Meaning and Basic Concepts of Accounting
Meaning of Accounting
Accounting is a service function that provides financial information to the interested parties inside and outside the organization for their effective decision-making. Hence, the primary role of accounting information is to provide useful and reliable information for decision-making purposes.Accounting is a systematic process of identifying, measuring, recording, classifying, summarizing, interpreting, communicating financial information to the users. It shows the profit earned or loss incurred during the accounting period, value and nature of assets, liabilities, and owners’ equity, i.e., the capital.
Usually, accounting is understood as the Language of Business. However, a business may have a lot of aspects that may not be of financial nature. As such, a better way to understand accounting could be to call it The Language of Financial Decisions. The better the understanding of the language, the better is the management of financial aspects of the business.
Accounting is the art and science of providing meaningful information about the financial activities of the company as a tool for management. This is used by a business for maintaining financial records on a cash basis or accrual basis.
Definition of Accounting
According to American Accounting Association - “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information”.According to the American Institute of Certified Public Accountants - “accounting is the art of recording, classifying and summarizing, in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof”.
Characteristics of Accounting
The definition of accounting brings to light the following characteristics of accounting.Identification of Financial Transactions and Events
Accounting records only those transactions and events which can be measured in terms of money. This involves identifying transactions and events that are part of economic activity, for example- purchase of raw material or sale of finished goods by a firm. Such transactions are identified with the help of bills and receipts as evidence of the transactions.
Measuring the Identified Transactions
Accounting measures the transactions and events in terms of a common measurement unit (that is the currency of a country). In other words, we can say financial transactions and events are measured in terms of money.
If a transaction has no financial character then it will not be measured in terms of money and will not be recorded.
For Example, you are a star performer in an organization, your health, your energy is of great use to the business. But, can you quantify your health value? Obviously not. Similarly, quarrels between you and your superior, bad working conditions for workers, etc. are facts that affect the earnings of the business, but they are not to be recorded in books because they do not have financial character, or cannot be measured in terms of money. Thus only those transactions and events, which are of financial character, will be recorded.
Recording
Accounting is an art of recording business transactions in the books of account. The recording is the process of recording business transactions of financial character in the book of original entry, i.e., Journal. This book is further sub-divided into Subsidiary Books such as Cash Journal or Cash Book (for recording cash transactions), Purchases Journal or Purchases book (for recording credit purchases of goods), Sales Journal or Sales Book (for recording credit sales), etc.
Classifying
Classifying is the process of grouping transactions or entries of one nature at one place. The transactions recorded in the “Journal” or the subsidiary books are classified or posted to the main book of account known as the “Ledger”. This book contains individual account heads under which all financial transactions of similar nature are collected. For example – in Patel & Sons a/c in the Ledger, all business transactions related to Patel & Sons are posted so that what is ultimately due to Patel & Son or due from Patel & Son can be ascertained.
Summarising
This involves presenting the classified data in a manner that is understandable and useful for internal as well as external users of the accounting statements. This process leads to the preparation of the following statement:
- Trial Balance,
- Trading and Profit and Loss A/c or Statement of Profit and Loss (in case of companies), and
- Balance Sheet
The above Statements are collectively known as Final Accounts or Financial Statements.
Analysis and Interpretation
This is an important function of accounting. A distinction is necessary to be made between the two terms - Analysis and Interpretation. Analysis refers to the methodical classification of data. If unconnected data are grouped together, understanding is not possible. All assets belonging to current assets are to be grouped together, similarly all current liabilities. If current assets and current liabilities are mixed together, data would be confusing.
Interpretation means drawing conclusions from the data and explaining the conclusions in a simple language, easy to understand, and planning further course of action. Analysis and interpretation are complementary to each other. Interpretation is not possible without analysis. The analysis is of no use unless followed by interpretation.
Communicating
Finally, the accounting function involves communicating the financial data, i.e., financial statements, to its users. The accounting information must be provided in time and presented to the users so that appropriate decisions may be taken at the right time.
