Introduction to Accounting

Introduction to Accounting:

Business entities and various organizations engage in transactions involving money, assets, or economic resources. When these activities reach a significant scale, it becomes imperative to record them. These records serve as vital tools for making crucial decisions regarding the feasibility, profitability, and continuity of these activities. Information about these entities isn’t just essential for their owners and managers; it’s also valuable for a spectrum of stakeholders including the government, investors, customers, employees, and researchers.

Systematic, scientific, and uniform recording of finance for diverse purposes stands as a crucial practice. Finance, second only to human resources, holds immense importance in driving economic endeavors. Thus, establishing principles, methodologies, and protocols for meticulously documenting financial transactions becomes imperative. Accountancy serves as the cornerstone, offering fundamental theories, principles, and methodologies to effectively document all financial undertakings within an organization. This systematic approach aids in evaluating the efficacy of these activities, furnishing essential data regarding the organization’s status for comprehensive analysis and strategic planning.

Accounting, often deemed the language of business, serves a crucial role in facilitating communication. It captures essential details about business entities, encompassing their operational performance and financial standing within the records. This recorded financial information is disseminated to various stakeholders, including proprietors, management, investors, customers, and government entities, enabling them to gain insights into the company’s status and performance.

Evolution of Accounting:

About 23 centuries ago in India, Kautilya, the Minister of Chandragupta Maurya, penned a book called ‘Arthashastra.’ Within its pages, there are discernible references to methods for maintaining accounting records.

Accounting’s origins trace back to ancient times when stewards oversaw the possessions of affluent individuals, providing periodic reports to these property owners. This stewardship accounting is considered the foundational concept. The concepts of debit and credit were evident as early as the 12th century. It wasn’t until 1494 that Luca Pacioli, an Italian, formalized the double-entry bookkeeping system. The surge of the Industrial Revolution in the 18th and 19th centuries saw the rise of expansive operations and the emergence of joint stock companies, necessitating a clear divide between ownership and management. To protect the interests of owners and investors, businesses required comprehensive financial information, prompting the development of a detailed financial accounting system.

Throughout the 20th century, the demand for analyzing financial data to guide managerial choices gave rise to Management Accounting as a distinct branch within the accounting realm. While accounting initially focused on individual-centric practices during its evolutionary stages, it has progressively evolved into Social Responsibility Accounting in the 21st century. This shift was fueled by the expansive growth in diverse industries, making accounting an indispensable element in today’s business landscape.

Meaning and Definition of Accounting:

Accounting involves a methodical approach encompassing the identification, measurement, recording, classification, summarization, interpretation, and dissemination of financial data. Its primary function is to furnish insights into:
(i) the available resources,
(ii) how these resources have been utilized, and
(iii) the outcomes derived from their utilization.

The recorded information in accounts facilitates the determination of the profit or loss incurred within a specific accounting period, along with discerning the value and type of assets, liabilities, and capital. The American Institute of Certified Public Accountants characterizes accounting as “the art of meaningfully recording, classifying, and summarizing transactions and events—expressed in monetary terms— that possess, at least partially, a financial nature, and interpreting the consequent outcomes.”

The American Accounting Association defines accounting as the process of identifying, quantifying, and conveying economic information, enabling informed judgments and decisions by those using this data. This definition highlights several key aspects of accounting:
(i) Accounting is an art that necessitates the expertise of accountants to craft systems and policies tailored to an organization’s needs.
(ii) Business transactions or events must be documented in monetary terms.
(iii) The accounting process encompasses recording, categorizing, and summarizing transactions, followed by analyzing and interpreting the outcomes.
(iv) The insights derived from this analysis need to be shared with individuals or entities interested in such information.

Accounting Cycle:

The accounting cycle represents the series of stages integral to the accounting process. It commences by identifying and recording the financial transactions within an organization, culminating in the creation of year-end financial statements. Subsequently, the cycle perpetuates into the following accounting year, carrying forward the prior year’s closing balances of assets and liabilities as opening balances. The steps encompassed within this cycle are:

(i) Identifying the transactions and journalising– Identifying a business’s financial transactions marks the initial stage of the accounting process. These monetary activities find their record in primary ledgers known as journals. This process, termed journalising, involves entering transactions into these journals following the sequence of their occurrence, as detailed in respective source documents, ensuring chronological organization.

