Accounting can be defined as the process of identifying, measuring, recording and communicating the required information relating to the economic events of an organization to the interested users of such information.
Economic Events
Business organizations involve economic events. An economic event is known as a happening of consequence to a business organization which consists of transactions and which are measurable in monetary terms.
For example, purchase of machinery, installing and keeping it ready for manufacturing is an event which comprises number of financial transactions such as buying a machine, transportation of machine, site preparation for installation of a machine, expenditure incurred on its installation and trial runs.
Thus, accounting identifies bunch of transactions relating to an economic event. If an event involves transactions between an outsider and an organization, these are known as external events. The following are the examples of such transactions:
- Sale of I phone to the customers.
- Rendering services to the customers by Reliance Limited.
- Purchase of materials from suppliers.
- Payment of monthly rent to the landlord.
An internal event is an economic event that occurs entirely between the internal wings of an enterprise,
e.g., supply of raw material or components by the stores department to the manufacturing department, payment of wages to the employees, etc.
Identification, Measurement, Recording and Communication
Identification:
It means determining what transactions to record, i.e., to identity events which are to be recorded.
It involves observing activities and selecting those events that are of considered financial character and relate to the organization.
The business transactions and other economic events therefore are evaluated for deciding whether it has to be recorded in books of account.
For example, the value of human resources, changes in managerial policies or appointment of personnel are important but none of these are recorded in books of account. However, when a company makes a sale or purchase, whether on cash or credit, or pays salary it is recorded in the books of account.
Measurement:
It means quantification (including estimates) of business transactions into financial terms by using monetary unit, viz. rupees and paisa as a measuring unit.
If an event cannot be quantified in monetary terms, it is not considered for recording in financial accounts. That is why important items like the appointment of a new managing director, signing of contracts or changes in personnel are not shown in the books of accounts.
Recording:
Once the economic events are identified and measured in financial terms, these are recorded in books of account in monetary terms and in a chronological order.
Recording is done in a manner that the necessary financial information is summarized as per well-established practice and is made available as and when required.
Communication:
The economic events are identified, measured and recorded in order that the pertinent information is generated and communicated in a certain form to management and other internal and external users.
The information is regularly communicated through accounting reports. These reports provide information that are useful to a variety of users who have an interest in assessing the financial performance and the position of an enterprise, planning and controlling business activities and making necessary decisions from time to time.
The accounting information system should be designed in such a way that the right information is communicated to the right person at the right time.
Reports can be daily, weekly, monthly, or quarterly, depending upon the needs of the users. An important element in the communication process is the accountant’s ability and efficiency in presenting the relevant information.
Organization
Organization refers to a business enterprise, whether for profit or not-for-profit motive. Depending upon the size of activities and level of business operation, it can be a sole-proprietary concern, partnership firm, cooperative society, company, local authority, Municipal Corporation or any other association of persons.
Interested Users of Information
Accounting is a means by which necessary financial information about business enterprise is communicated and is also called the language of business.
Many users need financial information in order to make important decisions. These users can be divided into two broad categories: internal users and external users.
Internal users include: Chief Executive, Financial Officer, Vice President, Business Unit Managers, Plant Managers, Store Managers, Line Supervisors, etc.
External users include: present and potential Investors (shareholders), Creditors (Banks and other Financial Institutions, Debenture-holders and other Lenders), Tax Authorities, Regulatory Agencies (Department of Company Affairs, Registrar of Companies, Securities Exchange Board of India, Labour Unions, Trade Associations, Stock Exchange and Customers, etc.
Why do the Users Want Accounting Information?
The owners/shareholders use them to see if they are getting a satisfactory return on their investment, and to assess the financial health of their company/business.- The directors/managers use them for making both internal and external comparisons in their attempts to evaluate the performance. They may compare the financial analysis of their company with the industry figures in order to ascertain the company’s strengths and weaknesses. Management is also concerned with ensuring that the money invested in the company/organization is generating an adequate return and that the company/organization is able to pay its debts and remain solvent.
- The creditors (lenders) want to know if they are likely to get paid and look particularly at liquidity, which is the ability of the company/organization to pay its debts as they become due.