Objectives of Accounting
1. Maintaining Accounting Records – The objective of accounting is to record financial transactions and events of the organizations in the books of account in a systematic manner following the principles of accountancy.2. Determining Profit or Loss- Another objective of accounting is to determine the net results of transactions for a period. In other words, to determine whether, during the accounting period, the firm has earned a profit or incurred a loss. For this purpose, a statement called an income statement or the trading and profit and loss account is prepared. Revenues resulting from the transactions of the period are recorded in the credit and expenses in the debit. The difference between the two sides is either profit or loss.
3. Determining Financial Position - another objective of accounting is to determine the financial position of the business over a period of time. It is known from the Income statement ie profit and loss account and balance sheet.
4. Facilitating Management – the management often requires financial information for decision-making, effective control, budgeting, and forecasting. Accounting provides financial information to assist the management in discharging this function.
5 Providing Accounting Information to Users – Another objective of accounting is to provide accounting information to users, both internal and external.
6. Protecting Business Assets – Another objective of accounting is to have records of the assets owned by the business, which enables the management to protect and control them.
Scope / Branches of Accounting
With the changing times, the following specialized branches of accounting have emerged to meet the changed requirements.Financial Accounting
Financial accounting is the original form of accounting. It is mainly limited to the preparation of financial statements i.e. Profit and Loss Account and Balance Sheet. Here, the preparation is made on a historical basis i.e. after the happening of the event. All the persons who deal with the joint-stock company want to know information about the financial health of the company. The profit and Loss account provides information on how the business has been conducted and the final position about the profit or loss of the firm for a specified period. The balance sheet shows the financial position of the firm on a particular date.
Cost Accounting
Cost Accounting has developed on account of the limitations of Financial Accounting.
Cost Accounting is, basically, concerned with the estimation of costs, in advance, and their subsequent detailed analysis for the purpose of control.
Management is interested to know the costs of the different products they make for the purpose of determining the price. Secondly, management has to take a suitable decision, when they receive a special order at a lower price than the current market price, for acceptance or rejection. When resources are scarce, everyone is interested to use the resources and manufacture that product, in priority, which gives them more profits than other products.
Cost accounting helps the management in achieving the profits they plan to achieve.
Management Accounting
Management accounting is the most recently developed branch of accounting.
Management Accounting is accounting for the Management. Management wants information to discharge its functions in forecasting, budgeting, cost control, and strategy formation.
Management accounting is a branch of accounting, which furnishes useful data to the management in carrying out various functions such as planning, decision-making, and controlling the activities of the business enterprise. Accounting information is presented in an easy and ready-to-understand manner to the management. Here, the emphasis is on the application of accounting techniques in planning and controlling the activities of the business enterprise and assisting the management in decision-making.
Single Entry System: Single entry system sounds economical, but it is, really, costly. In fact, it is rather a lack of system. This system is adopted where the business is run on cash basis only. It is not a scientific system and final accounts cannot be easily prepared on the basis of this system. Small businesses and organizations that do not require ascertainment of profit, follows this system.
Double Entry System: The only real system is the double entry system. Double Entry System recognises the fundamental factor that every transaction is double-sided affair.
According to this system, for every debit, there is a corresponding credit. For example- at the time of cash purchases, goods are received and in return, cash is paid. In the transaction, two aspects are involved, i.e., receiving goods and paying cash and under the double-entry system, both these aspects are recorded. One part, i.e., the receipt of goods is debited and the second part, i.e., payment of cash is credited.
This system is universally followed in accounting. On the basis of this system, the accuracy of accounting can be maintained and arithmetical correctness can easily be established. Financial statements i.e. Profit and Loss Account and Balance Sheet are easily prepared, following the double-entry system of accounting.
According to another type of classification, again there can be two systems of accounting- cash system and mercantile system.
Cost Accounting is, basically, concerned with the estimation of costs, in advance, and their subsequent detailed analysis for the purpose of control.
Management is interested to know the costs of the different products they make for the purpose of determining the price. Secondly, management has to take a suitable decision, when they receive a special order at a lower price than the current market price, for acceptance or rejection. When resources are scarce, everyone is interested to use the resources and manufacture that product, in priority, which gives them more profits than other products.
