Chapter I: Introduction to Accounting

Origin and development of accounting thought Bookkeeping Accounting, accountancy: meaning & objectives of accounting Functions of accounting Accounting principles concepts and conventions Accounting standards Basis of accounting cash system, mercantile system and hybrid system Systems of accounting recording of business transactions under double entry system journalising and ledger accounts preparation

Learning Objectives
In this chapter we will understand:
What is accounting process What are financial statements Classification of accounting How has Accounting developed? Concepts of accounting Conventions of accounting Principles of accounting

 Accounting is the process of financially measuring, recording, summarizing and communicating the economic activity of an organization. It is often referred to as the language of business and, like any other language, it has its own unique vocabulary and rules. However, technical accounting terms such as assets, liabilities, equity, revenue, expense, income, entity and cash flow are widely used even outside business world.

Definition of Accounting

Analysis of Definition
Accounting is the process: Identification of Transactions Measurement of them in monitory units Recording Classifying Summarizing Analyzing Interpreting

ACCOUNTING is Language of business Is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decision.

What is Accounting? Accounting is the process of:

Identifying Measuring Communicating Economic information about an entity

>

For decisions and informed judgments

ACCOUNTING PROCESS

JOURNALISING (RECORDING)

POSTING AND CLASSIFICATION (LEDGER)

SUMMARISING (TRIAL BALANCE AND FINANCIAL STATEMENTS)

INTERPRETATION (FFS, CFS, RATIO ANALYSIS)

Identification of transaction Passing of adjusting entries

Preparation of business documents

Preparation of adjusted Trial Balance

Recording of transaction in journal Profit & Loss account

Posting to ledger

Preparation of un-adjusted trial balance

Balance sheet

Information for decision making

Information
Non quantitative information Quantitative information

Accounting information Operating information Financial Accounting

Non-accounting information Management Accounting

Financial Statements for Managerial Decisions

Profit and loss account Balance sheet Cash flow statement/Fund Flow Statement Comparative statements Segmental analysis Incidental statements Explanatory materials Auditors report

 The Income Statement reports the organizations economic performance over a specified period of time. The Balance Sheet is a summary of the economic resources of an organization and the claims against those resources at a specific point in time. The Statement of Changes in Financial Position reports the organization's sources and uses of funds (also referred to as the Statement of Changes in Sources and Uses of Funds or the Cash Flow Statement). It explains how an organization obtains cash (sources of funds) and how it spends cash (use of funds) including the borrowing and repayment of debt, capital transactions, and other factors that may affect the cash position.

Contents of Balance Sheet

LIABILITIES Share capital Reserves and surplus Secured loans Unsecured loans Current liabilities & provisions Outstanding expenses Accounts payable ASSETS Fixed assets investments Current assets Loans & advances Miscellaneous expenditure and losses Prepaid expenses

Content of Profit and Loss Account

EXPENSES (Dr) INCOMES (Cr) Administration expenses Trading income Marketing expenses Income from sale of asset Depreciation Interest Bad debts Net profit Rent Interest & dividend commission Miscellaneous incomes

FINANCIAL ACCOUNTANCY

ACCOUNTANCY

COST ACCOUNTANCY

MANAGEMENT ACCOUNTANCY

Financial Accounting
Financial accounting generally refers to the process that results in the preparation and reporting of financial statements for an entity. Financial accounting is primarily externally oriented and concerned with the historical results of an entitys performance.

FINANCIAL ACCOUNTING
Financial accounting is concerned with recording of external transactions of a concern. Financial accounts are concerned with classifying, measuring and recording the transactions of a business in monetary units.
FINANCIAL ACCOUNTING RECORD

PURCHASES,SALE,SERVICES , AND EXPENSES

Managerial Accounting/Cost Accounting

Managerial accounting is concerned with the use of economic and financial information to plan and control many of the activities of the entity and to support the management decision-making process. Cost accounting relates to the determination and accumulation of product, process, or service costs.

