ACCOUNTING
(DEFINITION)
Accounting is the process of identifying, measuring and
communicating economic information to permit informed judgments and decisions
by the users of the information.
Accounting is the language of business and it is used to communicate
financial information. In order for that information to make sense,
accounting is based on fundamental concepts.
Accounting is the systematic recording, reporting, and analysis
of financial transactions of a business.
STEPS OF ACCOUNTING
·
Recording: This is the basic
function of accounting. It is essentially concerned with not only ensuring that
all business transactions of financial character are in fact recorded but also
that they are recorded in an orderly manner. Recording is done in the book
"Journal".
·
Classifying: Classification is
concerned with the systematic analysis of the recorded data, with a view to
group transactions or entries of one nature at one place. The work of
classification is done in the book termed as "Ledger".
·
Summarizing: This involves
presenting the classified data in a manner which is understandable and useful
to the internal as well as external end-users of accounting statements. This
process leads to the preparation of the following statements: (1) Trial
Balance, (2) Income statement (3) Balance sheet.
·
Analysis and Interprets: This
is the final function of accounting. The recorded financial data is analyzed
and interpreted in a manner that the end-users can make a meaningful judgment
about the financial condition and profitability of the business operations. The
data is also used for preparing the future plan and framing of policies for
executing such plans.
·
Communicate: The accounting
information after being meaningfully analyzed and interpreted has to be
communicated in a proper form and manner to the proper person. This is done
through preparation and distribution of accounting reports, which include
besides the usual income statement and the balance sheet, additional
information in the form of accounting ratios, graphs, diagrams, funds flow
statements etc.
FUNCTIONS
OF ACCOUNTING
- Keeping systematic record of business transactions.
- Protecting properties of the business.
- Communicating the results to various parties interested in or
connected with the business.
- Meeting legal requirements.
•
Timely and accurate picture of
performance
•
Generate financial reports for
management, lenders, creditors
•
Facilitate filing of tax returns
–
(sales and payroll taxes more important
than income tax)
•
Prevent and detect fraud, waste and
theft
BOOKKEEPING
(DEFINITION)
Bookkeeping is the art of recording the
business transactions in the books of accounts in a systematic manner.
LIMITATIONS
OF ACCOUNTING
- Accounting provides only limited information because it reveals the
profitability of the concern as whole.
- Accounting considers only those transactions which can be measured
in terms of money or quantitatively expressed. Qualitative information is
not taken into account.
- Accounting provides limited information to the management.
- Accounting is only historical in nature. It provides only a post mortem
record of business transactions.
BRANCHES OF ACCOUNTING
Financial
accounting- information
gathered is intended both for internal (e.g. managers) and external (e.g. banks
and other creditors, government agencies, investment advisers, etc.) parties.
Information recording is subject to certain ground rules internationally known
as Generally Accepted Accounting Principles (GAAP).
Management
accounting- information
gathered is primarily for the use of internal management. Such information is
used for management planning and control.
Cost
accounting- It
is the formal accounting system setup for recording cost. It is a systematic
procedure for determining the unit cost of output produced or service rendered.
ACCOUNTING
PRINCIPLE
Established by
human, ‘a general law or rule adopted or professed as a guide to action; a
settled ground or basis of conduct and practice’.
Accounting
Principles can be classified into two categories
- Accounting
Concepts
- Accounting Conventions
ACCOUNTING
CONCEPTS
Entity
Accounts are kept for entities and not the people who own or run the company. Even in proprietorships and partnerships, the accounts for the business must be kept separate from those of the owner(s).
Accounts are kept for entities and not the people who own or run the company. Even in proprietorships and partnerships, the accounts for the business must be kept separate from those of the owner(s).
Money-Measurement
For
an accounting record to be made it must be able to be expressed in monetary
terms. For this reason, financial statements show only a limited picture
of the business. Consider a situation where there is a labor strike
pending or the business owner’s health is failing; these situations have a huge
impact on the operations and financial security of the company but this
information is not reflected in the financial statements.
