cpt Fa Sm Cp1 Part1

chapter - 1

Unit 1

Meaning and

Scope of Accounting

ACCOUNTING :AN

INTRODUCTION

The Institute of Chartered Accountants of India

meaning and scope of accounting

1.2 common pRoficiencY test

Learning Objectives :

After studying this unit, you will be able to :

Understandthemeaningandsignificanceofaccounting.

Understand the meaning of book-keeping and the distinction of accounting with book-keeping.

Appreciatetheevolutionaryprocessofaccountingasasocialscience.

Explainsub-fieldsofaccounting.

Identifythevarioususergroupsforwhomaccountinginformationistobegenerated.

Describethevariousfunctionsorpurposesofaccountingdata.

Understand the relationship of accounting with Economics, Statistics, Mathematics, Law andManagement.

Explainthelimitationsofaccounting.

Appreciate the enlarged boundary of accounting profession and the areas where in a charteredaccountantplaysanimportantroleofrenderingusefulservicestothesociety.

1. IntrOductIOn Everyindividualperformssomekindofeconomicactivity.Asalariedpersongetssalaryandspendstobuyprovisionsandclothing,forchildrenseducation,constructionofhouse,etc.Asportsclub formed by a group of individuals, a business run by an individual or a group of individuals, a local authority like Calcutta Municipal Corporation, Delhi Development Authority, Governments, eitherCentralorState,allarecarryingsomekindofeconomicactivities.Notnecessarilyalltheeconomicactivitiesarerunforanyindividualbenefit;sucheconomicactivitiesmaycreatesocialbenefiti.e.benefitforthepublic,atlarge.Anywaysucheconomicactivitiesareperformedthroughtransactions and events. transaction is used to mean a business, performance of an act, an agreement while event isusedtomeanahappening,asaconsequenceoftransaction(s),aresult.

An individual invests ` 2,00,000forrunningastationerybusiness.On1stJanuary,hepurchasesgoods for ` 1,15,000 and sells for ` 1,47,000duringthemonthofJanuary.Hepaysshoprentforthemonth `5,000andfindsthatstillhehasgoodsworth`15,000inhand.Theindividualperformsaneconomicactivity.Hecarriesonafewtransactionsandencounterswithsomeevents.Isitnotlogical that he will want to know the result of his activity?

We see that the individual, who runs the stationery business, earns a surplus of `42,000.


fundamentals of accounting 1.3

`

Goods sold 1,47,000

Goods in hand 15,000

1,62,000

Less : Goods purchased 1,15,000

Shop rent paid 5,000 1,20,000

Surplus 42,000

Earning of `42,000surplusisanevent;alsohavingtheinventoriesinhandisanotherevent,whilepurchaseandsaleofgoods,investmentofmoneyandpaymentofrentaretransactions.

Similarly, a municipal corporation got government grant ` 500lakhsforadulteducation;itspent` 250 lakhs for purchasing literacy kits, paid ` 200 lakhs to the tutors and is left with a balance of `50lakhs.Thesearealsotransactionsandevents.

Similarly, the Central Government raised money through taxes, paid salaries to the employees, andspentonvariousdevelopmentalactivities.WheneverreceiptsoftheGovernmentaremorethanexpensesithassurplus,butifexpensesaremorethanreceiptsitrunsindeficit.Hereraisingmoneythroughvarioussourcescanbetermedastransactionandsurplusordeficitattheendoftheaccountingyearcanbetermedasanevent.

So, everybody wants to keep records of all transactions and events and to have adequate informationabouttheeconomicactivityasanaidtodecision-making.Accountingdisciplinehasbeen developed to serve this purpose as it deals with the measurement of economic activities involvinginflowandoutflowofeconomicresources,whichhelpstodevelopusefulinformationfordecision-makingprocess.