Accounting enjoys a remarkable heritage. The history of accounting is as old as civilisation. The seeds of accounting were most likely first sown in Babylonia and Egypt around 4000 B.C. who recorded transactions of payment of wages and taxes on clay tablets. Historical evidences reveal that Egyptians used some form of accounting for their treasuries where gold and other valuables were kept. The in charge of treasuries had to send day wise reports to their superiors known as Wazirs (the prime minister) and from there month wise reports were sent to kings. Babylonia, known as the city of commerce, used accounting for business to uncover losses taken place due to frauds and lack of efficiency. In Greece, accounting was used for apportioning the revenues received among treasuries, maintaining total receipts, total payments and balance of government financial transactions. Romans used memorandum or daybook where in receipts and payments were recorded and wherefrom they were posted to ledgers on monthly basis. (700 B.C to 400 A.D). China used sophisticated form of government accounting as early as 2000 B.C. Accounting practices in India could be traced back to a period when twenty three centuries ago. Kaulilya, a minister in Chandragupta's kingdom wrote a book named Avthashasthra. which also described how accounting records had to be maintained.

How was Accounting Developed?

Luca Pacioli's. a Franciscan friar (merchant class), book Summa de Arithmetica, Geometrica Proportion at Proportionality (Review of Arithmetic and Geometric proportions) in Venice (1494) is considered as the first book on double entry bookkeeping. A portion of this book contains knowledge of business and book-keeping. However, Pacioli did not claim that he was the inventor of double entry book-keeping but spread the knowledge of it. It shows that he probably relied on then-current book-keeping manuals as the basis for his masterpiece. In his book, he used the present day popular terms of accounting Debit (Dr.) and Credit (Cr.). These were the concepts used in Italian terminology. Debit comes from the Italian debito which comes from the Latin debita and debeo which means owed to the proprietor. Credit comes from the Italian credito which comes from the Latin 'credo which means trust or belief (in the proprietor or owed by the proprietor. In explaining double entry system, Pacioli wrote that 'All entries... have to be double entries, that is if you make one creditor, you must make some debtor". He also stated that a merchants responsibility include to give glory to God in their enterprises, to be ethical in all business activities and to earn a profit. He discussed the details of memorandum, journal, ledger and specialised accounting procedures.

How was Accounting Developed?

Mesopotamians record tax receipts on clay tablets.

3000 B.C.

How was Accounting Developed?

Luca Pacioli published first textbook describing a comprehensive doubleentry bookkeeping system.

3000 B.C. 1494

How was Accounting Developed?

The industrial revolution of the 19th century generated the need for large amounts of capital to finance the enterprises that supplanted individual craftsmen.

3000 B.C. 1494 1800s This need resulted in the corporate form of organization and the need to provide investors with reports showing the financial position and the results of operations.

How was Accounting Developed?

Accounting professionals in this country organized themselves in the early 1900s and worked hard to establish certification laws, standardized audit procedures, and other attributes of a profession.

3000 B.C. 1494 1800s 1900s

How was Accounting Developed?

Between 1932 to 1934 the American Institute Accountants and the New York Stock Exchange agreed on five broad principles of accounting.

3000 B.C. 1494 1800s 1900s 1932 1933 to & 1934 1934 The Securities Act of 1933 and the Securities Exchange Act of 1934 of US gave the Securities and Exchange Commission (SEC) the authority to establish accounting principles for companies whose securities had to be registered with the SEC.

How was Accounting Developed?

Although the SEC has the authority to establish accounting principles, the standard-setting process has been delegated to other organizations over the years.

3000 B.C. 1494 1800s 1900s 1932 1933 1939 to to & 1934 1934 1959 The Committee on Accounting Procedure of the American Institute of Accountants issued 51 Accounting Research Bulletins that dealt with accounting principles.

How was Accounting Developed?

In 1959, the Accounting Principles Board (APB) replaced the Committee on Accounting Procedure as the standard-setting body.

3000 B.C. 1494 1800s 1900s 1932 1933 1939 1959 to to & 1934 1934 1959 The APB ultimately issued 39 Opinions on serious accounting issues, but it failed to develop a conceptual underpinning for accounting.

How was Accounting Developed?

The Financial Accounting Foundation (FAF) was created and established the Financial Accounting Standards Board (FASB) as the authoritative standard-setting body within the accounting profession.

3000 B.C. 1494 1800s 1900s 1932 1933 1939 1959 1973 to to & 1934 1934 1959 The FASB has issued 145 Statements of Financial Accounting Standards that have established standards of accounting and reporting for particular issues.

How was Accounting Developed?

The Sarbanes-Oxley Act of 2002 creates a five-member Public Company Accounting Oversight Board (PCAOB) which has the authority to set and enforce auditing, attestation, quality control, and ethics standards for public companies.