Going Concern
Accounting assumes that an
entity will continue to operate indefinitely. This concept implies that
financial statements do not represent a company’s worth if its assets were to
be liquidated, but rather that the assets will be used in future
operations. This concept also allows businesses to spread (amortize) the
cost of an asset over its expected useful life.
Cost
An asset (something that is owned by the company) is entered into the accounting records at the price paid to acquire it. Because the “worth” of an asset changes over time it would be impossible to accurately record the market value for the assets of a company. The cost concept does recognize that assets generally depreciate in value and so accounting practice removes the depreciation amount from the original cost, shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.) Look at the following example:
An asset (something that is owned by the company) is entered into the accounting records at the price paid to acquire it. Because the “worth” of an asset changes over time it would be impossible to accurately record the market value for the assets of a company. The cost concept does recognize that assets generally depreciate in value and so accounting practice removes the depreciation amount from the original cost, shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.) Look at the following example:
Truck
$10,000 purchase price of the truck
Less depreciation $ 1,000 amount deducted as a depreciation expense
Net Truck: $ 9,000 net book-value of the truck
Less depreciation $ 1,000 amount deducted as a depreciation expense
Net Truck: $ 9,000 net book-value of the truck
The $9000 simply represents
the book value of the truck after depreciation has been accounted for.
This figure says nothing about other aspects that affect the value of an item
and is not considered a market price.
Dual Aspect
This concept is the basis of
the fundamental accounting equation:
Assets
= Liabilities + Equity
- Assets
are what the company owns.
- Liabilities
are what the company owes to creditors against those assets
- Equity
is the difference between the two and represents what the company owes to
its investors/owners.
All accounting transactions
must keep this equation balanced so when there is an increase on one side there
must be an equal increase on the other side or an equal decrease on the same
side.
Objectivity
The objectivity concept states that accounting will be recorded on the basis of objective evidence (invoices, receipts, bank statement, etc…). This means that accounting records will initiate from a source document and that the information recorded is based on fact and not personal opinion.
The objectivity concept states that accounting will be recorded on the basis of objective evidence (invoices, receipts, bank statement, etc…). This means that accounting records will initiate from a source document and that the information recorded is based on fact and not personal opinion.
Time Period
This concept defines a
specific interval of time for which an entity’s reports are prepared.
This can be a fiscal year (Mar 1 – Feb 28), natural year (Jan 1 – Dec 31), or
any other meaningful period such as a quarter or a month.
Conservatism
This requires understating rather than overstating revenue (income) and expense amounts that have a degree of uncertainty. The rule is to recognize revenue when it is reasonably certain and recognize expenses as soon as they are reasonably possible. The reasons for accounting in this manner are so that financial statements do not overstate the company’s financial position. Accounting chooses to err on the side of caution and protect investors from inflated or overly positive results.
This requires understating rather than overstating revenue (income) and expense amounts that have a degree of uncertainty. The rule is to recognize revenue when it is reasonably certain and recognize expenses as soon as they are reasonably possible. The reasons for accounting in this manner are so that financial statements do not overstate the company’s financial position. Accounting chooses to err on the side of caution and protect investors from inflated or overly positive results.
Realization
Revenues are recognized when they are earned or realized. Realization is assumed to occur when the seller receives cash or a claim to cash (receivable) in exchange for goods or services. This concept is related to conservatism in that revenue (income) is only recorded when it actually occurs and not at the point in time when a contract is awarded. For instance, if a company is awarded a contract to build an office building the revenue from that project would not be recorded in one lump sum but rather it would be divided over time according to the work that is actually being done.
Revenues are recognized when they are earned or realized. Realization is assumed to occur when the seller receives cash or a claim to cash (receivable) in exchange for goods or services. This concept is related to conservatism in that revenue (income) is only recorded when it actually occurs and not at the point in time when a contract is awarded. For instance, if a company is awarded a contract to build an office building the revenue from that project would not be recorded in one lump sum but rather it would be divided over time according to the work that is actually being done.
