What is Accounting?
Accounting is the art of recording, classifying, summarising and analyzing business transactions and interpreting the results thereof. In accounting, only those transactions and events are recorded which can be measured in terms of money.
The basic objective of accounting is to provide the desired information to the owner as well as to all other interested parties i.e. investors, creditors, employees, financial institutions, government etc.
In short, we can say that accounting is the language of business by which all the financial and other information are communicated to various interested parties.
Table of Contents
- 1 What is Accounting?
- 2 Introduction to Accounting
- 3 Definition of Accounting
- 4 Characteristics of Accounting
- 5 Divisions of Accounting
- 6 Functions of Accounting
- 7 Qualitative Characteristics of Accounting Information
- 8 Methods of Accounting
- 9 Concept of Accounting Process
- 10 Objectives of Accounting
- 11 Users of Accounting Information
- 12 Advantages of Accounting
- 13 Limitation of Accounting
- 14 Accounting Process
Introduction to Accounting
Accounting is a business language which explains the various kinds of transactions during a given period of time. Accounting is used by business entities for keeping records of their money or financial transactions.
A businessman who invested money in his business would like to know whether his business is making a profit or incurring a loss, the position of his assets and liabilities and whether his capital in the business has increased or decreased during a particular period. The main object of a business house is to earn profit. Accounting is the medium of recording business activities and it is considered a language of business.
To find out the results of a business, the information relating to the cost of the products and revenues from the products is collected. Then the costs and revenues are compared to find out the profit or loss of the business. If volume of sales of the products is high and the number of transactions of the business is very high, it is impossible to keep all these transactions in the mind of a businessman.
Thus a need of recording of all these business transactions rose. The recording of business transactions or activities is done through a process of accounting.
Definition of Accounting
The Accounting definition is given by the American Institute of Certified Public Accountants (‘AICPA’) clearly brings out the meaning of accounting. According to it, 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”.
As per Robert N. Anthony, “Accounting system is a means of collecting, summarizing, analyzing and reporting, in monetary terms, information about the business”.
As per Smith and Ashburne, “Accounting is the science of recording and classifying business transactions and events, primarily of a financial character and the art of making significant summaries, analysis and interpretations of these transactions and events and communicating the results to persons who must take decisions or form judgment.”
As per R.N. Anthony “Nearly every business enterprise has accounting system, it is a means of collecting, summarising and reporting in monetary terms, information about business.”
Characteristics of Accounting
Following are the characteristics of accounting:
- Accounting is an art which it helps us in attaining our aim of ascertaining the financial results, that is, operating profit and financial position. Analysis and interpretation of financial data require special knowledge, experience and judgement.
- In accounting the financial transactions are recorded in the Journal. With the help of Journal, the recorded data are classified into ledger under appropriate heads. Then with the help of ledger the trial balance and financial statements are prepared.
- It records only those transactions and events which are of financial character: If a transaction has no financial character then it will not be measured in terms of money and not recorded.
- It records transactions in terms of money. All transactions are recorded in terms of common measure i.e. money.
- On account of recording of business transactions in a systematic manner, it is also called a science. First the business transactions are recorded in the primary books i.e. Journal, for classification the ledger is prepared.
With the help of ledger the Trial Balance, Profit and Loss account and Balance Sheet is prepared. Profit and Loss account is prepared after a period to find the result of the business and Balance Sheet to know the financial position of the business
Divisions of Accounting
Accountants tend to specialize in various types of accounting work and this has resulted in the development of different branches of accounting. Some of the divisions of accounting are given as:
- Financial Accounting
- Management Accounting
- Cost Accounting
- Tax Accounting
- Social Accounting
- Human Resource Accounting
- National Accounting
- Green Accounting
- Creative Accounting
- Forensic Accounting
Accounting designed or meant for outsiders is known as financial accounting. It is concerned with the recording of business transactions and the periodic preparation of income statement, balance sheets and cash flow statement from such records.
It is concerned with the interpretation of accounting information to guide the management for future planning, decision-making, control, etc. Management accounting, therefore, serves the information needs of the insiders, e.g., owners, managers and employees.
