entry System and Double Entry System. The
single entry system appears to be time-saving and economical but it is unscientific as under
this system, some transactions are not recorded at all whereas some other transactions are
recorded only partially. On the other hand, the double entry system is based on scientific
principles and is, therefore, used by most of the business houses. The system recognises the
fact that every transaction has two aspects and records both aspects of each and every
transaction. Under this system, in every transaction an account is debited and some other
account is credited. The crux of accountancy lies in finding out which of the two accounts are
affected by a particular transaction and out of these two accounts which account is to be
debited and which account is to be credited.

Merits of Double Entry System

(i) It keeps a complete record of business transactions. Both personal accounts and
impersonal accounts are kept. The entire information regarding the values of assets
and profits earned during the year can be easily obtained.

(ii) It provides a check on the arithmetical accuracy of accounts, since every debit has
corresponding credit to it and vice-versa.

(iii) The detailed profit and loss account can be prepared to show profit earned or loss
suffered during any given period.

(iv) The system makes possible the comparison of purchases as well as sales, expenditure,
income etc. of current year with those of the previous years, thus enabling a
businessman to control its business activities. The balance sheet can be prepared at
any specified point of time or any date showing the actual amounts of assets,
liabilities and capital.

(v) It significantly reduces the chances of a fraud and if a fraud is committed it can be
easily detected.

(vi) The accurate details with regard to any account can be easily obtained.

ROLE OF ACCOUNTANT
The role of accountant may be summarized as under:

1) Maintenance of Books of Accounts: The primary role of an accountant is to offer his services for
maintaining systematic records of financial transactions in order to ascertain the net profit or loss
for the accounting period and the financial position as on a particular date.
2) Statutory Audit: Every limited company is required to appoint a chartered accountant as an
auditor who is statutorily required to report each year whether the financial statements have been
prepared in accordance with the generally accepted accounting principles, accounting standards
and legal requirements and that they show a true and fair view of the financial position and profit
and loss.
3) Internal Audit: In addition to statutory audit, a big company employs its own staff to conduct
internal audit to ensure that the transactions are recorded, classified and summarized in
accordance with the established accounting procedures to ensure that instructions of the
management are being followed throughout the company.
4) Budgeting: Budgeting means the planning of business activities before they occur. On completion
of the actual activities for a given period, the planned activities are compared with the actual
activities to find out the variation, if any.
5) Taxation: An accountant can handle the taxation matters of a business and can represent before
the tax authorities and settle the tax liability under the prevailing statute. He also assists in
reducing the tax burden by proper tax planning.
6) Investigation: Accountants are often called upon to carry out investigation to ascertain the
financial position of the business for the information of interested parties.
7) Management Advisory Service: An accountant is largely responsible for internal reporting to the
management for planning, controlling, decision-making on matters for long-term plans. He
provides management consultancy services in the areas of management information systems,
expenditure control and evaluation of appraisal techniques.
8) Other Activities: Accountants among many other duties perform duties of arbitrator registrars for
settling of disputes, liquidators, cost accountants, etc.