Matching
To avoid overstatement of income in any one period, the matching principle requires that revenues and related expenses be recorded in the same accounting period. If you bill $20,000 of services in a month, in order to accurately represent the income for the month you must report the expenses you incurred while generating that income in the same month.
To avoid overstatement of income in any one period, the matching principle requires that revenues and related expenses be recorded in the same accounting period. If you bill $20,000 of services in a month, in order to accurately represent the income for the month you must report the expenses you incurred while generating that income in the same month.
Consistency
Once an entity decides on one method of reporting (i.e. method of accounting for inventory) it must use that same method for all subsequent events. This ensures that differences in financial position between reporting periods are a result of changed in the operations and not to changes in the way items are accounted for.
Once an entity decides on one method of reporting (i.e. method of accounting for inventory) it must use that same method for all subsequent events. This ensures that differences in financial position between reporting periods are a result of changed in the operations and not to changes in the way items are accounted for.
Materiality
Accounting practice only records events that are significant enough to justify the usefulness of the information. Technically, each time a sheet of paper is used, the asset “Office supplies” is decreased by an infinitesimal amount but that transaction is not worth accounting for.
Accounting practice only records events that are significant enough to justify the usefulness of the information. Technically, each time a sheet of paper is used, the asset “Office supplies” is decreased by an infinitesimal amount but that transaction is not worth accounting for.
By understanding and applying
these principles you will be able to read, prepare, and compare financial
statements with clarity and accuracy. The bottom-line is that the ethical
practice of accounting mandates reporting income as accurately as possible and
when there is uncertainty, choosing to err on the side of caution.
ACCOUNTING CONVENTIONS
- Convention of
Disclosure: The disclosure of all material
information is one of the important accounting conventions. According to
this conventions all accounting statements should be honestly prepared and
all facts and figures must be disclosed therein. The disclosure of
financial information is required for different parties who are interested
in welfare of that enterprise. Convention of disclosure is required to be
kept as per the requirement of the companies Act and Income Tax Act.
- Convention of
conservatism: This convention is closely related
to the policy of playing safe. This principle is often described as
“anticipate no profit, and provide for all possible losses”. Thus this
convention emphasis that uncertainties and risks inherent in business
transactions should be given proper consideration.
- Convention of
Consistency: The convention of consistency
implies that accounting policies, procedures and methods should remain
unchanged for preparation of financial statements from one period to
another. In order to measure the operational efficiency of a concern, this
convention allows a meaningful comparison in the performance of different
period.
- Convention of
Materiality: It defined as “the characteristic
attaching to a statement fact, or item whereby its disclosure or method of
giving it expression would be likely to influence the judgment of a
reasonable person”.
DOUBLE
ENTRY SYSTEM OF ACCOUNTING
Accounting records can
be prepared under any one of the following system:
- Single
Entry System
- Double
Entry System
SINGLE ENTRY SYSTEM
Under this system, all
transactions relating to a personal aspect are recorded in the books of
accounts but leave all impersonal transactions. Single Entry system is based on
the Dual Aspect Concept and is incomplete and inaccurate
DOUBLE ENTRY
SYSTEM
There are
numerous transactions in a business concern. Each transaction, when closely analyzed,
reveals two aspects. One aspect will be “receiving aspect” or “incoming aspect”
or “expenses/loss aspect”. This is termed as the “Debit aspect”. The
other aspect will be “giving aspect” or “outgoing aspect” or “income/gain
aspect”. This is termed as the “Credit aspect”. These two aspects namely
“Debit aspect” and “Credit aspect” form the basis of Double Entry System. The
double entry system is so named since it records both the aspects of a
transaction.
In short, the
basic principle of this system is, for every debit, there must be a
corresponding credit of equal amount and for every credit, there must be a
corresponding debit of equal amount.
DEFINITION
According to J.R.Batliboi
“Every business transaction has a two-fold effect and that it affects two
accounts in opposite directions and if a complete record were to be made of
each such transaction, it would be necessary to debit one account and credit
another account. It is this recording of the two fold effect of every
transaction that has given rise to the term Double Entry System”.