Accounting has universal application for recording transactions and events and presenting suitable information to aid decision-making regarding any type of economic activity ranging from a family functiontofunctionsofthenationalgovernment.Buthereinafterweshallconcentrateonlyonbusiness activities and their accounting because the objective of this study material is to provide abasicunderstandingonaccountingforbusinessactivities.Nevertheless,itwillgiveadequateknowledgetothinkcoherentlyofaccountingasafieldofstudyforuniversalapplication.

Thegrowthofaccountingdisciplineiscloselyassociatedwiththedevelopmentofthebusinessworld.Thus,tounderstandaccountingasafieldofstudyforuniversalapplication,itisbestidentifiedwithrecordingofbusinesstransactionsandcommunicationoffinancialinformationaboutbusinessenterprisetofacilitatedecision-making. Theaimofaccountingistomeettheinformation needs of the rational and sound decision-makers, and thus, called the language of business.




2. MeanIng Of accOuntIng TheCommitteeonTerminologysetupbytheAmericanInstituteofCertifiedPublicAccountantsformulatedthefollowingdefinitionofaccountingin1961:

Accountingistheartofrecording,classifying,andsummarisinginasignificantmannerandintermsofmoney,transactionsandeventswhichare,inpartatleast,ofafinancialcharacter,andinterpretingtheresultthereof.

Asperthisdefinition,accountingissimplyanartofrecordkeeping.Theprocessofaccountingstartsbyfirstidentifyingtheeventsandtransactionswhichareoffinancialcharacterandthenberecordedinthebooksofaccount.ThisrecordingisdoneinJournalorsubsidiarybooks,alsoknownasprimarybooks.Everygoodrecordkeepingsystemincludessuitableclassificationoftransactionsandeventsaswellastheirsummarisationforreadyreference.Afterthetransactionsandeventsarerecorded,theyaretransferredtosecondarybooksi.e.Ledger.Inledgertransactionsandeventsareclassifiedintermsofincome,expense,assetsandliabilitiesaccordingtotheircharacteristicsandsummarised inprofit& lossaccountandbalance sheet.Essentially the transactionsandeventsaretobemeasuredintermsofmoney.Measurementintermsofmoneymeansmeasuringattherulingcurrencyofacountry,forexample,rupeeinIndia,dollarinU.S.A.andlike.Thetransactionsandeventsmusthaveatleastinpart,financialcharacteristics.Theinaugurationofanewbranchofabankisaneventwithouthavingfinancialcharacter,whilethebusinessdisposedofbythebranchisaneventhavingfinancialcharacter.Accountingalsointerpretstherecorded,classifiedandsummarisedtransactionsandevents.

However,theabove-mentioneddefinitiondoesnotreflectthepresentdayaccountingfunction.Thedimensionof accounting ismuchbroader than thatdescribed in the abovedefinition.Accordingtotheabovedefinition,accountingendswithinterpretationoftheresultsofthefinancialtransactionsandeventsbutinthemodernworldwiththediversificationofmanagementandownership, globalisation of business and society gaining more interest in the functioning of the enterprises, the importance of communicating the accounting results has increased and therefore, this requirement of communicating and motivating informed judgement has also become the part ofaccountingasdefinedinthewidelyaccepteddefinitionofaccounting,givenbytheAmericanAccountingAssociationin1966whichtreatedaccountingas

the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the users of accounts.

In 1970, theAccountingPrinciples Board (APB) ofAmerican Institute ofCertifiedPublicAccountants(AICPA)enumeratedthefunctionsofaccountingasfollows:

Thefunctionofaccountingistoprovidequantitativeinformation,primarilyoffinancialnature,abouteconomicentities,thatisneededtobeusefulinmakingeconomicdecisions.

Thus,accountingmaybedefinedastheprocessofrecording,classifying,summarising,analysingandinterpretingthefinancialtransactionsandcommunicatingtheresultsthereoftothepersonsinterestedinsuchinformation.