It has been developed to ascertain the costs incurred for carrying out various business activities and to help the management to exercise strict cost control.
This branch of accounting has grown in response to the difficult tax laws such as relating to income tax, sales tax, excise duties, customs duties, etc. An accountant is required to be fully aware of various tax legislations.
This branch of accounting is also known as social reporting or social responsibility accounting. It discloses the social benefits created and the costs incurred by the enterprise. Social benefits include such facilities as medical, housing, education, canteen, provident fund and so on while the social costs may include such matters as extra hours worked by employees without payment, environment pollution, unreasonable terminations, etc.
Human Resource Accounting
It is concerned with the human resources of an enterprise. Accounting methods are applied to evaluate the human resources in money terms so that the society might judge the total work of the business enterprises including, its non-human assets.
It is, therefore, accounting for the people of the organisation. Unfortunately, no objectively verifiable method has been developed for universal application.
The accounting for the resources of the nation as a whole. It is generally not concerned with the accounting of individual business entities and is not based on generally accepted accounting principles. It has been developed by economists and statisticians.
The concept of green accounting is related to the calculation of national income in which standard measures of income and output are Gross National Product (GNP) Gross Domestic Product (GDP) Gross National Income (GNP) etc.
In simple words, Green Accounting is a kind of accounting that tries to take into consideration the environmental costs in the calculation of the operating income of an enterprise. Green Accounting discloses or emphasizes more clearly about the quality of economic growth in terms of sustainable development.
It is the primary duty of the persons in accounting professions, the accountants, to report a true and fair view of the financial statements, namely: the profit and loss account and the balance sheet.
Creative accounting is nothing but the manipulation of the operating results and financial position of the company, of course, within the confines (limits) of the accounting standards.
Financial scams and frauds in accounting practices have drawn attention of the users of the accounting information supplied by business enterprises. Even the well-governed multinational companies like Enron and other World companies have not escaped from the fraudulent accounting practices.
Auditors who are also qualified accountants have the increased responsibility of detecting the frauds and scams in the corporate world
Functions of Accounting
As mentioned earlier, accounting information is used by different stakeholders, especially the management, to decide the future course of action for the organisation.
There are three main functions of accounting, which are explained as follows:
These functions of accounting include the following:
- Recording, classifying and summarising the financial transactions of an organisation
- Analysing the financial data
- Representing the financial position of the organisation by displaying various results such as net profit, credit, debit, loan, etc.
- Communicating the financial information to the interested stakeholders.
These functions of accounting include the following:
- Formulating a financial policy
- Conducting planning
- Preparing budget and controlling costs
- Preventing financial errors and frauds
Statutory compliance function
These functions include the following:
- Submitting financial statements such as profit and loss account, balance sheet, etc. to regulatory bodies as a legal and regulatory requirement
- Providing the bases for filing returns for both direct and in- direct taxes
Qualitative Characteristics of Accounting Information
Relevance: Financial information obtained through financial statements should be according to the objectives of the organization. The objective-oriented information helps the investors, managers and creditors to take decisions about the business. The information should be given according to the priorities and needs of each and every interested party.
Financial Information should be based on facts which can easily be verified. Financial information can be verifiable if it is based on original source documents. Source documents include cash memo, purchase invoices, sales invoices, property transfer papers and written agreements, etc.
Financial information should be presented in a simple and easy way so that the users i.e. investors, debenture holders, employees and government officials can understand it easily. It should be simple enough even for a person who is not aware about the rules and terms used in accounting. Some explanatory notes should be given so as to make the information more understandable.
The financial statements must show corresponding information for the preceding year(s) so that the users may be able to compare the financial performance, position and cash flows of different years. The measurement and display of the net financial effects of similar type of transactions must be treated in a consistent form.
Methods of Accounting
It is an incomplete system of recording business transactions. The business organization maintains only cash book and personal accounts of debtors and creditors. So the complete recording of transactions cannot be made and trail balance cannot be prepared.