FEATURES
- Every
business transaction affects two accounts.
- Each
transaction has two aspects, i.e., debit and credit.
- It
is based upon accounting assumptions concepts and principles.
- Helps
in preparing trial balance which is a test of arithmetical accuracy in
accounting.
- Preparation of
final accounts with the help of trial balance.
ADVANTAGES OF
DOUBLE ENTRY SYSTEM
- Scientific system: This is the
only scientific system of recording business transactions. It helps to
attain the objectives of accounting.
- Complete record of transactions: This system
maintains a complete record of all business transactions.
- A check on the accuracy of accounts: By the use
of this system the accuracy of the accounting work can be established by
the preparation of trial balance.
- Ascertainment of profit or loss: The profit
earned or loss occurred during a period can be ascertained by the
preparation of profit and loss account.
- Knowledge of the financial position: The
financial position of the concern can be ascertained at the end of each
period through the preparation of balance sheet.
- Full details for control: This system
permits accounts to be kept in a very detailed form, and thereby provides
sufficient information for the purpose of control.
- Comparative study: The results
of one year may be compared with those of previous years and the reasons
for change may be ascertained.
- Helps in decision making: The
management may be able to obtain sufficient information for its work,
especially for making decisions. Weaknesses can be detected and remedial
measures may be applied.
- Detection of fraud: The
systematic and scientific recording of business transactions on the basis
of this system minimizes the chances of fraud.
CLASSIFICATION
OF ACCOUNTS (TYPES OF ACCOUNTS)
Transactions can
be divided into three categories.
- Transactions
relating to individuals and firms
- Transactions
relating to properties, goods or cash
- Transactions
relating to expenses or losses and incomes or gains.
Therefore,
accounts can also be classified into Personal, Real and Nominal. The
classification may be illustrated as
I. Personal
Accounts: The
accounts which relate to persons. Personal accounts include the following.
1. Natural Persons:
Accounts
which relate to individuals. For example, Mohan’s A/c, Shyam’s A/c etc.
2. Artificial
persons: Accounts
which relate to a group of persons or firms or institutions. For example, HMT
Ltd., Indian Overseas Bank, Life Insurance Corporation of India, Cosmopolitan
club etc.
3. Representative
Persons: Accounts
which represent a particular person or group of persons. For example,
outstanding salary account, prepaid insurance account, etc. The business
concern may keep business relations with all the above personal accounts,
because of buying goods from them or selling goods to them or borrowing from
them or lending to them. Thus they become either Debtors or Creditors.
The proprietor
being an individual his capital account and his drawings account are also
personal accounts.
II. Impersonal
Accounts: All
those accounts which are not personal accounts. This is further divided into
two types. Real and Nominal accounts.
1. Real Accounts: Accounts
relating to properties and assets which are owned by the business concern. Real
accounts include tangible and intangible accounts. For example, Land, Building,
Goodwill, Purchases, etc.
a. Tangible Real Accounts
b. Intangible Real Accounts.
2.
Nominal Accounts: These accounts do not have any
existence, form or shape. They relate to incomes and expenses and gains and
losses of a business concern. For example, Salary Account, Dividend Account, etc.
QUE: CLASSIFY THE FOLLOWING ITEMS
INTO PERSONAL, REAL AND NOMINAL ACCOUNTS.
Items
|
Type of Account
|
Capital
|
Personal
account
|
Sales
|
Real account
|
Drawings
|
Personal
account
|
Outstanding
salary
|
Personal
(Representative) account
|
Cash
|
Real account
|
Rent
|
Nominal
account
|
Interest paid
|
Nominal
account
|
Indian Bank
|
Personal
(Legal Body) account
|
Discount
received
|
Nominal
account
|
Building
|
Real account
|
Bank
|
Personal
account
|
Chandrasekar
|
Personal
account
|
Murugan
Lending Library
|
Personal
account
|
Advertisement
|
Nominal
account
|
Purchases
|
Real account
|
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