- The prospective investors use them to assess whether or not to invest their money in the company/organization.
- The government and regulatory agencies require information for the payment of various taxes such as Value Added Tax (VAT), Income Tax (IT), Customs and Excise duties for protecting the interests of investors, creditors (lenders), and also to satisfy the legal obligations imposed by the Companies Act 1956 and SEBI from time-to-time.
Accounting as a Source of Information
- provide information for making economic decisions;
- serve the users who rely on financial statements as their principal source of information;
- provide information useful for predicting and evaluating the amount, timing and uncertainty of potential cash-flows;
- provide information for judging management’s ability to utilize resources effectively in meeting goals;
- provide factual and interpretative information by disclosing underlying assumptions on matters subject to interpretation, evaluation, prediction, or estimation; and
- provide information on activities affecting the society.
Qualitative Characteristics of Accounting Information
Qualitative characteristics are the attributes of accounting information which tend to enhance its understandability and usefulness. In order to assess whether accounting information is decision useful, it must possess the characteristics of reliability, relevance, understandability and comparability.
Reliability means the users must be able to depend on the information. The reliability of accounting information is determined by the degree of correspondence between what the information conveys about the transactions or events that have occurred, measured and displayed.
Reliable information should be free from error and bias and faithfully represents what it is meant to represent. To ensure reliability, the information disclosed must be credible, verifiable by independent parties use the same method of measuring, and be neutral and faithful
To be relevant, information must be available in time, must help in prediction and feedback, and must influence the decisions of users by:
(a) Helping them form prediction about the outcomes of past, present or future events; and/or
(b) Confirming or correcting their past evaluations.
Understandability means decision-makers must interpret accounting information in the same sense as it is prepared and conveyed to them.
The qualities that distinguish between good and bad communication in a message are fundamental to the understandability of the message.
A message is said to be effectively communicated when it is interpreted by the receiver of the message in the same sense in which the sender has sent.
Accountants should present the comparable information in the most understandable manner without sacrificing relevance and reliability.
It is not sufficient that the financial information is relevant and reliable at a particular time, in a particular circumstance or for a particular reporting entity.
But it is equally important that the users of the general purpose financial reports are able to compare various aspects of an entity over different time period and with other entities.
To be comparable, accounting reports must belong to a common period and use common unit of measurement and format of reporting.
Branches of Accounting
Financial accounting: The purpose of this branch of accounting is to keep a record of all financial transactions so that:
(a) The profit earned or loss sustained by the business during an accounting period can be worked out,
(b) The financial position of the business as at the end of the accounting period
can be ascertained, and
(c) The financial information required by the management and other interested
parties can be provided.
Cost Accounting: The purpose of cost accounting is to analyze the expenditure so as to ascertain the cost of various products manufactured by the firm and fix the prices. It also helps in controlling the costs and providing necessary costing information to management for decision-making.
Management Accounting: The purpose of management accounting is to assist the management in taking rational policy decisions and to evaluate the impact of its decisions and actions.
Objectives of Accounting
As an information system, the basic objective of accounting is to provide useful information to the interested group of users, both external and internal.
The necessary information, particularly in case of external users, is provided in the form of financial statements, viz., profit and loss account and balance sheet.
Besides these, the management is provided with additional information from time to time from the accounting records of business. Thus, the primary objectives of accounting include the following:
- Maintenance of Records of Business Transactions
Accounting is used for the maintenance of a systematic record of all financial transactions in book of accounts.
Even the most brilliant executive or manager cannot accurately remember the numerous amount of varied transactions such as purchases, sales, receipts, payments, etc. that takes place in business every day.
Hence, proper and complete records of all business transactions are kept regularly. Moreover, the recorded information enables verifiability and acts as evidence.
- Calculation of Profit and Loss
The owners of business are keen to have an idea about the net results of their business operations periodically, i.e. whether the business has earned profits or incurred losses.
Thus, another objective of accounting is to ascertain the profit earned or loss sustained by a business during an accounting period which can be easily workout with help of record of incomes and expenses relating to the business by preparing a profit or loss account for the period.