2.1 PrOceduraL asPects Of accOuntIng

Onthebasisoftheabovedefinitions,procedureofaccountingcanbebasicallydividedintotwoparts:

(i) Generatingfinancialinformationand

(ii) Usingthefinancialinformation.

Theproceduralaspectsofaccountingcanbeexplainedwiththehelpofthefollowingchart:

chart 1

2.1.1 generating financial Information

1. recording Thisisthebasicfunctionofaccounting.Allbusinesstransactionsofafinancialcharacter,asevidencedbysomedocumentssuchassalesbill,passbook,salaryslipetc.arerecordedinthebooksofaccount.RecordingisdoneinabookcalledJournal.Thisbookmay further be divided into several subsidiary books according to the nature and size of the business.Studentswilllearnhowtopreparejournalandvarioussubsidiarybooksinchapter2.

2. classifying Classificationisconcernedwiththesystematicanalysisoftherecordeddata,with a view to group transactions or entries of one nature at one place so as to put information incompactandusableform.ThebookcontainingclassifiedinformationiscalledLedger.Thisbookcontainsondifferentpages,individualaccountheadsunderwhich,allfinancialtransactionsofsimilarnaturearecollected. Forexample,theremaybeseparateaccountheadsforSalaries,Rent,PrintingandStationeries,Advertisementetc.Allexpensesundertheseheads,afterbeingrecordedintheJournal,willbeclassifiedunderseparateheadsintheLedger.Thiswillhelpinfindingoutthetotalexpenditureincurredundereachoftheaboveheads.Studentswilllearnhowtoprepareledgerbooksinchapter2.

3. summarising Itisconcernedwiththepreparationandpresentationoftheclassifieddatainamannerusefultotheinternalaswellastheexternalusersoffinancialstatements.Thisprocessleadstothepreparationofthefollowingfinancialstatements:

(a)TrialBalance(b)ProfitandLossAccount(c)BalanceSheet(d)Cash-flowStatement.

ProcedureofAccounting

GeneratingFinancialInformation

UsingtheFinancialInformation

Recording Classifiying Summarising Analysing Interpreting Communicating




StudentswilllearnhowtoprepareTrialBalanceinchapter2andFinancialStatementsinchapter6whileCash-flowStatementwillbediscussedintheIntermediate(IPC)Course.

4. analysing ThetermAnalysismeansmethodicalclassificationofthedatagiveninthefinancialstatements.Thefiguresgiveninthefinancialstatementswillnothelpanyoneunlesstheyareinasimplifiedform.Forexample,allitemsrelatingtofixedassetsareputatoneplacewhileallitemsrelatingtocurrentassetsareputatanotherplace.Itisconcernedwiththe establishmentof relationshipbetween the itemsof theProfit andLossAccountandBalanceSheeti.e.itprovidesthebasisforinterpretation.StudentswilllearnthisaspectoffinancialstatementsinthelaterstagesoftheCharteredAccountancyCourse.

5. Interpreting Thisisthefinalfunctionofaccounting.Itisconcernedwithexplainingthemeaningandsignificanceoftherelationshipasestablishedbytheanalysisofaccountingdata.Therecordedfinancialdataisanalysedandinterpretedinamannerthatwillenabletheend-userstomakeameaningfuljudgementaboutthefinancialconditionandprofitabilityofthebusinessoperations.Thefinancialstatementshouldexplainnotonlywhathadhappenedbutalsowhyithappenedandwhatislikelytohappenunderspecifiedconditions.StudentswilllearnthisaspectoffinancialstatementsinthelaterstagesoftheCharteredAccountancyCourse.

6. communicating It is concerned with the transmission of summarised, analysed and interpretedinformationtotheend-userstoenablethemtomakerationaldecisions.Thisis done through preparation and distribution of accounting reports, which include besides theusualprofitandlossaccountandthebalancesheet,additionalinformationintheformofaccountingratios,graphs,diagrams,fundflowstatementsetc.StudentswilllearnthisaspectoffinancialstatementsinthelaterstagesoftheCharteredAccountancyCourse.

