Lesson-1

FUNDAMENTALS OF ACCOUNTING AND MANAGEMENT – I ACCOUNTING: AN OVERVIEW 1. Accounting: Meaning, Nature and Role in Business The starting point for the unit on fundamentals of accounting and management is to first understand the concept of accounting. It is also important to appreciate the role that accounting plays in business and the importance of various branches of accounting.

This is the subject matter of the present lesson. In the subsequent lessons further conventions of accounting and financial statements will be discussed.

1.0

Objectives After going through this lesson, you will be able to:

• • • • •

1.1

Understand accounting as a business language Appreciate the need for accounting Read the Balance Sheet and Profit and Loss account for a company Understand the process flow of accounting Acknowledge the importance of various branches of accounting

Introduction This lesson familiarises you with the use of accounting as a business language and the need for accounting, the various branches of accounting and its mechanisms.

You should try in the first place to understand the meaning of accounts and very clearly try to grasp the mechanism involved in account preparation to make a successful journey ahead for further lessons. You should, to start with, correlate the situation. For example, if your household income and expenses have to be accounted for, the income is earned and expenses are utilized from income, the balance is saving. It is a similar case with professional accounting, only at a larger scale, which you will learn in forthcoming lessons.

1.2

Definition of Accounts Every business, whether public or private, large or small, profit making or non profit making is a '‘financial concern”. Most decisions taken in business involve finance, and its success or failure depends, to a great extent, on the quality of its financial decisions.

1

Anyone who is involved in business is primarily concerned with the profit or loss made and the current situation of the business. These can be known only if the transactions resulting to the business are recorded in a systematic manner. This is how the principle of accounting came into the picture. The American Institute of Certified Public Accountants (AICPA) has defined Accountancy as “Accounting is the art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events which are of a financial character and interpreting the results thereof.”

Accounting is also considered as the language of business, which communicates, or reports, the result of the business transactions or operations carried out during a particular period of time to its various users.

The process of recording the business transactions in a defined set of records which in technical terms is called the Book of Accounts and is referred to as Book keeping, which is “the art of keeping accounts in a regular and systematic manner “. Bookkeeping and Accountancy practically mean the same thing, although the term Accountancy is usually used for accounting work of a higher order. Accountancy also refers to the process of analyzing and interpreting the information already recorded in the Books of Accounts with the final intention of answering the above stated questions.

Self-Check Questions 1. Do Book Keeping & Accountancy mean the same thing?

1.3

Branches of Accounting The total accounting process can be split into three branches which are briefly described as follows:

1.3.1 Financial Accounting Financial accounting is the systematic recording of the business transactions in the various Books of Accounts maintained by an organisation, with the ultimate intention of preparing the financial statements.

The end product of financial accounting is the Profit and Loss account and the Balance Sheet. These terms are defined below: •

2

Annual Profit and Loss statement – This indicates the income and expenses of an organisation showing how much profit the organisation has earned in a particular period, usually a year.

•

Balance Sheet – This indicates the state of affairs of the organisation at any given point of time, in terms of what it possesses (assets), what it owes to others (liabilities) and how much belongs to the proprietors (capital).

1.3.2 Cost Accounting The Institute of Cost and Management Accountants London has defined Cost Accounting as “the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability as well as the presentation of information for the purpose of managerial decision making”.

Cost Accounting seeks to ascertain the cost of each product or job produced or undertaken by the firm. In financial accounting, the expenditure incurred is recorded but in cost accounting the same expenditure is analysed job-wise or product-wise. For example, payments towards administration expenses are recorded as an expense in financial accounting, while in cost accounting these expenses are bifurcated into those incurred for factory and office.

1.3.3 Management Accounting Management accounting can be defined as the process of analysis and interpretation of financial data collected with the help of financial accounting and cost accounting. The objective of Management Accounting is to draw certain conclusions to assist the management in the process of decision making.

In earlier days when business volumes were small, financial accounting was considered to be sufficient. As businesses progressed however, financial accounting was realized to be insufficien,t which is primarily due to certain limitations within financial accounting.

In today’s modern and competitive era for businesses, financial accounting and preparation of financial statements are not sufficient for the successful and smooth running of businesses. The analysis and interpretation of financial accounting data is also considered to be necessary, which may not be available in financial accounting. This is how Management Accounting came into the picture.

The Institute of Chartered Accountants of England and Wales has defined Management Accounting as “any form of accounting which enables a business to be carried out more efficiently”.

In today’s competitive era, Management Accounting has become an invaluable part of any business. Its salient features are: • • •

It facilitates management in taking decisions by providing required information to them.

It uses not only historical data but projections and forecasts for evaluation of alternatives.