Profit represents excess of revenue (income), over expenses. If the total revenue of a given period is Rs 6, 00,000 and total expenses are Rs. 5, 40,000 the profit will be equal to Rs. 60,000(Rs. 6, 00,000 – Rs. 5, 40,000).
If however, the total expenses exceed the total revenue, the difference reflects the loss.
- Depiction of Financial Position
Accounting also aims at ascertaining the financial position of the business concern in the form of its assets and liabilities at the end of every accounting period. A proper record of resources owned by business organization (Assets) and claims against such resources (Liabilities) facilitates the preparation of a statement known as balance sheet position statement.
- Providing Accounting Information to its Users
The accounting information generated by the accounting process is communicated in the form of reports, statements, graphs and charts to the users who need it in different decision situations.
As already stated, there are two main user groups, viz. internal users, mainly management, who needs timely information on cost of sales, profitability, etc. for planning, controlling and decision-making and external users who have limited authority, ability and resources to obtain the necessary information and have to rely on financial statements (Balance Sheet, Profit and Loss account).
- Investors and potential investors-information on the risks and return on investment;
- Unions and employee groups-information on the stability, profitability and distribution of wealth within the business;
- Lenders and financial institutions-information on the creditworthiness of the company and its ability to repay loans and pay interest;
- Suppliers and creditors-information on whether amounts owed will be repaid when due, and on the continued existence of the business;
- Customers-information on the continued existence of the business and thus the probability of a continued supply of products, parts and after sales service;
- Government and other regulators- information on the allocation of resources and the compliance to regulations;
- Social responsibility groups, such as environmental groups-information on the impact on environment and its protection;
- Competitors-information on the relative strengths and weaknesses of their competition and for comparative and benchmarking purposes. Whereas the above categories of users share in the wealth of the company, competitors require the information mainly for strategic purposes.
Role of Accounting
It is regarded as a language of business. It also performs the service activity by providing quantitative financial information that helps the users in various ways.
Accounting as an information system collects and communicates economic information about an enterprise to a wide variety of interested parties.
However, accounting information relates to the past transactions and is quantitative and financial in nature, it does not provide qualitative and non-financial information. These limitations of accounting must be kept in view while making use of the accounting information.
Basic Terms in Accounting
- Entity
Entity means a reality that has a definite individual existence.
Business entity means a specifically identifiable business enterprise like Super Bazaar, Hire Jewelers, ITC Limited, etc.
An accounting system is always devised for a specific business entity (also called accounting entity).
- Transaction
An event involving some value between two or more entities. It can be a purchase of goods, receipt of money, payment to a creditor, incurring expenses, etc. It can be a cash transaction or a credit transaction.
- Assets
Assets are economic resources of an enterprise that can be usefully expressed in monetary terms.
Assets are items of value used by the business in its operations. For example, Super Bazaar owns a fleet of trucks, which is used by it for delivering foodstuffs; the trucks, thus, provide economic benefit to the enterprise. This item will be shown on the asset side of the balance sheet of Super Bazaar.
Assets can be broadly classified into two types: Fixed Assets and Current Assets.
Fixed Assets are assets held on a long-term basis, such as land, buildings, machinery, plant, furniture and fixtures. These assets are used for the normal operations of the business.
Current Assets are assets held on a short-term basis such as debtors (accounts receivable), bills receivable (notes receivable), stock (inventory), temporary marketable securities, cash and bank balances.
- Liabilities
Liabilities are obligations or debts that an enterprise has to pay at some time in the future.
They represent creditors’ claims on the firm’s assets. Both small and big businesses find it necessary to borrow money at one time or the other, and to purchase goods on credit.
Long-term liabilities are those that are usually payable after a period of one year, for example, a term loan from a financial institution or debentures (bonds) issued by a company.
Short-term liabilities are obligations that are payable within a period of one year, for example, creditors, bills payable, bank overdraft.
- Capital
Amount invested by the owner in the firm is known as capital. It may be brought in the form of cash or assets by the owner for the business entity capital are an obligation and a claim on the assets of business. It is, therefore, shown as capital on the liabilities side of the balance sheet.
