CHAPTER 1: INTRODUCTION TO ACCOUNTING

1) Definition of Accounting:
In 1941, The American Institute of Certified Public Accountants
(AICPA) defined accounting as 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 financial
character, and interpreting the results.
In 1966, The American Accounting Association (AAA) defined
accounting

as

the

process

of

identifying,

measuring

and

communicating economic information to permit informed judgments

and decisions by users of information.
Accounting can be defined as the process of recording,
classifying,

summarizing,

analyzing,

interpreting

the

financial transactions and communicating the results to the

interested users of such information.

2) Functions of Accounting:
a) Recording:
This is the basic function of accounting.
Concerned with all business transactions of financial character are
recorded.
Recording is done in the book Journal
Journal is sub-divided into Cash Journal(for

recording

cash

transactions), Purchases Journal(for recording credit purchase of

goods), Sales Journal(for recording credit sales of goods).

b) Classifying:
Concerned with the systematic analysis of the recorded data, with
a view to group transactions or entries of one nature at one place.
The classification is done in the book termed as Ledger
Ledger contains different or separate individual account heads
under which all financial transactions of similar nature are
collected. For e.g.: There are separate account heads for Travelling
expenses, Printing & stationary, Advertising.
All expenses under these heads after being recorded in the Journal
will be classified under separate heads in the Ledger, which will
help in finding out the total expenditure incurred under each of the
above heads.
c) Summarizing:
Involves in presenting the classified data in a manner which is
understandable and useful to the internal as well as external endusers of accounting statements.
This process leads to preparation of Trial balance, Income
Statement, Balance Sheet.
d) Analyzing & Interpreting:
The recorded financial data is analysed and interpreted in a
manner that end-users can make a meaningful judgement about
the financial condition and profitability of the business operations.
Analysis is methodical classification of the data given in the
financial statements. For e.g.: All items related to Current Assets
are put at 1 place while all items related to Current Liabilities are
put at another place.
Interpretation means explaining the meaning and significance of
the data so simplified.
e) Communicating:

 Preparation and distribution of accounting reports, which include

income statement, balance sheet and additional information in the
form

of

accounting

ratios,

graphs,

diagrams,

funds

flow

statements, cash flow statements.

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.

3) Users of Accounting Information:

Users of Accounting Information

External

Internal
-Management-BOD/MD
-Partners
Individual proprietor

Direct Financial Interest

Indirect Financial Interest
--Shareholders
--Regulators
--Banks/ financial institutions
--Employees
--Creditors
--Customers
--General public
--Research scholars

The main users of accounting information may be broadly

classified into Internal and external users.
Internal users: Management- it refers to the group of people who
are responsible for operating the business aimed at achieving
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organizational

goals.

Management

refers

to

accounting

information as a tool.
That enables them in planning, executing, evaluating and
controlling the business activities of the organization.
External users are individuals and organizations who have present
and future economic interest in the business but not a part of the
management team. It includes those who have a direct financial
interest like-- Shareholders/ investors use accounting information to make
decisions on future investment and to protect their current
holdings.
Creditors/ banks/ financial institutions use accounting information
to appraise the financial soundness of the business and judge the
risks involved in lending to the concerned organizations.
Apart from these there are others who have an indirect financial
interest in the accounting information of the organization. They
may be categorized as:
Government/ Regulators that are appointed to regulate business
activities and certain types of business. Agencies like SEBI, Board
of Industrial Finance and Reconstruction (BIFR), Income Tax and
Sales Tax authorities keep a track on accounting information
brought out by organizations. This information is used by agencies
primarily to protect the interest of investors and to collect revenue
for the government in the form of direct and indirect taxes.
Employees of an organization are interested in knowing about the
stability, continuity and growth of their organization. It also
enables them to protect their legitimate demands like pay revision
and bonus.

 Customers- to establish good accounting control so that cost of

production may be reduced with the resultant reduction of prices
of goods offered in the market.
Research scholars and analysts use accounting information to
study, analyses and forecast the future of an organization or to
study the industry as a whole in various parameters like
profitability, performance etc.
General public- the public is interested in the functioning of the
organization as it may make a substantial contribution to the local
economy in many ways.