Double Entry System
The double entry system is based on scientific principles and is, therefore, used by most of business houses. The system recognizes the fact that every transaction has two aspects and records both aspects of each and every transaction.
Under this system, in every transaction an account is debited and other account is credited. The crux of accountancy lies in finding out which of the two accounts are affected by a particular transaction and out of these two accounts which account is to be debited and which account is to be credited.
Concept of Accounting Process
Accounting process is the complete sequence of accounting procedures which begin with the recording of business transactions from source documents in the Journal or in subsidiary books, as the case may be, and end with the preparation of two basic financial statements, namely Income Statement (or profit and loss account) and Balance Sheet. In the case of Limited Liability Companies, the Cash Flow Statement is also prepared.
The essential steps in the Accounting Process are:
- To enter the transactions in the source documents such as purchase invoice, sales invoice, cash receipts, bank pay-in-slips etc.
- To record or enter the transactions in the Journal or in subsidiary books, as the case may be.
- Classifying the transactions (i.e., the entries found in the Journal or Subsidiary Books) to post or transfer those entries in the appropriate accounts in the ledger.
- To enter the adjustments, if any, in the Journal.
- To balance the various accounts in the ledger to prepare the trial balance in order to check the arithmetical accuracy of the ledger accounts.
- To prepare the final accounts or final statements in the form of trading and profit and loss account (i.e., income statement) and Balance Sheet from the Trial Balance, at the end of the accounting period to ascertain profit or loss of the business for the accounting period and the financial position of the business at the end of the accounting period.
Objectives of Accounting
Following are the objectives of accounting:
- Maintaining systematic records
- Communicating the financial results
- Meeting legal needs
- Fixing responsibility
Maintaining systematic records
Business transactions are properly recorded, classified under appropriate accounts and summarized into financial statement.
Communicating the financial results
Accounting is used to communicate financial information in respect of net profits (or loss), assets, liabilities etc., to the interested parties.
Meeting legal needs
The provisions of various laws such as Companies Act, Income Tax and GST Acts require the submission of various statements, i.e., annual account, income tax returns and so on.
Accounting assists the management in the task of planning, control and coordination of business activities.
In the case of limited companies, the management is entrusted with the resources of the enterprise. The managers are expected to act true trustees of the funds and the accounting helps them to achieve the same.
Accounting helps in the computation of the profits of different departments of an enterprise which help in fixing the responsibility of departmental heads.
Users of Accounting Information
- Prospective Investors
- Creditors, Bankers and other Lending Institutions
The primary aim of accounting is to provide necessary information to the owners related to business.
In large business organizations and in corporations, there is a separation of ownership and management functions. The management of such business are more concerned with the accounting information because they are answerable to the owners.
The person who is contemplating an investment in a business will like to know about its profitability and financial position. They derive this information from the accounting reports of the concern.
Creditors, Bankers and other Lending Institutions
Trade creditors, bankers and other lending institutions would like to be satisfied that they will be paid on time. The financial statements help them in judging such position. Banks and other lending agencies rely heavily upon accounting statements for determining the acceptability of a loan application.
The Government is interested in the financial statements of business enterprise on account of taxation, labour and corporate laws.
Employees are interested in financial statements on accounts because their wage increase and payment of bonus depend on the size of the profit earned.
Customers may also have either short-term or long-term interest in the reporting entity or long-term interest in the reporting entity and they may be satisfied with the profitability, liquidity and solvency position.
Advantages of Accounting
Following are the advantages of accounting:
- Helpful in the Determination of Financial Results
- Comparison of Results
- Assistance to Management
- Helpful in Assessing the Tax Liability
- Helpful in the Case of Insolvency
- Provides Information to Interested Parties
- Raising of Funds Become Easy
Helpful in the Determination of Financial Results
Accounting is very useful in the determination of the profit and loss of a business and showing the financial position of the business.
Comparison of Results
Accounting information when properly recorded can be used to compare the results of one year with those of earlier years so that the significant changes can be analyzed.
Assistance to Management
The accounting information helps the management to plan its future activities by preparing budgets in respect of sales, production, expenses, cash, etc. Accounting helps in the coordination of various activities in different departments by providing financial details of each department.