Thefirsttwoproceduralstagesoftheprocessofgeneratingfinancialinformationalongwiththepreparationoftrialbalancearecoveredunderbook-keepingwhilethepreparationoffinancialstatements and its analysis, interpretation and also its communication to the various users are consideredasaccountingstages.Studentswilllearnthetermbook-keepinganditsdistinctionwithaccounting,inthecomingtopicsofthisunit.(ReferChart2)

2.1.2 using the financial Information

Therearecertainusersofaccounts.Earlieritwasviewedthataccountingismeantfortheproprietororownerofthebusiness,butchangingsocialrelationshipsdilutedtheearlierthinking.Itisnowbelieved that besides the owner or the management of the business enterprise, users of accounts include the investors, employees, lenders, suppliers, customers, government and other agencies andthepublicatlarge.Accountingprovidestheartofpresentinginformationsystematicallytotheusersofaccounts.Accountingdataismoreusefulifitstresseseconomicsubstanceratherthantechnicalform.Informationisuselessandmeaninglessunlessitisrelevantandmaterialtoausersdecision.Theinformationshouldalsobefreeofanybiases.Theusersshouldunderstandnotonlythefinancialresultsdepictedbytheaccountingfigures,butalsoshouldbeabletoassessitsreliabilityandcompareitwithinformationaboutalternativeopportunitiesandthepastexperience.Theownersorthemanagementoftheenterprise,commonlyknownasinternalusers,usetheaccountinginformationinananalyticalmannertotakethevaluabledecisionsforthebusiness.Sothe information served to them is presented in a manner different to the information presented



totheexternalusers.Eventhesmalldetailswhichcanaffecttheinternalworkingofthebusinessaregiveninthemanagementreportwhilefinancialstatementspresentedtotheexternaluserscontains key information regarding assets, liabilities and capital which are summarised in a logical mannerthathelpsthemintheirrespectivedecision-making.Studentscanstudyindetailaboutthedifferentusersoffinancialstatementsinpara9ofthischapter.

Theentireprocedureofaccountingcanbeexplainedwiththehelpofchartgivenbelow:

PrOcess Of accOuntIng

Identificationoftransaction

Accounting Cycle

Input

Economic events measured infinancialterms

Output

Communicating Information to

usersRecordingoftransactions in the books of original

entry

Postingto

ledger

Preparationoffinal

accounts

Preparationof trial balance

Internal users External users

BoardofDirectors

Partners

Managers

Officers

Investors

Lenders

Suppliers

Govt.agencies

Customers

chart 2




3. eVOLutIOn Of accOuntIng as a sOcIaL scIence Initsoldestformaccountingaidedthestewardstodischargetheirstewardshipfunction.Thewealthymen employed stewards tomanage theirproperty; the stewards in turn renderedanaccountperiodicallyof their stewardship.This StewardshipAccountingwas the rootoffinancialaccountingsystem.Thepresentlyfollowedsystemofdouble-entrybook-keepinghasbeendevelopedonlyinthe15thCentury.However,historiansfoundrecordsofdebitandcreditdatingback to the12thCentury.Althoughdouble-entry systemwas followed, stewardshipaccountingservedthepurposeofbusinessmenandwealthypersonsatthattime.InIndiatoo,stewardship accounting was prevalent till the emergence of large-scale enterprises in the form ofpubliclimitedcompanies.