Cost accounting helps the management in achieving the profits they plan to achieve.
Management Accounting
Management accounting is the most recently developed branch of accounting.
Management Accounting is accounting for the Management. Management wants information to discharge its functions in forecasting, budgeting, cost control, and strategy formation.
Management accounting is a branch of accounting, which furnishes useful data to the management in carrying out various functions such as planning, decision-making, and controlling the activities of the business enterprise. Accounting information is presented in an easy and ready-to-understand manner to the management. Here, the emphasis is on the application of accounting techniques in planning and controlling the activities of the business enterprise and assisting the management in decision-making.
Systems of Accounting
According to the first type of classification, there are two systems of accounting for recording transactions - Single Entry System and Double Entry System.Single Entry System: Single entry system sounds economical, but it is, really, costly. In fact, it is rather a lack of system. This system is adopted where the business is run on cash basis only. It is not a scientific system and final accounts cannot be easily prepared on the basis of this system. Small businesses and organizations that do not require ascertainment of profit, follows this system.
Double Entry System: The only real system is the double entry system. Double Entry System recognises the fundamental factor that every transaction is double-sided affair.
According to this system, for every debit, there is a corresponding credit. For example- at the time of cash purchases, goods are received and in return, cash is paid. In the transaction, two aspects are involved, i.e., receiving goods and paying cash and under the double-entry system, both these aspects are recorded. One part, i.e., the receipt of goods is debited and the second part, i.e., payment of cash is credited.
This system is universally followed in accounting. On the basis of this system, the accuracy of accounting can be maintained and arithmetical correctness can easily be established. Financial statements i.e. Profit and Loss Account and Balance Sheet are easily prepared, following the double-entry system of accounting.
According to another type of classification, again there can be two systems of accounting- cash system and mercantile system.
Cash System: It is used where only cash transactions take place and the object of the concern is not to make a profit.
In this system of accounting, entries are made only when cash is received. No entry is made when receipt or payment is due.
In the case of clubs, libraries, educational institutes, religious trusts, etc., the objective of the concern is not to make profits. Only Cash Book is kept under this system.
Some professionals like doctors, lawyers, and chartered accountants follow this system of accounting.
Mercantile System of Accounting: In this system of accounting, accounting entries are made when payment or receipt is merely due. It is not necessary that the actual receipt of payment has to take place. For instance, when service is received and actual payment is not made, and books of accounts are to be closed for the year-end, payment due is recognized and recorded for the services received. To illustrate, repairs have been made for machinery. Bill is received, but not paid. Books of accounts are to be closed as the year has come to an end. Payment due for the services received is recorded before the books are closed. In other words, repairs though not paid, are recognized as expenses, and liability is created. Even if the bill is not received, repairs are estimated and the relative amount is provided as an expense. Similarly, when a sale is made and sale proceeds are not received, the amount due on sale is recorded as an asset, and income is recognized. The idea is to record all the transactions as if they are completed in all aspects. The objective of this system is to ascertain the correct profit position of the firm.
In this system of accounting, entries are made only when cash is received. No entry is made when receipt or payment is due.
In the case of clubs, libraries, educational institutes, religious trusts, etc., the objective of the concern is not to make profits. Only Cash Book is kept under this system.
Some professionals like doctors, lawyers, and chartered accountants follow this system of accounting.
Mercantile System of Accounting: In this system of accounting, accounting entries are made when payment or receipt is merely due. It is not necessary that the actual receipt of payment has to take place. For instance, when service is received and actual payment is not made, and books of accounts are to be closed for the year-end, payment due is recognized and recorded for the services received. To illustrate, repairs have been made for machinery. Bill is received, but not paid. Books of accounts are to be closed as the year has come to an end. Payment due for the services received is recorded before the books are closed. In other words, repairs though not paid, are recognized as expenses, and liability is created. Even if the bill is not received, repairs are estimated and the relative amount is provided as an expense. Similarly, when a sale is made and sale proceeds are not received, the amount due on sale is recorded as an asset, and income is recognized. The idea is to record all the transactions as if they are completed in all aspects. The objective of this system is to ascertain the correct profit position of the firm.