3000 B.C. 1494 1800s 1900s 1932 1933 1939 1959 1973 2002 to to & 1934 1934 1959

Objectives of accounting
To maintain records of business To calculate of profit or loss Depiction of Financial Position Ascertainment of Liquidity Position Filing Tax Returns Making information available to various groups

Users and Uses of Accounting Information

User Management Investors

Decision/Informed Judgment Made Planning, direc ting and c ontrolling Assessing amounts, timing, and unc ertainty of future c ash returns on thei investment Creditors Assessing probability of c ollection and th risk of late (or non-) payment Employ ees Planning for retirement and future job prospec ts Sec urities and Reviewing for c ompliance of all required Exc hange Commission information

The users of financial statements

Management Share holders, security analysts and investors Lenders Suppliers/creditors Customers Employees Government and regulating agencies Research and academia

BOOK-KEEPING
Book-keeping may be defined as the art and science of recording all the dealings related to money.

SYSTEM OF BOOK-KEEPING

SINGLE ENTRY SYSTEM

DOUBLE ENTRY SYSTEM

 SINGLE ENTRY SYSTEM :

Single entry system records only one side of the transaction and hence it does not provide complete information about a transaction

DOUBLE ENTRY SYSTEM :

Double entry system records both the sides of the transaction and thus provides complete information of the business transactions

Double Entry System

Now the accounts are invariably maintained in the double entry system which recognizes both cash and credit transactions. Accounts are maintained on accrual basis under this system. A cost incurred is duly accounted for irrespective of whether it is paid or not during that period. In addition all transaction are supposed to have dual aspect- a debit aspect and a credit aspect

TRANSACTION

CREDIT

CASH

In business context, transaction means a monitory activity performed by two of more parties, wherein one gives the benefit and the other receives it.

ACCOUNTING EQUIATIONS:
TOTAL ASSETS =TOTAL LIABILITY
FOR EXAMPLE:CASH Rs.10000 +BUILDING Rs.25000=CAPITAL Rs.25000+LIABILITY Rs.10000 35000=35000

CLASSIFICATION OF ACCOUNTS

PERSONAL

IMPERSONAL

PERSONAL ACCOUNTS

NATURAL

ARTIFICIAL

REPRESENTATIVE

IMPERSONAL ACCOUNTS

REAL ACCOUNTS

NOMINAL ACCOUNTS

TYPES OF ACCOUNTS
1.PERSONAL ACCOUNTS: They are related to either an individual or a private company or a partnership firm etc.
RULES OF ACCOUNTS

DEBIT THE RECEIVER

CREDIT THE GIVER

FOR EXAMPLE: - GOODS PURCHASE FROM X COMPANY Rs.1000/PURCHASES ACCOUNT DR------------ 1000 TO X COMPANY ACCOUNT CR 1000

1.REAL ACCOUNT: - Relate with assets like a Machinery, Building, Land, Cash and Bank*, Stock.
RULES OF ACCOUNTS

DEBIT WHAT COMES IN

CREDIT WHAT GOES OUT

FOR EXAMPLE: - BUILDING PURCHASE Rs.10000/BUILDING ACCOUNT------------DR CASH ACCOUNT --------------------CR

10000/10000/-

1.NOMINAL ACCOUNT: - Relate with income and expenditure of business. For example: - Salary, Wages, Rent, Profit, Commissions received, etc this are example of nominal account.

RULE OF ACCOUNT

DEBIT THE EXPENSES OR GIVER SIDE

CREDIT THE RECEIVER OR INCOME SIDE

FOR EXAMPLE:-Salary paid Rs.1000/Salary Account ---------------------DR To Cash ------------------------CR 1000/1000/-

Rules for Recording in Accounts

NATURE OF ACCOUNT PERSONAL REAL DEBIT CREDIT

The Receiver

The Giver

What Comes in What Goes out

NOMINAL

All Expenses and Losses

All Incomes and Gains

Accounting Concepts
1. Business entity 2. Money measurement 3. Going concern 4. Cost 5. Dual aspect (or Duality) 6. Accounting period 7. Conservatism (Prudence) 8. Revenue recognition (Realization) 9. Matching 10. Full disclosure 11. Consistency 12. Materiality 13. Objectivity

BASIC ACCOUNTING CONCEPTS

1. The Entity Concept- The owners of the business are considered separate and distinct from the business itself. Hence, accounts are kept for the entity as distinguished from the persons associated with the entity. Money Measurement- An accounting record is made only of information that can be expressed in monetary terms. The Going-Concern Concepts- unless there is good evidence to the contrary, it is assumed that the business will operate indefinitely. The Cost Concept- The economic resources of an entity are called assets. An asset is ordinarily entered in the accounting records at the price paid to acquire it- that is, at its cost.