It assists management to attain economic objectives and take proper decisions.

3

•

It involves application of various special techniques and concepts for attainment of objects.

Financial accounting is historical while management accounting is forward looking and may relate to the future.

Self-Check Questions Answer True or False 2. Profit and Loss account is prepared for a period.

3. Balance Sheet is prepared for a period.

4. On what basis data is normally recorded under financial accounting, historical cost or current cost?

1.4

Role of Accounting in Business Accounting plays a critical role in business. The salient advantages to a business, if a proper system of accounting is followed, are the following:

1.4.1 Maintaining of records Accounting provides a systematic approach for recording business transactions.

The transactions are recorded in an orderly manner, classified, and then summarised to shed light on financial results and financial positions.

1.4.2 Ascertainment of profit & loss Accounting helps to assess in a business how much profit it has earned or how much loss it has incurred in a particular period. This is essential for the business to know whether it is moving on the right path or not. Take the case of a hospital, college or a charitable trust whose primary purpose is not to seek profit, but is also in knowing whether its current income is sufficient to meet the expenditure.

In order to judge whether business is moving on right path or not, the Profit and Loss Account or the Income and Expenditure Account is prepared. By knowing whether the business is making profit or loss, the reasons leading to the profit or loss may also be ascertained. This knowledge will enable the firm to take the necessary corrective action to increase profits and also to convert losses into profits.

1.4.3 Determination of financial position

4

Accounting helps all the businesses whether seeking to earn a profit or not, to ascertain periodically the financial position of the business i.e. the assets and liabilities. This is judged by the preparation of the Balance Sheet which is the statement setting out the assets, liabilities and capital of the concerned business.

A comparative study of the firm’s Balance Sheet for various years helps in understanding a firm’s progress.

1.4.4 Control over assets It is extremely important for all businesses to see that all assets and properties of an organisation are used only in its own interest and should be disposed off only in an authorised manner. Frauds, misappropriations or unnecessary losses have to be avoided. By following proper accounting practices in respect of individual assets and liabilities, this objective can be achieved.

1.4.5 Providing information to tax authorities and other government agencies Proper accounting practices assist in providing the required information to all government authorities such as income tax and sales tax authorities. The tax authorities require a good deal of information for a proper assessment.

1.4.6 Evidence in Courts In order to settle disputes in courts, accounting records serve as evidence to resolve disputes.

1.4.7 Comparative Analysis Accounting records comparisons.

help

businesses

in

making

intra-firm

&

inter-firm

Self-Check Questions 5. Is Profit & Loss account or Income and Expenditure account the same?

1.5

Accounting Mechanism Accounting, in order to communicate the results of the operations of a business, records business transactions, classifies them, summarises and presents them in a manner useful for interpretation. The various steps involved in the accounting procedure are briefly described as under:

1.5.1 Transaction

5

The starting point for accounting is a business transaction. Transaction refers to exchange of goods or services between two parties in which one is the receiver and the other is the giver. It involves transfer of money or money’s worth from one party to another. For example, purchase of furniture, sale of goods etc.

However an “Order” to purchase or sell goods is not a transaction as it does not involve transfer of money or money’s worth. Only the actual sale or purchase of goods is a transaction as it now involves transfer of money or money’s worth.

A transaction is evidenced by a document called ‘voucher’. Take the case of the purchase of raw material. A purchase voucher gives the details of the material purchased, the name of the party from whom goods have been purchased either on credit or on cash. Similarly, ‘receipt’ for the payment of a rent is the voucher for the transaction of ‘payment of rent’.

1.5.2 Recording Every business transaction has two aspects and these transactions are recorded in various Books of accounts on the basis of vouchers. Such Books of accounts include Cash Book and Journal. This system of recording is called the Double Entry Book Keeping system. The transactions are evidenced by some documentation and on the basis of documentary evidence they are recorded in Books of accounts. The Journal is a book to record all those transactions which are not recorded in any specific book.

1.5.3 Classification The next step in accounting procedure is to classify the recorded information into related groups like salaries, rent payments, raw material, etc. Classification helps to put information in compact and usable form. This is done by analyzing the transactions recorded in the Books of accounts and posting transactions of a similar nature under one head. The book containing classified information is called the ‘Ledger Book’. For example, all transactions relating to ‘salaries’ may be posted in ‘salaries account’, or those relating to ‘rent paid’ may be posted in ‘rent payment account’.

1.5.4 Summarisation The basic objective of accounting is to generate financial information useful to decision makers. To achieve this objective, accounts containing classified information in the ledger are balanced and a statement of accounts having balances is prepared known as “Trial Balance”. On the basis of Trial Balance, summaries are prepared to give useful information about financial results of a particular period and financial position at a given point of time. All Ledger accounts are balanced periodically, say, at the end of a month, and the account balances are placed together.