Inthesecondphase,theideaoffinancialaccountingemergedwiththeconceptof jointstockcompanyanddivorceofownership from themanagement.To safeguard the interestof theshareholdersandinvestors,disclosureoffinancialstatements(mainly,profitandlossaccountandbalancesheet)andotheraccountinginformationwasmouldedbylaw.FinancialstatementsgiveperiodicperformancereportbywayofprofitandlossaccountandfinancialpositionattheendoftheperiodbywayofBalanceSheet.Itgotthelegalstatusduetochangingrelationshipsbetweentheowners,economicentityandthemanagers.Withthedemocratisationofsociety,therelationships between the enterprise on the one hand, the investors, employees, managers and governmentsontheother,havealsoundergoneasea-change.Alsotheprospective investorsand other business contact groups want to know a lot about the business before entering into transactions.Thus,financialaccountingemergedasaninformationsystemtoidentify,measureand communicate useful information for informed judgements and decisions by a broad group ofusers.Inthethirdphase,accountinginformationwasgeneratedtoaidmanagementdecision-makinginparticular.Itcontributedalottoimprovethequalityofmanagementdecisions.Thisnew dimension of accounting is called Management Accounting and it is the development of 20th Centuryonly.Itispervasiveenoughtocoverallspheresofmanagementdecisions.

Lastly,SocialResponsibilityAccountingisintheformativeprocess,whichaimsataccountingforthesocialcostincurredbybusinessaswellasthesocialbenefit,createdbyit.Itemergesfromthegrowingsocialawarenessabouttheundesirableby-productsofeconomicactivities.Whileearningprofit, anenterprise incursnumerous social costs likepollution,using the resourcesofsocietylikematerials,land,labouretc.Tocompensateforthissocialcost,intodaysworld,anenterpriseisexpectedtogeneratesomesocialbenefitsalsolikeemploymentopportunities,recreationactivities,morechoicetocustomersatreasonableprice,betterqualityproductsetc.Thereforeit isdemandedthattheaccountingsystemshouldproduceareportmeasuringthesocialcostincurredandsocialbenefitsgenerated.

SocialSciencestudymanasamemberofsociety;theyconcernaboutsocialprocessesandtheresultsandconsequencesofsocialrelationships.Theusefulnessofaccountingtosocietyasawholeisthefundamentalcriteriontotreatitasasocialscience.Althoughindividualsmaybenefitfrom the availability of accounting information, the accounting system generates information for socialgood.Itservessocialpurposes,itcontributesforsocialprogress;alsoitisbeingadaptedtokeeppacewithsocialprogress.So,accountingistreatedasasocialscience.



4. ObjectIVes Of accOuntIng Theobjectivesofaccountingcanbegivenasfollows:

1. systematic recording of transactions Basicobjectiveofaccountingistosystematicallyrecordthefinancialaspectsofbusinesstransactionsi.e.book-keeping.Theserecordedtransactionsarelateronclassifiedandsummarisedlogicallyforthepreparationoffinancialstatementsandfortheiranalysisandinterpretation.

2. ascertainment of results of above recorded transactions Accountantpreparesprofitandlossaccounttoknowtheresultsofbusinessoperationsforaparticularperiodoftime.Ifrevenueexceedexpensesthenitissaidthatbusinessisrunningprofitablybutifexpensesexceedrevenuethenitcanbesaidthatbusinessisrunningunderloss.Theprofitandlossaccounthelpsthemanagementanddifferentstakeholdersintakingrationaldecisions.Forexample,ifbusinessisnotprovedtoberemunerativeorprofitable,thecauseofsuchastateofaffaircanbeinvestigatedbythemanagementfortakingremedialsteps.

3. Ascertainment of the financial position of the business Businessmanisnotonlyinterestedinknowingtheresultsofthebusinessintermsofprofitsorlossforaparticularperiodbutis also anxious to know that what he owes (liability) to the outsiders and what he owns (assets)onacertaindate.Toknowthis,accountantpreparesafinancialpositionstatementpopularlyknownasBalanceSheet.Thebalancesheetisastatementofassetsandliabilitiesofthebusinessataparticularpointoftimeandhelpsinascertainingthefinancialhealthofthebusiness.