(ii) Posting and balancing- Moving the records from the journal to the ledger is referred to as posting. Within the ledger, entries are recorded for each account, and categorized under shared categories. The process of determining the variance between the total in the debit column and the credit column across all ledger accounts is known as balancing.

(iii) Preparation of trial balance- The subsequent step involves compiling the ledger balances into a list known as the trial balance. Financial statements are then crafted based on these ledger balances.

(iv) Preparation of trading account- Following that, the subsequent step involves creating a trading account for a specific accounting period. Here, all direct revenues and expenses are moved to the trading account. The resulting balance in the trading account represents either the gross profit or gross loss.

(v) Preparation of profit and loss account- The subsequent stage involves preparing the profit and loss account for a specific accounting period. This entails transferring all indirect revenues and expenses, in addition to the gross profit or gross loss, to the profit and loss account. The resulting balance in the profit and loss account signifies either the net profit or net loss.

(vi) Preparation of balance sheet- The ultimate phase in the accounting process involves creating a statement known as the balance sheet, which displays the balances of assets and liabilities. Typically prepared on the final day of the accounting period, it represents a snapshot of the financial status at a specific date.

At the onset of a new accounting year, the closing balances from the previous year are carried forward as the opening balances. Subsequent transactions for the new year are identified, recorded, and processed through posting and related procedures. The outcomes derived are then communicated to users of accounting data, facilitating analysis and aiding in decision-making processes.

Objectives of Accounting:

The aims of accounting encompass:

(i) Maintaining an organized log of financial transactions and occurrences.

(ii) Determining the profitability or losses incurred by the business entity.

(iii) Establishing the financial standing and condition of the enterprise.

(iv) Supplying essential information to diverse stakeholders as per their needs.

(v) Safeguarding the assets owned by the enterprise.

(vi) Evaluating the financial stability and liquidity position of the enterprise.

Functions of Accounting:

The main functions of accounting are as follows:

(i) Assessment- Accounting serves as the backbone for recording transactions systematically, transferring them to ledgers, and eventually constructing the final accounts. Its primary role lies in measuring the performance and illustrating the financial status of business enterprises.

(ii) Prognostication- Utilizing diverse accounting tools, businesses can forecast their future performance and financial standing.

(iii) Comparative Analysis- Accounting facilitates comparisons between actual and planned performances, as well as evaluations against established accounting policies. By juxtaposing real financial outcomes with projected figures and standards, it enables the implementation of effective measures to bolster operational efficiency.

(iv) Decision-making Support- Through the provision of pertinent information, accounting equips management with insights for planning, performance evaluation, and control. This information empowers them to make informed decisions concerning costs, pricing, sales strategies, activity levels, and more.

(v) Control- Accounting functions as a control tool by identifying both strengths and weaknesses within adopted measures, offering crucial feedback. It plays a pivotal role in evaluating the adherence to business policies and programs, providing a means to assess compliance effectively.

(vi) Assistance to government- The government requires comprehensive financial information from businesses for diverse purposes like taxation, subsidy allocation, and more. Accounting plays a vital role in furnishing pertinent business data, enabling government oversight and control over business enterprises.

Importance of Accounting:

“Accounting stands as an indispensable cornerstone for all enterprises, showcasing its significance through various facets:

(i) Systematic Record-Keeping: Financial transactions within an enterprise are meticulously documented in the books of accounts, employing a systematic classification under common headings, leading to concise summaries.

(ii) Financial Statement Preparation: Periodic assessments of business operations and financial standings are made possible through the creation of financial statements such as income statements and balance sheets. These aid in profit distribution, funding future growth, and providing a clear financial snapshot.

(iii) Progress Evaluation: Thorough analysis and interpretation of financial data allow for an evaluation of progress and the identification of weaknesses. This comprehensive view helps management gauge liquidity, profitability, and business solvency.

(iv) Decision-Making Support: Relevant accounting data empowers management to make informed routine and strategic decisions, enabling the planning of future policies and programs.

