Introduction
Definition of Accounting
Accounting is an art of identifying,recording,classifying,summarizing, analysis and interpretation of business transactions of financial nature.
The following are the main objectives of accounting:
1. To keep systematic records:
Accounting is done to keep a systematic record of financial transactions. In the absence of accounting there would have been terrific burden on human memory which in most cases would have been impossible to bear.
2. To protect business properties:
Accounting provides protection to business properties from unjustified and unwarranted us. This is possible on account of accounting supplying the information to the manager or the proprietor.
3. To ascertain the operational profit or loss:
Accounting helps is ascertaining the net profit earned or loss suffered on account of carrying the business. This is done by keeping a proper record of revenues and expenses of a particular period. The profit and loss account is prepared at the end of a period and if the amount of revenue for the period is more than the expenditure incurred in earning that revenue, there is said to be a profit. In case the expenditure exceeds the revenue, there is said to be a loss.
4. To ascertain the financial position of business:
The profit and loss account gives the amount of profit or loss made by the business during a particular period. However, it is not enough. The businessman must know about his financial position i.e., where he stands; what he owes and what he owns? This objective is served by the balance sheet or position statement.
5. To facilitate rational decision making:
Accounting these days has taken upon itself the task of collection, analysis and reporting of information at the required points of time to the required levels of authority in order to facilitate rational decision making
Importance /objectives /Advantages/ need of financial accounting
1. Preparation of budgets and plans : budgets Provide direction and co-ordination, so that business objectives can be turned into practical reality
2. To avoid fraud and misrepresentation : Internal financial controls are essential to avoid fraud and misrepresentation in business.
3. To find out the profitability of the business: the biggest need for accounting information is to determine overall profitability of the business.
4. Investment decisions: After calculation of profit executive management will decide what amount of cash should be reinvested into the business and what amount should be invested in interest bearing securities.
6. Performance analysis : after preparation of income statement and position statement (balance sheet) comparison can be done from one year result to another year
7. For tax computation purpose: tax is calculated on the basis of accounts maintained by a concern.
8. Making information available to various people: information should be made available to leaders, investors, researchers, government workers and consumers.
9. For effective control over the business
10. To know the due from others and due to others
11. Computation of performance of different business
12. Books of accounts provides legal evidence in the court of law
13. Compare the performance of different business
14. Depiction of the financial position.
Accounting Cycle:
Recording:
First, all transactions should be recorded in the journal or books of original entry known as subsidiary books as and when they take place.
Classifying:
All entries in the journal of books of original entry should be posted to the appropriate ledger accounts to find out at a glance the total effect of all such transactions in a particular account.
Summarizing:
Last stage is to prepare the trial balance and final accounts with a view to ascertaining the profit or loss made during a trading period and the financial position of the business of a particular date.
Branches of accounting
These branches are as follows:
- Financial accounting
- Cost accounting
- Managerial accounting
The above three branches of accounting are briefly discussed below:
1. Financial Accounting
The main purpose of financial accounting is to ascertain the true result (profit or loss) of the business operations during a particular period of time and to state the financial position of the business on a particular point of time.
Financial accounting produces general purpose reports for the use by the great variety of people who are interested in the organization but who are not actively engaged in its day-to-day operation.
2. Cost Accounting:
The main object of cost accounting is to determine the cost of goods manufactured or produced by the business. It also helps the management of the business in controlling the costs by indicating avoidable losses and wastes.
In order to set prices of the products of the companies, correct calculation of all manufacturing as well as non-manufacturing costs is necessary. Cost accounting is also helpful to accomplish this task.
3. Managerial Accounting:
The object of managerial accounting is to communicate the relevant information periodically to the management of the business to enable it to take suitable decisions.
Financial accounting is the oldest and the other branches have developed from it according to the need of different parties. The objects of financial accounting can only be achieved by recording business transactions in a systematic manner according to a set of principles.
In order to meet the ever increasing demands made on accounting by different interested parties (such as owners, management, creditors, taxation authorities and other govt. agencies etc.) the various branches of accounting have come into existence.
Accounting concepts
Let us take an example. In India there is a basic rule to be followed by everyone that one should walk or drive on his/her left hand side of the road.It helps in the smooth flow of traffic. Similarly, there are certain rules that an accountant should follow while recording business transactions and preparing accounts. These may be termed as accounting concept. Thus, this can be said that :
Accounting concept refers to the basic assumptions and rules and principles which work as the basis of recording of business transactions and preparing accounts.The ICAI has so far issued are universally accepted rules. Following are the various accounting concepts that have been discussed in the following sections :
- Business entity concept
- Money measurement concept
- Going concern concept
- Accounting period concept
- Accounting cost concept
- Duality aspect concept
- Realization concept
- Accrual concept
- Matching concept
- Objectivity concept
- Business entity concept
This concept assumes that, for accounting purposes, the business enterprise and its owners are two separate independent entities. Thus, the business and personal transactions of its owner are separate. For example, when the owner invests money in the business, it is recorded as liability of the business to the owner. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not treated as business expense.