4. Providing information to the users for rational decision-making Accounting as a language ofbusiness communicates thefinancial resultsof anenterprise tovarious stakeholdersbymeansoffinancialstatements.Accountingaimstomeettheinformationneedsofthedecision-makersandhelpstheminrationaldecision-making.

5. to know the solvency position:Bypreparing thebalance sheet,managementnotonlyreveals 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(solvencyposition)asandwhentheyfalldue.




Anoverviewofobjectivesofaccountingisdepictedinthechartgivenbelow:

5. functIOns Of accOuntIng Themainfunctionsofaccountingareasfollows:

(a) Measurement: Accounting measures past performance of the business entity and depicts its currentfinancialposition.

(b) forecasting:Accountinghelpsinforecastingfutureperformanceandfinancialpositionoftheenterpriseusingpastdata.

(c) decision-making: Accounting provides relevant information to the users of accounts to aid rationaldecision-making.

(d) comparison & evaluation: Accounting assesses performance achieved in relation to targets and discloses information regarding accounting policies and contingent liabilities which play animportantroleinpredicting,comparingandevaluatingthefinancialresults.

(e) control:Accountingalso identifiesweaknessesof theoperational systemandprovidesfeedbacksregardingeffectivenessofmeasuresadoptedtochecksuchweaknesses.

(f) government regulation and taxation: Accounting provides necessary information to the governmenttoexercisecontrolontheentityaswellasincollectionoftaxrevenues.

6. bOOk-keePIng Book-keepingisanactivityconcernedwiththerecordingoffinancialdatarelatingtobusinessoperationsinasignificantandorderlymanner.Itcoversproceduralaspectsofaccountingworkandembracesrecordkeepingfunction.Obviouslybook-keepingproceduresaregovernedby

ObjectivesofAccounting

Systematic RecordingofTransactions

Ascertainment of Results

Ascertainment ofFinancialPosition

Communicating Information to Various Users

Book-keeping :Journal,

Ledger and TrialBalance

Manufacturing Trading,Profit

and Loss Account

BalanceSheet

FinancialReports



theendproduct,thefinancialstatements.InIndia,thetermfinancialstatementsmeansProfitandLossAccountandBalanceSheetincludingSchedulesandNotesformingpartofAccounts.Asdiscussedearlier,ProfitandLossAccountgivesresultofeconomicactivitiesforaperiodandBalanceSheetstatesthefinancialpositionattheendoftheperiod.Book-keepingalsorequiressuitableclassificationoftransactionsandevents.Thisisalsodeterminedwithreferencetotherequirementoffinancial statements. Abook-keepermaybe responsible forkeepingall therecords of a business or only of a minor segment, such as position of the customers accounts inadepartmentalstore.Asubstantialportionofthebook-keepersworkisofaclericalnatureandisincreasinglybeingaccomplishedthroughtheuseofamechanicalandelectronicdevices.Accountingisbasedonacarefulandefficientbook-keepingsystem.

Theessentialideabehindmaintainingbook-keepingrecordsistoshowcorrectpositionregardingeachheadofincomeandexpenditure.Abusinessmaypurchasegoodsoncreditaswellasincash.Whenthegoodsareboughtoncredit,arecordmustbekeptofthepersontowhommoneyisowed.Theproprietorofthebusinessmayliketoknow,fromtimetotime,whatamountisdueoncreditpurchaseandtowhom.Ifproperrecordisnotmaintained,itisnotpossibletogetdetailsofthetransactionsinregardtotheexpenses.Attheendoftheaccountingperiod,theproprietorwantstoknowhowmuchprofithasbeenearnedorlosshasbeenincurredduringthecourseoftheperiod.Forthislotofinformationisneededwhichcanbegatheredfromaproperrecordofthetransactions.Therefore,inbook-keeping,thepropermaintenanceofbooksofaccountisindispensableforanybusiness.