6

INPUT

PROCESS

DATA

FUNCTION

OUTPUT

INFORMATION

RECORDING IDENTIFICATION OF MEASUREMENT DOCUMENTS: • VOUCHERS • BILLS • INVOICES

CLASSIFYING SUMMARISING ANALYSING

DECISION MAKERS • Management • Investors • Lenders • Suppliers • Govt. employees

INTERPRETING COMMUNICATING

Accounting Mechanism

As in any system, and also in the accounting mechanism shown above, the system consists of an Input and a process which finally results in an Output.

In the Input stage we have the source / raw data like bills, vouchers, invoices etc.

This raw data is recorded, classified, summarised, analysed, interpreted and communicated. Thus in the last stage we have the output i.e. the information which is useful to the Management, investors, lenders, suppliers and other agencies.

Self-Check Questions 6. List the various steps involved in a standard accounting procedure?

7

1.6

Summing Up In this lesson, you have familiarised yourself with the term accountancy, the various branches of accounting, the role played by accountancy in business and the standard steps followed in an accounting procedure.

1.7

Answers to the Self-Check questions.

1. Yes 2. Only statement no. 1 is correct. A balance sheet is prepared as on a particular date (a given point of time) 3. True 4. Historical cost 5. Yes 6. Steps involved in a standard accounting procedure: Transaction, Recording, Classification, Summarisation

1.8

Terminal Questions

1. List the advantages of following a proper system of accounting practices for a business?

2. Is it necessary for an enterprise not carrying out business for profit to implement the accounting system and procedures? Explain.

3. What is the difference between Financial Accounting and Cost Accounting?

1.9

References

1. Grewal, T.S. Introduction to Accountancy; S Chand & Company 2. Dhameja, N., Financial Management

1.10 Suggested Further Reading 1. Weygandt, J.J., Kieso, D.E., & Kimmel, P.D. (2000). Financial accounting (University of Phoenix Special Edition Series). New York: Wiley 2. Needles Jr, B.E., Power, M. & Crosson, S.V. (2005). Financial and Managerial Accounting". New Delhi: BizMantra Publishers.

3. Gupta. Financial Accounting for Management: An Analytical Perspective. New Delhi: Pearson Education.

1.11 Glossary •

8

Account - Account is the record of all the transactions pertaining to a person, asset, liability, income or expenditure which have taken place during a specified period and shows the net effect of all these transactions finally.

•

• •

• • •

• • • • • • • • • • • • •

• • •

Accounting period - A period of twelve months for which the accounts are maintained. Generally it is the Financial year starting 1st April and ending 31st next year. It could be also any other period as decided by the organisation.

Assets - All the properties owned by the business are collectively referred to as the assets of the business.

Balance Sheet - Balance Sheet is the summarised statement of what the business owns i.e. assets and what the business owes i.e. liabilities at any given point of time.

Books of Account - Books in which the transactions are recorded.

Business - Activity carried with profit motive.

Capital - Capital indicates the amount of funds invested by the owners (i.e. by proprietors in case of individual, by partners in partnership business and shareholders in a joint stock company).

Credit Side - Credit side of the account is right hand side of the account.

Creditor - Amount due to persons from whom goods or services are received in credit.

Debit Side - Debit side of the account is left hand side of the account.

Debtor - Persons from whom amount is due for goods sold or services rendered on credit.

Drawings - Drawings indicate the amount of funds or goods withdrawn by the owner of the business for the personal use.

Entry - Entry means the record of a financial transaction in the books of accounts.

Expenditure - Expenditure means spending of money or incurring an obligation to pay at a later date.

Expense - Expense means an expenditure whose benefit is enjoyed and finished immediately or almost immediately. Examples are payment of wages, rent etc.

Financial Position - Position of Assets and liabilities of a business at a given point of time.

Gain - Gain means acquisition of some asset or the extinguishing of liability without any effort. For example, increase in the value of land.

Income - Income means receipt of cash or equivalent without it having to be returned to any one. For example receipt of proceeds on sale of goods.

Liabilities - All the amounts owned by the business to various providers of funds or services are collectively referred to as liabilities.

Losses - Losses are usually taken to include expenses also. However losses should be used for money (or money’s worth) given up without any benefit.

Examples are loss due to fire, payment of damages to others etc.

Profit and Loss Account - An account showing profit or loss of business during an accounting period Trial Balance - A summary of closing balances of all accounts which could be either debit or credit. The Trial Balance should always tally.

Transaction - Transaction means transfer of money or money’s worth from one party to another. For example, purchase of furniture, sale of goods etc.

9