2. 3. 4.

BASIC ACCOUNTING CONCEPTS

5. 6. 7. 8. The Dual-Aspect Concept- Assets= Liabilities+ Owners Equity Accounting Period- Accounting measures activities for a special time interval, usually one (1) specified. Conservatism- revenues are recognized only when they are reasonably certain, whereas Expenses are recognized as soon as they are reasonably possible. Realization- Revenues are usually recognized in the period in which goods were delivered to costumers or in which services were rendered. The amount recognized is the amount that costumers are certain to pay.

9. 10.

BASIC ACCOUNTING CONCEPTS

11.

12. 13.

Matching- when a given event affects both revenues and expenses, the effect on each should be recognized in the same accounting period. Full disclosure: The principle of full disclosure requires that all material and relevant facts concerning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes. Consistency- Once an entity has decided on a certain accounting method, it should use the same method in all subsequent events of the same character unless it has sound reasons to change methods. Materiality- insignificant events may be disregarded, but there must be full disclosure of all important information The concept of objectivity requires that accounting transaction should be recorded in an objective manner, free from the bias of accountants and others.

Basic Underlying Accounting Principles

Revenue Recognition Persuasive evidence of an arrangement exists. Delivery has occurred or services have been rendered The sellers price to the buyer is fixed Collectibility is reasonably assured

Basic Underlying Accounting Principles

The Matching Concept Requires that revenue and expenses related to generating the corresponding revenue be recorded in the same period. As a sale is made, the appropriate charges for COGI or other expenses should be consistent from one accounting period to the next.

Basic Underlying Accounting Principles

Historical Cost Is the proper basis for the recording of assets, expenses, equity, etc. Full Disclosure The financial statements of a firm must include all information necessary for the formation of valid decisions by the users.

Basic Underlying Accounting Principles

Consistency Firms must employ consistent accounting procedures from period to period. Variations or changes in accounting policy and procedures must be justifiable. Standards used to value inventory, depreciate assets, or accrue expenses must be consistent from one accounting period to the next.

Basic Underlying Accounting Principles

Objectivity Accounting records must be designed and kept on objective rather than subjective evidence. Underlying verifiability must exist for the information contained in the financials. The historical cost must be verifiable through legitimate proof of purchase.

Basic Underlying Accounting Principles

Separate Entity Assumption Economic activity of an entity must be kept separate from other personal or business entities

Basic Underlying Accounting Principles

Going Concern Continuity Assumption There is an assumption that the life of an entity will be long enough to fulfill its financial and legal obligations. Any evidence to the contrary must be reported in the financial statements of an entity.

Basic Underlying Accounting Principles

Unit of Measure All financial reports are based on the monetary unit of the firms home country. Adjustments for inflationary trends are not shown in the financial statements of the entity.

Basic Underlying Accounting Principles

Periodicity Time Period Assumption The life of an entity is divided into short economic time periods on which reporting statements are fashioned

Modifying Conventions
Conservatism When considering an accounting matter in which there are two alternatives that equally satisfy conceptual and implementation principles for a transaction the accountant must take the conservative approach, and follow the alternative that will have the least favorable impact on the net income of the entity.

Modifying Conventions
Industry Practices & Peculiarities The peculiarities and practices of an industry (such as banking, investment, insurance etc) May warrant selective exceptions to accounting principles . Some differences in Accounting also occur in response to legal requirements.

Modifying Conventions
Substance over form The economic substance of a transaction determines the accounting treatment , even when the legal aspects of the transaction indicate otherwise. Example : lease contract

Modifying Conventions
Application of Judgment An accountant may depart from GAAP if the results of departure appear reasonable under the circumstances, especially when the strict adherence to GAAP will produce unreasonable results.

Modifying Conventions
Materiality The amount of an item is material if its omission would affect the judgment of a Reasonable person who is relying on the financial statements.