Chapter 1

Introduction to Accounting

 Introduction

Accountancy is an interesting practical subject. People are increasingly recognizing its importance these days. It is a simple technique of organizing and recording financial information. This will enable easy reference, easy comparison and easy decision making. Many people think that Accountancy is a hard mathematical application. In fact you don’t need to know much Mathematics to do Accounting or to do a banking job. All that is required is just the basic Arithmetic.

Now what is the real problem? Why some students find Accountancy hard to understand? I think the trouble is mainly with the language. Business language has certain style and terminology. At class XI level you may find this bit difficult or confusing. But once you get acquainted with this terminology and style, you will find that the business language is much easier for communicating business information. These notes are prepared in simple plain English, using very little business terminology. Once you understand the concept from the notes, read the text book to have a detailed picture.

I have prepared these notes strictly according to your syllabus. Now don’t come and ask me if these notes are enough for the examination. Read the text book for the detailed picture. These notes are just the basic minimum.

Accounting – Meaning

Accounting is the process of maintaining financial information. This is a process of classifying and recording the information. Business information is mainly kept in the book called Ledger. Each important item of such information is recorded in a separate page in the ledger. Each page in the ledger, reserved for recording a specific item is known as account. For example Salary Account means a page in the ledger in which all the details of expense of salary are recorded. ‘Machinery Account’ is meant for recording all details of machinery and Ashok’s Account is kept for all the details of business with Mr. Ashok.

Accounting Process

Following are the steps in accounting process:

1. Recording in the Journal (Journalizing)

Journal is the first book of entry. Transactions are first recorded in the Journal Book. This book is also known as the book of original entry. The journal has a prescribed format. The purpose of journal is formatting accounting information for convenient transfer of information into Ledger Accounts. Journal also helps to organize related documents in the office according to the sequence of journal entry. Journal has a specific format. When the number of transactions to be recorded is large, special journals are maintained for each major activity. Purchases Book is a special journal meant for recording credit purchases only. Sales Book is the special journal for credit sales.

2. Recording in the Ledger (Posting to Ledger)

The ledger is the main book of accounting information. Under double entry book keeping, every journal entry is subsequently entered into at least two accounts. At this stage the transactions are recorded at the appropriate side of the ledger as mentioned in the journal. The left hand side of an account is known as ‘debit side’ and the right hand side is known as ‘credit side’. Making and entry on the debit side is known as debiting the account and on the credit side is known as crediting the account. Debiting or crediting a ledger account on the basis of journal entries is known as ‘posting the transactions’.

3. Summarizing the Activities

This is the process of re-grouping or summarizing the ledger accounts to help easy understanding of facts. This involves listing of all accounts with their respective balances in one statement called ‘Trial Balance”. A trial balance contains all accounts of a business. Thus it is a list of Assets, Liabilities, Capital, Incomes and Expenses. This trial balance is further summarized by taking out all incomes and expenses into a ‘profit and loss account’ which indicates the result of business activity for the accounting period. The rest of the items in trial balance which are assets, liabilities and capital along with the net result of profit and loss accounts are presented in a statement called Balance Sheet. This is the statement of financial position of a business. The balance sheet contains complete list of Assets, Liabilities, and Capital of the business.

4. Analysis and Interpretation

This is the final stage of accounting process. Business information has value only when they are effectively used for decision making. Analysis of information will help the management to identify the result of their past decisions. The business can run smoothly by paying full attention to the right spots. The wrong decisions can be corrected for better performance in future. Other business associates such as suppliers and customers can decide the nature of their relationship on the basis of information presented by the financial statements.

Objectives of Accounting

The following are the important objectives or purpose of Accounting

1. Maintaining Records

The most important objective of accounting is to record financial information systematically. Since the number of transactions that takes place in a business is large, it is impossible to keep all the details in memory. An unscientific recording does not serve any useful purpose, as the information will not be readily available when it is needed. It is essential that the businessman is able to refer to the details of relevant information from time to time while running the business. Systematic accounting involves preserving the business information on the basis of well defined rules, which enables maintaining large volume of data in a easily accessible format.

2. Estimating Profit or Loss

Profit is the aim of any business. The businessman should have clear information regarding the result of his business activity. If there is accurate measure of profit of loss, the businessman will take blind actions that will ultimately fail.

3. Presenting the Financial Position

Financial position of the business is presented in the form of Balance Sheet. This is an essential statement sought by banks, creditors and prospective investors to find out exactly what the business owns and what owes.