Example : Let us take an example. Suppose Mr. Sahoo started business investing Rs100000. He purchased goods for Rs40000, Furniture for Rs20000 and plant and machinery of Rs30000. Rs10000 remains in hand. These are the assets of the business and not of the owner. According to the business entity concept Rs100000 will be treated by business as capital i.e. a liability of business towards the owner of the business. Now suppose, he takes away Rs5000 cash or goods worth Rs5000 for his domestic purposes. This withdrawal of cash/goods by the owner from business is his private expense and not an expense of the business. It is termed as Drawings.
Thus, the business entity concept states that business and the owner are two separate/distinct persons. Accordingly, any expenses incurred by owner for himself or his family from business will be considered as expenses and it will be shown as drawings.
2. Money measurement concept
This concept assumes that all business transactions must be in terms of money, that is in the currency of a country. In our country such transactions are in terms of rupees. Thus, as per the money measurement concept, transactions which can be expressed in terms of money are recorded in the books of accounts.
For example, sale of goods worth 200000, purchase of raw Rs.100000, Rent Paid 10000 etc. are expressed in terms of money, and so they are recorded in the books of accounts. But the transactions which cannot be expressed in monetary terms are not recorded in the books of accounts. For example, sincerity, loyality, honesty of employees are not recorded in books of accounts because these cannot be measured in terms of money although they do affect the profits and losses of the business concern.
Another aspect of this concept is that the records of the transactions are to be kept not in the physical units but in the monetary unit. For example, at the end of the year 2006, an organization may have a factory on a piece of land measuring 10 acres, office building containing 50 rooms, 50 personal computers, 50 office chairs and tables, 100 kg of raw materials etc. These are expressed in different units. But for accounting purposes they are to be recorded in money terms i.e. in rupees
3. Going concern concept
This concept states that a business firm will continue to carry on its activities for a long period of time. Simply stated, it means that every business entity has continuity of life. Thus, it will not be dissolved in the near future.This is an important assumption of accounting, as it provides a basis for showing the value of assets in the balance sheet;
For example, a company purchases a plant and machinery of 100000 and its life span is 10 years. According to this concept every year some amount will be shown as expenses and the balance amount as an asset. Thus, if an amount is spent on an item which will be used in business for many years, it will not be proper to charge the amount from the revenues of the year in which the item is acquired. Only a part of the value is shown as expense in the year of purchase and the remaining balance is shown as an asset.
4. Accounting period concept
Definition
According to this concept, the lifespan of a business is divided into fixed period of time (months, quarters, half-years or years) for which accounts are prepared.
In most cases an accounting period is a year. Note that the accounting year need not be the same as the calendar year. For example, the accounting year for business X can be from 1 June to 31 May, for business B from 1 September to 31 August or for business C from 1 April to 31 March.
Implication
Accounts of the business are closed at a specific date every year and final accounts are prepared (profits/ losses calculated)
5. Accounting cost concept or Historical Cost Concept
Accounting cost concept states that all assets are recorded in the books of accounts at their purchase price, which includes cost of acquisition,transportation and installation and not at its market price. It means that fixed assets like building, plant and machinery, furniture, etc are recorded in the books of accounts at a price paid for them
For example, a machine was purchased by XYZ Limited for 500000, for manufacturing shoes. An amount of 1,000 were spent on transporting the machine to the factory site. In addition, 2000 were spent on its installation. The total amount at which the machine will be recorded in the books of accounts would be the sum of all these items i.e. 503000. This cost is also known as historical cost.
Suppose the market price of the same is now 90000 it will not be shown at this value. Further, it may be clarified that cost means original or acquisition cost only for new assets and for the used ones, cost means original cost less depreciation. The cost concept is also known as historical cost concept. The effect of cost concept is that if the business entity does not pay anything for acquiring an asset this item would not appear in the books of accounts. Thus, goodwill appears in the accounts only if the entity has purchased this intangible asset for a price.
7. Duality aspect concept :
Dual aspect is the foundation or basic principle of accounting. It provides the very basis of recording business transactions in the books of accounts. This concept assumes that every transaction has a dual effect, i.e. it affects two accounts in their respective opposite sides. Therefore, the transaction should be recorded at two places. It means, both the aspects of the transaction must be recorded in the books of accounts.
For example, goods purchased for cash has two aspects which are (i) Giving of cash (ii) Receiving of goods. These two aspects are to be recorded.Thus, the duality concept is commonly expressed in terms of fundamental accounting equation :
Assets = Liabilities + Capital
The above accounting equation states that the assets of a business are always equal to the claims of owner/owners and the outsiders. Transactions are recorded using the double entry system whereby each transaction has a debit entry and a corresponding credit entry.