4) Objectives of Accounting:
a. Systematic recording of transactions:
The basic objective of Accounting is to systematically record of all
financial aspects of business (i.e.) Book Keeping.
These recorded classifications are later on

classified

and

summarized logically for preparation of financial statements and

for their analysis and interpretation.
b. Ascertainment of operational profit or loss:
Ascertainment of profit earned or loss sustained by a business
during an accounting period can be done with help of record of
incomes and expenses relating to the business by preparing a
profit or loss account for the period.
If revenue exceed expenses then it is said that business is running
profitably but if expenses exceed revenue then it can be said that
business is running under loss.
The profit and loss account helps the management and different
stakeholders i.e. taking rational decisions. For example, if business
is not proved to be profitable, the cause of such a state of affair
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can be investigated by the management for taking remedial

steps.
c. Ascertainment of the financial position of the business:
Businessman is not only interested in knowing the results of the
business in terms of profits or loss for a particular period but is
also anxious to know that what he owes (liability) to the outsiders
and what he owns (assets) on a certain date.
To know this, accountant prepares a financial position statement
popularly known as Balance Sheet or position statement.
The balance sheet is a statement of assets and liabilities of the
business at a particular point of time and helps in ascertaining the
financial health of the business.
d. Providing information to the users for rational decisionmaking:
Accounting as a language of business communicates the
financial results of an enterprise to various stakeholders by means
of financial statements.
Accounting aims to meet the information needs of the decisionmakers and helps them in rational decision-making.
e. To know the solvency position:
By preparing the balance sheet, management not only reveals
what is owned and owed by the enterprise, but also it gives the
information regarding concerns ability to meet its liabilities in the
short run (liquidity position) and also in the Long-run (solvency
position) as and when they fall due.

5) Book Keeping:

 Book Keeping is an activity concerned with the recording of

financial data relating to business operations in a significant and
orderly manner.
It covers procedural aspects of accounting work and embraces
record keeping function.
Book keeping procedures

are

governed

by

the

financial

statements. In India, the term financial statements means Profit

and Loss Account and Balance Sheet including Schedules and
Notes forming part of Accounts.
As we know, Profit and Loss Account gives result of economic
activities for a period and Balance Sheet states the financial
position at the end of the period, Book-keeping also requires
suitable classification of transactions and events. This is also
determined

with

reference

to

the

requirement

of

financial

statements.
A book keeper may be responsible for keeping all the records of a
business or only of a minor segment, such as position of the
customers accounts in a departmental store.
The essential idea behind maintaining book keeping records is to
show correct position regarding each head of income and
expenditure.
A business may purchase goods on credit as well as cash. When
the goods are bought on credit, a record must be kept of the
person to whom money is owed.
The proprietor of the business may like to know, from time to time,
what account is due on credit purchase and to whom. If proper
record is not maintained, it is not possible to get details of the
transactions in regard to the expenses.
At the end of the accounting period, the proprietor wants to know
how much profit has been earned or loss has been incurred during
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the course of the period. For this lot of information is needed which
can be gathered from a proper record of the transactions. So Book
keeping is very essential.
6) Objectives of Book keeping:
A. Complete Recording of Transactions :

It is concerned with complete and permanent record of all

transactions in a systematic and logical manner to show its
financial effect on the business.
B. Ascertainment of Financial Effect on the Business:
It is concerned with the combined effect of all the transactions
made during the accounting period upon the financial position of
the business as a whole.

7) Distinguish between Book Keeping and Accounting:

Book-keeping is the recording phase while accounting is concerned
with the summarizing phase of an accounting system.
Book-keeping provides necessary data for accounting
accounting starts where book-keeping ends.

and

8) Types of Accounting:
I. Financial Accounting:
It is the original form of accounting.
Financial accounting covers the preparation and interpretation of
financial statements & communication to the users of accounts.
It is historic in nature as it records transactions which have already
been occurred.
The final step of accounting is the preparation of profit and loss
account, and balance sheet.
It primarily helps in determination of the net result for an
accounting period and the financial position as on the given date.
II.

Management Accounting:
It is concerned with internal reporting of necessary accounting
information to the people within the organization (managers of a
business unit) to enable them in decision-making, planning and
controlling business operations.
Management accounting draws the relevant information mainly
from financial accounting and cost accounting which helps the
management in budgeting, assessing profitability, taking pricing

decisions, capital expenditure decisions which are relevant for

decision-making in the organization.
III.