- Sales
Sales are total revenues from goods or services sold or provided to customers. Sales may be cash sales or credit sales.
- Revenues
These are the amounts of the business earned by selling its products or providing services to customers, called sales revenue. Other items of revenue common to many businesses are: commission, interest, dividends, royalties, rent received, etc. Revenue is also called income.
- Expenses
Costs incurred by a business in the process of earning revenue are known as expenses. Generally, expenses are measured by the cost of assets consumed or services used during an accounting period. The usual items of expenses are: depreciation, rent, wages, salaries, interest, cost of heater, light and water, telephone, etc.
- Expenditure
Spending money or incurring a liability for some benefit, service or property received is called expenditure. Payments of rent, salary, purchase of goods, purchases of machinery, purchase of furniture, etc. are examples of expenditure.
If the benefit of expenditure is exhausted within a year, it is treated as an expense (also called revenue expenditure). On the other hand, the benefit of expenditure lasts for more than a year; it is treated as an asset (also called capital expenditure) such as purchase of machinery, furniture, etc.
- Profit
The excess of revenues of a period over its related expenses during an accounting year is profit. Profit increases the investment of the owners.
- Gain
A profit that arises from events or transactions which are incidental to business such as sale of fixed assets, winning a court case, appreciation in the value of an asset. This is not recurring in nature.
- Loss
The excess of expenses of a period over its related revenues its termed as loss. It decreases in owner’s equity. It also refers to money or money’s worth lost (or cost incurred) without receiving any benefit in return, e.g., cash or goods lost by theft or a fire accident, etc. It also includes loss on sale of fixed assets.
- Discount
Discount is the deduction in the price of the goods sold. It is offered in two ways. Offering deduction of agreed percentage of list price at the time selling goods is one way of giving discount. Such discount is called ‘trade discount’. It is generally offered by manufactures to wholesalers and by wholesalers to retailers. After selling the goods on credit basis the debtors may be given certain deduction in amount due in case if they pay the amount within the stipulated period or earlier. This deduction is given at the time of payment on the amount payable. Hence, it is called as cash discount. Cash discount acts as an incentive that encourages prompt payment by the debtors.
- Voucher
The documentary evidence in support of a transaction is known as voucher. For example, if we buy goods for cash, we get cash memo, if we buy on credit, we get an invoice; when we make a payment we get a receipt and so on.
- Goods
It refers to the products in which the business unit is dealing, i.e. in terms of which it is buying and selling or producing and selling.
The items that are purchased for use in the business are not called goods. For example, for a furniture dealer purchase of chairs and tables is termed as goods, while for other it is furniture and is treated as an asset.
Similarly, for a stationery merchant, stationery is goods, whereas for others it is an item of expense (not purchases)
- Drawings
Withdrawal of money and/or goods by the owner from the business for personal use is known as drawings. Drawings reduces the investment of the owners i.e. capital investment.
- Purchases
Purchases are total amount of goods procured by a business on credit and on cash, for use or sale.
In a trading concern, purchases are made of merchandise for resale with or without processing.
In a manufacturing concern, raw materials are purchased, processed further into finished goods and then sold. Purchases may be cash purchases or credit purchases.
- Stock
Stock (inventory) is a measure of something on hand-goods, spares and other items in a business.
It is called Stock in hand. In a trading concern, the stock on hand is the amount of goods which are lying unsold as at the end of an accounting period is called closing stock(ending inventory).
In a manufacturing company, closing stock comprises raw materials, semi-finished goods and finished goods on hand on the closing date.
Similarly, opening stock (beginning inventory) is the amount of stock at the beginning of the accounting period.
- Debtors
Debtors are persons and/or other entities who owe to an enterprise an amount for buying goods and services on credit.
The total amount standing against such persons and/or entities on the closing date is shown in the balance sheet as sundry debtors on the asset side.
- Creditors
Creditors are persons and/or other entities that have to be paid by an enterprise an amount for providing the enterprise goods and services on credit.
The total amount standing to the favor of such persons and/or entities on the closing date is shown in the Balance Sheet as sundry creditors on the liabilities side.