The managerial control is achieved by analyzing in money terms the departures from the planned activities and by taking corrective measures to improve the situation in future.
Helpful in Assessing the Tax Liability
Generally, a businessman has to pay corporate tax, VAT and excise duty, etc. Therefore, it is necessary that proper accounts should be maintained to compute the tax liability of the business.
Helpful in the Case of Insolvency
Sometimes the businessman becomes insolvent. If he has properly maintained the accounts, he will not face the problems in explaining few things in court.
Provides Information to Interested Parties
Interested parties like owners, creditors, management, employees, customers, government, etc. are interested in accounting information.
Raising of Funds Become Easy
It helps in raising funds from investors or financial institutions by promising investors a fixed claim (interest payments) on the cash flows generated by the assets, with a limited or no role in the day-to-day running of the business.
Limitation of Accounting
Following are the limitation of accounting:
- Recording of Monetary Items Only
- Effect of Inflation
- Accounting Information May be Biased
- Conflict Between Accounting Principles
Recording of Monetary Items Only
In accounting, only those transactions, which have monetary value, are recorded. And those transactions which do not have financial value whether those are important in business are not recorded in the accounting.
Effect of Inflation
In accounting, the transactions are recorded at the historical cost. Accordingly, the assets of the business are shown at cost in the balance sheet. Thus the balance sheet prepared on the basis of historical cost ignores the price-level changes (inflation). In this way, the balance sheet of the business does not present the true and fair picture of the business.
Accounting Information May be Biased
Accounting information is not without personal influence or bias of the accountant. In measuring income, accountant has a choice between different methods of inventory valuation, deprecation methods, treatment of capital and revenue items etc. Hence, due to the lack of objectivity income arrived at may not be correct in certain cases.
Conflict Between Accounting Principles
In accounting, one accounting principle conflicts another. For instance, inventory should be valued on the basis of ‘least of the cost and market price’ as per the principle of conservatism.
Accounting process involves the following steps or stages:
- Identification of Transaction
- Recording the Transaction
- Presentation of Financial Information
Identification of Transaction
In accounting, only business transactions are recorded. A transaction is an event which can be expressed in terms of money and which brings a change in the financial position of a business enterprise. An event is an incident or a happening which may or may not being any change in the financial position of a business enterprise.
Therefore, all transactions are events but all events are not transactions. A transaction is a complete action, to an expected or possible future action. In every transaction, there is a movement of value from one source to another.
For example, when goods are purchased for cash, there is a movement of goods from the seller to the buyer and a movement of cash from buyer to the seller. Transactions may be external (between a business entity and a second party, e.g., goods sold on credit to Hari or internal (do not involve a second party, e.g., depreciation charged on the machinery).
Recording the Transaction
Journal is the first book of original entry in which all transactions are recorded event-wise and date-wise and presents a historical record of all monetary transactions. It may further be divided into sub-journals as well which are also known subsidiary books.
Accounting is the art of classifying business transactions. Classification means statement setting out for a period where all the similar transactions relating to a person, a thing, expense, or any other subject are groped together under appropriate heads of accounts.
Summarising is the art of making the activities of the business enterprise as classified in the ledger for the use of management or other user groups i.e. Sundry debtors, Sundry creditors etc. Summarisation helps in the preparation of Profit and Loss Accounts and Balance sheet for a particular fiscal year.
Analysis and Interpretation The financial information or data as recorded in the books of an account must further be analyzed and interpreted so to draw useful conclusions. Thus, analysis of accounting information will help the management to assess in the performance of the business operations and forming future plans also.
Presentation of Financial Information
The end users of accounting statements must be benefited from analysis and interpretation of data as some of them are the ‘stock holders’ and other one the ‘stakeholders’. Comparison of past and present statements and reports, use of ratio analysis and trend analysis are the different tools of analysis and interpretation.
From the above discussion, one can conclude that accounting is a art which starts and includes steps right from recording of business transactions of monetary character to the communicating or reporting the results thereof to the various interested parties.