(v) Compliance with Legal Requirements: Accounting ensures adherence to various legal requisites like Provident Fund maintenance, Employees State Insurance contributions, tax filings, and preparation of financial statements, meeting regulatory standards.

(vi) Information Dissemination: It caters to diverse stakeholders—owners, management, creditors, employees, financial institutions, tax authorities, and governmental bodies—by providing pertinent information.

(vii) Legal Validity: Accounting records serve as accepted evidence in legal settings and aid in resolving disputes.

(viii) Tax Computation: These records serve as foundational data for computing and settling income tax and other related taxes.

(ix) Merger Settlements: In the event of business mergers, accounting records furnish vital information determining merger terms and any ensuing compensation.”

Basic Accounting terminologies:

(i) Transaction- A transaction is an activity that entails the exchange of money or something of value (such as goods, services, or ideas) from one individual or entity to another.

(ii) Cash transaction- A cash transaction refers to an exchange where payment is made or received in physical currency, involving immediate cash either as payment or receipt.

(iii) Credit transaction- A credit transaction is an exchange where immediate cash payment or receipt doesn’t occur; instead, the payment or receipt is deferred to a later time.

(iv) Account- An “account” is the fundamental element in accounting, serving as a measurement unit. It’s a distinctive marker used to identify individuals, items, or entities within accounting practices. Each account is uniquely opened for a person, asset, expense, income, or other elements. Within a ledger, an account functions as a compilation or summary of transactions categorized under a specific classification or heading.

(v) Capital- The term “Capital” refers to the sum of money invested by an owner or proprietor into an organization.

Branches of Accounting:

Various branches or subfields of accounting have been developed to cater to the diverse informational needs of users. These branches include:

(i) Financial Accounting: Financial accounting focuses on recording financial transactions and events, operating on a historical basis. It involves the identification, recording, classification, and summarization of financial transactions, culminating in the preparation of financial statements—such as the trading and profit and loss account or income statement, and the balance sheet. These statements convey information about the business’s profit or loss during a specific accounting period and its financial position on a given date.

(ii) Cost Accounting: Cost accounting encompasses the collection, recording, classification, and appropriate allocation of expenditures. Its primary purpose is to determine the costs associated with products or services. The resulting data aids in cost control and managerial decision-making processes.

(iii) Management Accounting: Management accounting focuses on presenting accounting information to assist management in decision-making and daily operations. It involves grouping, modifying, and presenting information collected from financial accounting, cost accounting, etc., to meet the management’s specific requirements for discharging their functions effectively.

(iv) Social Responsibility Accounting: Social responsibility accounting involves the presentation of accounting information from a societal perspective. It showcases social costs incurred by businesses, such as environmental pollution, and social benefits, including infrastructure development and employment opportunities. This branch arises due to corporate social responsibility considerations.

(v) Human Resources Accounting: Human resources accounting deals with the identification, quantification, and reporting of investments made in the human resources of an enterprise. It focuses on recognizing the value of the workforce and reporting on the investments made in developing and maintaining this crucial asset.

Bases of Accounting:

There are three commonly used bases of accounting: (i) Cash basis, (ii) Accrual or mercantile basis, and (iii) Mixed or hybrid basis.

(i) Cash Basis: Under the cash basis of accounting, actual cash receipts and payments are recorded. Revenue is recognized upon receiving cash, and expenses are acknowledged when cash is paid. Credit transactions are only recorded when cash is exchanged. This basis considers any income received, any expenditure paid, any asset purchased with cash, and any liability settled during the accounting period, whether related to the past, present, or future.

(ii) Accrual or Mercantile Basis: The accrual basis of accounting records revenue earned or accrued during the accounting period, regardless of whether it has been received, and expenses incurred, whether paid or not. Revenue is recognized when earned or accrued, and expenses are recognized when incurred. This basis includes any income earned, any expenditure incurred, any asset purchased (whether or not cash is paid), and any liability incurred (whether or not paid) during the accounting period.

(iii) Mixed or Hybrid Basis: The mixed basis of accounting combines elements of both cash and accrual bases. In this approach, revenues and assets are generally recorded on a cash basis, while expenses and liabilities are typically accounted for on an accrual basis.