8. Realisation concept
This concept states that revenue from any business transaction should be included in the accounting records only when it is realized. The term realization means creation of legal right to receive money. Selling goods is realization, receiving order is not. In other words, it can be said that : Revenue is said to have been realized when cash has been received or right to receive cash on the sale of goods or services or both has been created.
Let us study the following examples :
Suppose an order for the supply of goods was received on 1st april, 1999. The goods was legally transferred to the buyer on 1st May, 1999 and the payment for the goods sold was received on 1st june, 1999.
In this case revenue realised considered only on 1st may, 1999 i.e the time when goods or services are actually delivered. In short, the realisation occurs when the goods and services have been sold either for cash or on credit. It also refers to inflow of assets in the form of receivables.
9. Accrual concept or Matching concept
The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.
Example :Company A has received cash of $40,000 from his customers. However, the company actually has done all work satisfactorily and the customers have acknowledged the work done which the company can billed for another $20,000. Furthermore, the expenses for the $20,000 work-done has been taken up into the books of account.
Question: Should the company just close their accounting book by presently its income as $40,000 for the cash received or should it be $40,000+$20,000 =$60,000
Answer: Based on this concept, the company has actually completed all work done, also, the work done have being acknowledged by the customers, hence income of $60,000 should be taken up and not just the cash received.
A significant relationship exists between revenue and expenses. Expenses are incurred for the for the purpose of producing revenue. In measuring net income for a period, revenue should be equal by all the expenses incurred in producing that revenue.
This concept of offsetting expenses against revenue on the basis of "causes and effect" is called the Matching Concept.
The term 'matching' means appropriate association of related revenues and expenses. In matching expenses against revenue the question when the payment was made or received is 'irrelevant'.
For example if a salesman is paid commission in January, 2001, for sale made by him in December, 2000. According to this concept commission expense should be equal against sales of December 2000 because this expense is incurred for producing revenue in December 2000. On account of this concept, adjustments are made for all outstanding expenses, accrued revenues, prepaid expenses and unearned revenues, etc, while preparing the final accounts at the end of the accounting period.
10. Objectivity concept :
this concept means that all accounting entries should be evidenced and supported by business documents, such as invoice, vouchers, etc. This concept also implies that the evidences (i.e., the business documents supporting the accounting entries ) must be completely objective (i.e., must state the facts as they are without bias or fraud),
Accounting conventions
An accounting convention refers to common practices which are universally followed in recording and presenting accounting information of the business entity. They are followed like customs, tradition, etc. in a society. Accounting conventions are evolved through the regular and consistent practice over the years to facilitate uniform recording in the books of accounts. Accounting Conventions help in comparing accounting data of different business units or of the same unit for different periods. These have been developed over the years. The most important conventions which have been used for a long period are:
- Convention of consistency.
- Convention of full disclosure.
- Convention of materiality.
- Convention of conservatism.
Convention of consistency
This convention means that accounting practices should remain uncharged from one period to another. For example, if stock is valued at cost or market price whichever is less; this principle should be followed year after year. Similarly, if depreciation is charged on fixed assets according to diminishing balance method, it should be done year after year. This is necessary for the purpose of comparison. However, consistency does not mean inflexibility. It does not forbid introduction of improved accounting techniques. If a change becomes necessary, the change and its effect should be stated clearly.
Convention of Disclosure:
The disclosure of all significant information is one of the important accounting conventions. It implies that accounts should be prepared in such a way that all material information is clearly disclosed to the reader. The term disclosure does not imply that all information that any one could desire is to be included in accounting statements.
The term only implies that there is to a sufficient disclosure of information which is of material in trust to proprietors, present and potential creditors and investors. The idea behind this convention is that any body who want to study the financial statements should not be misled. He should be able to make a free judgment. The disclosures can be in the way of foot notes. Within the body of financial statements, in the minutes of meeting of directors etc.
Convention of Materiality:
It refers to the relative importance of an item or even. According to this convention only those events or items should be recorded which have a significant bearing and insignificant things should be ignored.
This is because otherwise accounting will be unnecessarily over burden with minute details. There is no formula in making a distinction between material and immaterial events. It is a matter of judgment and it is left to the accountant for taking a decision. It should be noted that an item material for one concern may be immaterial for another. Similarly, an item material in one year may not be material in the next year.
Convention of Conservatism:
This convention means a caution approach or policy of "play safe". This convention ensures that uncertainties and risks inherent in business transactions should be given a proper consideration. If there is a possibility of loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up to the time it does not materialize.
On account of this reason, the accountants follow the rule 'anticipate no profit but provide for all possible losses'. On account of this convention, the inventory is valued 'at cost or market price whichever is less.' The effect of the above is that in case market prices has gone down then provide for the 'anticipated loss' but if the market price has gone up then ignore the 'anticipated profits.' Similarly a provision is made for possible bad and doubtful debt out of current year's profits.