Cost Accounting:
It is the process of accounting for cost which begins with the
recording of income and expenditure or the bases of which they
are calculated and ends with the preparation and periodical
statements and reports for ascertaining and controlling costs.
It is a systematic procedure for determining the unit cost of output
produced or services rendered.
The basic functions of cost accounting are to ascertain the cost of
a product and to help the management in the control of cost.

9) Relationship of Accounting with other Disciplines:

a. Accounting and Economics:
Economics is concerned with rational decision making regarding
efficient use of scarce resources for satisfying human wants.
The efficient utilization of resources, particularly when they are
scarce, is important both from the viewpoint of a business firm and
of the country as a whole.
Accounting is viewed as a system, which provides appropriate
information to the management for taking rational-decisions. Some
non-accounting

data

are

also

relevant

for

decision-making.

However, accounting provides a major and dependable data base

for decision making.
The basic objective of Accounting is to maximize the wealth of its
owners. This is also objective of economics. Efficient use of scare
resources results in maximizing the wealth of a nation. Thus
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accounting and economics both have similarities both seek the

optimum utilization of resources of the firm or the nation.
Moreover Accountants have got the ideas of value of assets,
income and capital maintenance from the economists. Of course,
the accountants have suitably adapted these ideas keeping in view
their own requirements and limitations.
Accountants developed the valuation, measurement and decisionmaking techniques which may owe to the economic theorems for
origin.
According to Economists the value of an asset is the present value
of all future earnings that can be derived from the assets. However
it is difficult for one to estimate correctly the future earnings
particularly when an asset has a very long life say-50 years or
more. The accountants have therefore adopted a realistic basis of
valuation of asset-the cost paid for the acquisition of the asset.
b. Accounting and Statistics:
Statistics in concerned with numerical data as well as various
statistical techniques which are used for collection, analysis, and
interpretation

of

such

data.

Statistical techniques

are now

increasingly used for managerial decision making.

Accounting is an important information tool. It provides significant
information about the working of a business firm to the outsiders
(i.e.) shareholders, creditors, financial institutions and insiders
(i.e.) the management.
Accounting has a close relationship with statistics. A number of
statistical

techniques

are

used

in

collection,

analysis,

and

interpretation of the accounting data.

For instance, computation of accounting ratios is based on

statistical method, particularly averaging. Similarly, the technique
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of regression is being increasingly used for forecasting, budgeting,

and cost control.
The technique of standard deviation, co-efficient of variation are
used for capital budgeting decisions. The technique of index
numbers is used for computation of present value of an asset in
case of accounting for price level changes.
Accounting records generally take a shorten view of events and are
confined to a year while statistical analysis is more useful if a
longer view is taken for the purpose. For example, to fit the trend
line a longer period will be required. However, statistical methods
do use past accounting records maintained on a consistent basis.
Statistical methods are helpful in developing accounting data and
in their interpretation. For example, time series and cross sectional
comparison of accounting data is based on statistical techniques.

Nowadays multiple discriminant analysis is popularly used to

identify the symptoms of sickness of a business firm. Therefore,
the study and application of statistical methods would add extra
edge to the accounting data.
c. Accounting and Mathematics:
Accounting bears a close relationship with Mathematics too.
Dual aspect concept which is the basic concept of accounting is
expressed in the form of a mathematical equation. It is popularly
termed as accounting equation.
The knowledge of mathematics is now considered to be a
prerequisite for accounting computations and measurements. For
example, computing depreciation, ascertaining the cash price in
hire-purchase

and

instalments

payment

transactions,

determination of the loan installment, setting of lease rentals all

require use of mathematical techniques.
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d. Accounting and Law:

A business entity operates within a legal framework.
An accountant records, classifies, summarizes and presents the
various transactions. Naturally, these transactions have to be in
accordance with the rules and regulations applicable to such
business entity.
There are laws which are applicable in general to all business
transactions e.g. the Indian Contract Act, the Sale of Goods Act,
the Negotiable Instruments Act, etc.
There are laws governing specific business entities, e.g. the
Companies Act which is applicable to joint stock companies, the
Banking Regulation Act is applicable to banking companies, the
Insurance Act is applicable to Insurance companies.
While preparing the accounts of different business entities, the
accountant has to keep in mind the specific provisions given by the
specific Acts applicable to the specific business entities. Similarly
there are a number of industrial laws such as the Factories Act, the
Payment of Wages Act, the Minimum Wages Act, the Employees
Provident Fund and Miscellaneous Provident Act. The accountant
has to abide by the provisions of these acts and prepare and
maintain appropriate records keeping in mind their provisions.
e. Accounting and Management:
Management is a broad occupational field, which comprises many
functions

and

encompasses

application

of

many

disciplines

including those mentioned above.

Accountants are well placed in the management and play a key
role in the management team.

A large portion of accounting information is prepared for

management decision making. Although management relies on
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other data sources, accounting data are used as basic source

documents.
In the management team, an accountant plays an active role in
management, he understands the data requirements. So the
accounting system can be mould to serve the management
purpose.
10) Limitations of Accounting:
A. Provides only limited information:

11) Role of Accountants in the society:

A. Maintenance of Books of Accounts :
An accountant is able to maintain a systematic record of financial
transactions in order to establish the net result of the transactions
entered into during a period and to state the financial position of
the concern as at a particular date.
For the fulfillment of the twin objective of ascertaining the profit
earned or loss suffered and the financial position, it is necessary
that all transactions be recorded in a systematic manner, which
can be done only by an accountant.
Proper maintenance of books of accounts assists management in
planning, decision making, and controlling functions.
B. Statutory Audit :
Every limited company is required to appoint a chartered
accountant or a firm of chartered accountants as their auditor who
are statutorily required to report each year whether in their opinion
the balance sheet shows a true and fair view of the state of affairs
on the balance sheet date, and the profit and loss account shows a
true and fair view of the profit or loss for the year.
Auditing is not confined to the accounts of companies, other
organizations may also have their accounts audited, either

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because the law so requires (for example, the C o-operative

Societies Act, the Income-tax Act, etc.) or because the proprietors
wisely decided so (for example, a partnership firm or an individual
trader).
C. Internal Audit :
It is a management tool whereby an internal auditor thoroughly
examines the accounting transactions and also the system,
according to which these have been recorded with a view to
ensure the management that the accounts are being properly
maintained and the system contains adequate safeguards to check
any leakage of revenue or misappropriation of property or assets
and the operations have been carried out in conformity with the
plans of management.
Now-a-days internal auditing has developed as a service to
management. The internal auditor constructively contributes in
improving the operational efficiency of the business through an
independent review and appraisal of all business operations.
D. Taxation :
An accountant can handle taxation matters of a business or a
person and he can represent that business or person before the
tax authorities and settle the tax liability under the statute
prevailing. He can also assist in avoiding or reducing tax burden by
proper planning of tax affairs.
Accountants also have a social obligation to express their views on
broad tax policy, on the effect of tax rate on business and the
economy in general and our all other aspects of taxation in which
they have knowledge superior to that of the general public.
E. Management Accounting and Consultancy Services :
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 Management accountant performs an advisory function. He is

largely responsible for internal reporting to the management for
planning and controlling current operations, decision-making on
special matters and for formulating long-range plans.
His job is to collect, analyze, interpret and present all accounting
information which is useful to the management.
Accountant provides management consultancy services in the
areas of management information system, expenditure control and
evaluation of appraisal techniques for new investments and
divestments, working capital management, corporate planning etc.
F. Financial Advice :
Many people need help and guidance in planning their personal
financial affairs. An accountant who knows about finances, taxation
and family problems is well placed to give such advice. Some of
the areas in which an accountant can render financial advice are:
(a) Investments: An accountant can explain the significance of the
formidable documents which shareholders receive from companies
and help in making decisions relating to their investments.
(b) Insurance: An accountant can provide information to his clients
on various insurance policies and helps in choosing appropriate
policy.
(c) Business Expansion: As businesses grow in size and complexity
and mergers are being considered, accountants are in the forefront
in interpreting accounts, making suggestions as to the form of
schemes and the fairness of proposals considering cost and
financial consequences and generally advising their clients.

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