Types of Accounting Information

Accounting information may be divided into balance sheet information or profit and loss information etc. for name sake. But actually this classification does not make much sense.

Advantages and Limitations

Advantages

1. Availability of information

Systematic recording enables easy retrieval of information. Modern business required quick and accurate decisions. Proper accounting information helps management decision making at the right time.

2. Identify the strength and weakness of business

Accounting helps the management to identify the strength and weakness of the business by analyzing past performance. Management can focus on areas that are crucial and thereby maximize profit.

3. Enables comparison

Proper accounting enables the business to compare results of different periods. Comparison can be made between different branches of the business and between different businesses in the same industry.

4. Evidence in the court of law

In the event of a legal dispute the audited accounts are recognized as the primary source of financial information. This helps fair settlement of disputes and prevents a lot of interference bu the authorities. This also enables recovery of debts from defaulted customers, prevents undue claims by creditors.

5. Payment of tax

Income tax is paid on the basis of profit earned by the business. Proper accounts help accurate estimate of tax due to Government. Moreover it enables the business to claim all legal rebates and deductions allowed in the tax law.

6. Helps in realisation of debts

Accounting helps to prove debts. Accounting statements and convenient record of transactions which can be convince the debtor in the first place and the court of law in case the matter is referred in there.

Limitations

1. Financial accounting is not absolutely exact

Accounting information is not necessarily exact. Lot of information presented in the books of account are based on personal judgment. There cannot be absolute guarantee of accuracy when assumptions are based on personal opinion.

2. Financial accounting does not show the exact worth of business

The values of most of the assets in the books are presented on the basis of their purchase price, which is known as historic figures. Their present market values or realizable values are usually quite different. In other words the books of accounts fail to show the exact value of assets or liabilities.

3. Problem of window dressing

Balance sheet figures are often modified to make it look better. This process conceals many weaknesses of the business. Thus the accounting information becomes unreliable for accurate judgment.

4. Worthless assets often shown in the balance sheet

Several worthless items can appear in the balance sheet as asset. This will project a wrong picture of the business.

5. No effect of inflationary trends

Currency is not a stable unit of measurement of value. Inflation can make the value of currency itself different. Measurement with this “elastic tape” can give conflicting results.

Qualitative Characteristics of accounting information:

Reliability, relevance, understandability and comparability

Accounting information is meaningful only when it posses the essential qualities of reliability, relevance understandability and comparability.

1. Reliability

The basic purpose of accounting is to provide information to the management, owners or whoever genuinely interested in it. The information is meaningful only if it is reliable. The reliable information enables accurate decision making. It should be verifiable. I should lead to same or similar conclusion, when analyzed by different accounting professionals.

2. Relevance

There is lot of information about a business having no practical use. Accounting should be concise and precise. Meaningless information makes the analysis difficult. A report stuffed with immaterial information simply wastes time. A decision is made on the basis of facts. Therefore it is essential to ensure that a person searching for it does not have to search the facts hidden deep in the garbage of irrelevant information.

3. Understandability

Information is useful only when it is understandable. This does not mean that every layman should be able to understand every information presented in an accounting report. Understandability means the information is presented in universally accepted accounting format which every accountant is able to understand and explain. International accounting standards enable o ensure accounting information is processed and presented in a uniform manner, which paves way to accurate analysis and interpretation.

4. Comparability

Accounting information should enable comparison between the results of different years of the same company. It should also enable comparison between different business houses in the same industry.

Basic Accounting Terms

Business Transaction

The term transaction in the business refers to business dealing. It indicates each individual activity done in a business with a common aim of making profit. A business involves lot of various activities, like purchase of goods, payment for transport, payment of wages, salaries, sale of goods, collection of money etc. Each of these activities can be called a business transaction. All business transactions are coordinated like an orchestra. It is tuned to the single objective of making profit. In business we must keep proof of every transaction. For example when we pay salary we need salary receipt signed by the employee. When we pay money to a supplier we need receipt from the supplier. These papers are useful as a evidence. Transactions are can be broadly classified into cash transactions and credit transaction depending on whether immediate cash payment is made or not.

Asset

The properties owned by a business and its claims against parties are collectively called assets. Assets are classified into:

i) Fixed Assets

Assets that are intended for permanent use with the aim of generating income are called fixed assets. Fixed assets are not meant for sale. Examples of fixed assets are land and buildings, plant, machinery, furniture, fittings etc.

ii) Current Assets

Current assets are the ones which keep on circulating from business to business, party to party. These assets are not held for permanent use. They just come into the possession of the business during normal course of business. More and more assets are added each day from one side and sold out or exchanged from the other side, which make their balance always fluctuating.