Users of Accounting Information:

Numerous individuals require accounting information for diverse purposes, and they can be categorized into two groups: (A) Internal users and (B) External users.

Internal Users: Internal users within the organization consist of owners, management, and employees.

(i) Owners- Business proprietors contribute capital to finance the operations of the enterprise. They seek information regarding the profitability of the business over a specific time frame and its financial standing on a particular date. The owners require accounting reports to evaluate the company’s performance, make informed judgments about future prospects, and ensure that their anticipated returns and capital are secure.

(ii) Management- Management relies on accounting data as the fundamental groundwork for the majority of their decision-making processes. Key information, such as sales and purchase trends, the correlation between expenses and sales, employee efficiency, comparative profitability across various departments, capital structure, and solvency position, are crucial for effective planning and control of business operations. The essential data needed by management for these purposes is derived from financial statements and other reports generated through financial accounting.

(iii) Employees- Employees are keenly interested in the business’s profit-earning capacity, as it directly influences their remuneration, working conditions, retirement benefits, as well as the overall stability and growth prospects of the enterprise.

External Users: External users refer to individuals outside the organization who utilize accounting information for their specific needs. This category includes:

(i) Creditors and financial institutions: This encompasses suppliers of goods and services, commercial banks, public deposit holders, and debenture holders. Their primary interest lies in understanding the business’s liquidity position and its capacity to repay, ensuring the secure retrieval of amounts owed to them, including interest and principal amounts.

(ii) Investors: Individuals considering investing their funds in an organization seek insight into the business unit’s financial condition to inform their investment decisions. Their focus is primarily on the future earnings and risk-bearing capacity of the organization, as these factors significantly impact the returns for the investors.

(iii) Customers: Individuals who purchase and utilize the goods and services offered by businesses seek comprehensive information about product details and associated pricing. Their curiosity extends to understanding the stability and profitability of the enterprise, ensuring a reliable and sustained supply of products or services.

(iv) Tax authorities and other regulatory bodies: Accounting information plays a crucial role in assisting tax authorities in calculating income tax, taxes on goods and services, and other levies imposed on business entities. Various regulatory bodies also rely on this information to monitor revenues, expenses, and other financial aspects, ensuring businesses adhere to statutory requirements.

(v) Government: Given that business enterprises utilize the country’s limited resources, the government relies on insights into the performance of different industry units for policy formulation. This includes decisions related to trade and industry development, resource allocation, subsidies, and price regulation, where adherence to pricing guidelines is crucial.

(vi) Researchers: Researchers leverage accounting information and published financial statements for analysis and evaluation in the pursuit of their research endeavors.

(vii) General public: Accounting information serves as a window for the general public, offering insights into the enterprise’s earning capacity, stability, and social responsibility initiatives, particularly within its operational area. Additionally, it provides a glimpse into the employment opportunities created for the local populace.

Role of an accountant:

An accountant is responsible for devising the accounting procedures within an enterprise and fulfills various roles within the organization, including:

(i) Record Keeper: The accountant systematically records financial transactions, prepares financial statements, and generates other essential financial reports.

(ii) Provider of Information to Management: The accountant supports the management by furnishing necessary financial information crucial for decision-making and maintaining control.

(iii) Protector of Business Assets: By meticulously documenting business-owned assets, the accountant facilitates effective asset protection and control for the management. Additionally, they offer advice on asset insurance and its proper maintenance.

(iv) Financial Advisor: In the capacity of a financial advisor, the accountant conducts thorough analyses of financial data and offers guidance to business managers on investment opportunities, cost-saving strategies, capital budgeting, provisions for future growth and development, and the expansion of the enterprise.

(v) Tax Manager: The accountant ensures the accurate and timely preparation and filing of tax returns, as well as the timely payment of taxes. Moreover, they provide valuable advice to managers on effective tax management, reducing the tax burden, and leveraging opportunities for tax exemptions.

(vi) Public Relations Officer: Serving as a public relations officer, the accountant disseminates accounting information to various stakeholders based on their specific needs. This involves catering to the requirements of interested users, and providing them with relevant data for analysis.