Examples of current assets are cash, debtors, stock of goods etc.

Liability

Liabilities are claims of creditors against the business. They are the claims on the assets or wealth of the business. Liabilities are one of the ways by which assets come into the business. For example when a company borrows money it gets asset in the form of cash and at the same time it accepts a liability named loan. Liabilities can be classified into the following categories:

i) Current liabilities

These are liabilities to be paid off within a short period, usually less than one year. These are usually paid off by current assets. Current portion of long term liabilities are also considered current liabilities. There is no strict rule that the current liabilities should be settled by current assets only. We can even give fixed asset to settle a current liability.. Examples of current liabilities are: bank overdraft, trade creditors and outstanding expenses.

ii) Long Term liabilities

As the name indicates, long term liabilities are paid off after a long period. All liabilities maturing after one year are considered current liabilities. These liabilities can be settled either by payment of cash, or by delivery of fixed assets or by conversion of liabilities into equity.

Examples of long term liabilities are: mortgage loans and debentures.

iii) Contingent liabilities

Contingent liabilities are not actual liabilities. They are probable liabilities on the happening of a certain contingency. For example a claim against the business in court is a contingent liability. If the court decides against the business the claim becomes a real liability to pay. Other liabilities are loan guaranteed by the business, bills receivable discounted with the bank etc.

 Capital

Capital is normally understood as the owner’s investment in a business. The owner’s investment does not mean the exact amount he put in to start the business. The capital of the owner will increase when he makes profit. It will decrease when he makes loss. If he takes out money or goods for personal use, we call it drawings. His capital will reduce when an owner makes a drawing. In fact Capital is excess of total assets of the business over the liabilities. In other words capital is the net worth of the business.

Wealth of the business is stored in assets. Assets are cash and other properties owned or controlled by the business. When owner invests money it comes in the form of cash. Slowly this cash will become other assets. When a business buys furniture for cash it is actually changing one asset to another. On the basis of assets owned by capital can be divided into fixed capital or working capital.

The amount invested in the fixed assets of the business is known as fixed capital.

Working capital is the value of current assets over current liabilities.

Drawing

Drawing is the withdrawal or cash or goods by the owner. In accounting this is considered negative capital.

Revenue

Revenue is the increase in assets without a corresponding increase in liability or owners investment. According to The Financial Accounting Standards Board (FSAB) revenue is “inflow or other enhancements of assets to an entity… from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations”. [Did you understand the definition? What the definition says is this. Revenue brings in assets to a business. Revenue comes from production or sale or rendering or service.] Revenue is creation of wealth by the process of doing business. It is the reward for doing business while expense is the sacrifice. Revenue represents what the company charges its customers for the goods and services it provides. Revenue is generated from production, trade and service. A manufacturing company generates revenue from production. A merchant generates revenue from trade and service firms such as audit firms advocates etc. earn revenue from service

Theory Questions

Short Answers

1. Define accounting.

2. State what is end product of financial accounting.

3. Enumerate main objectives of accounting.

4. List any five users who have indirect interest in accounting.

5. State the nature of accounting information required by long-term lenders.

6. Who are the external users of information?

7. Enumerate informational needs of management.

8. Give any three examples of revenues.

9. Distinguish between debtors and creditors.

10. ‘Accounting information should be comparable’. Do you agree with this statement? Give two reasons.

11. If the accounting information is not clearly presented, which of the qualitative characteristic of the accounting information is violated?

12. “The role of accounting has changed over the period of time”- Do you agree? Explain.

13. Giving examples, explain each of the following accounting terms :

• Fixed assets • Gain • Profit

• Revenue • Expenses • Short-term liability

• Capital

14. How will you define revenues and expenses?

15. What is the primiary reason for the business students and others to familiarise themselves with the accounting discipline?

Long Answers

1. Explain the factors, which necessitated systematic accounting.

2. Describe the brief history of accounting.

3. Explain the development of and role of accounting.

4. Define accounting and state its objectives.

5. Describe the informational needs of external users.

6. What do you mean by an asset and what are different types of assets?

7. Explain the meaning of gain and profit. Distinguish between these two terms.

8. Explain the qualitative characteristics of accounting information.

9. Describe the role of accounting in the modern world.

End of Chapter 1