AtCPT level, themajor concernof the curriculum iswithbook-keepingandpreparationoffinancialstatements.Itseemsimportanttomentionatthispointthatbook-keepingandpreparationoffinancialstatementshavelegalimplicationsalso.MaintenanceofbooksofaccountsandthepreparationoffinancialstatementsofacompanyareguidedbytheCompaniesAct,2013,Co-operative society by Co-operative Societies Act, banks and insurance companies by special Acts governingtheseinstitutionsandsoon.However,forsole-proprietorshipandpartnershipbusiness,there isno specific legislation regardingmaintenanceofbooksof accounts andpreparationoffinancialstatements.However, theIncome-taxAct,1961requiresmaintenanceofbooksofaccountsinsomecases.

6.1 ObjectIVes Of bOOk-keePIng

1. complete recording of transactions It is concerned with complete and permanent record ofall transactions ina systematic and logicalmanner to show itsfinancial effecton thebusiness.

2. ascertainment of financial effect on the business It is concerned with the combined effectofallthetransactionsmadeduringtheaccountingperioduponthefinancialpositionofthebusinessasawhole.

7. dIstInctIOn between bOOk-keePIng and accOuntIng Some people mistake book-keeping and accounting to be synonymous terms, but in fact they aredifferentfromeachother.Accountingisabroadsubject.Itcallsforagreaterunderstandingof records obtained from book-keeping and an ability to analyse and interpret the information




providedbybook-keepingrecords. Book-keepingistherecordingphasewhileaccountingisconcernedwiththesummarisingphaseofanaccountingsystem.Book-keepingprovidesnecessarydataforaccountingandaccountingstartswherebook-keepingends.

s.no. book-keeping accounting1. It is a process concerned with

recordingoftransactions.It is a process concerned with summarisingoftherecordedtransactions.

2. It constitutes as a base for accounting.

It is considered as a language of the business.

3. Financialstatementsdonotformpartofthisprocess.

Financialstatementsarepreparedinthisprocess on the basis of book-keeping records.

4. Managerial decisions cannot be taken with the help of these records.

Management takes decisions on the basis oftheserecords.

5. Thereisnosub-fieldofbook-keeping.

Ithasseveralsub-fieldslikefinancialaccounting,managementaccountingetc.

6. Financialpositionofthebusinesscannot be ascertained through book-keepingrecords.

Financialpositionofthebusinessisascertained on the basis of the accounting reports.

RelationshipofAccountingandBook-keepingcanbedepictedinthefollowingchartas:

Accountancy

Accounting

Bookkeeping



8. sub-fIeLds Of accOuntIng Thevarioussub-fieldsofaccountingare:

(i) financial accounting Itcoversthepreparationandinterpretationoffinancialstatementsandcommunicationtotheusersofaccounts.Itishistoricalinnatureasitrecordstransactionswhichhadalreadybeenoccurred.ThefinalstepoffinancialaccountingisthepreparationofProfitandLossAccountandtheBalanceSheet.Itprimarilyhelpsindeterminationofthenetresultforanaccountingperiodandthefinancialpositionasonthegivendate.

(ii) Management accounting It is concerned with internal reporting to the managers of a businessunit.Todischargethefunctionsofstewardship,planning,controlanddecision-making, themanagementneedsvarietyof information.Thedifferentwaysofgroupinginformation and preparing reports as desired by managers for discharging their functions arereferredtoasmanagementaccounting.Averyimportantcomponentofthemanagementaccountingiscostaccountingwhichdealswithcostascertainmentandcostcontrol.

ManagementAccountingwillbedealtwithatFinal levelof theCharteredAccountancyCourse.

(iii) cost accounting TheterminologyofCostAccountingpublishedbytheInstituteofCostandManagementAccountantsofEnglanddefinescostaccountingas:

the process of accounting for cost which begins with the recording of income and expenditure or the bases on which they are calculated and ends with the preparation of periodical statements and reports for ascertaining and controlling costs.

CostAccountingwill be coveredat Intermediate (IPC)Course andFinalCourseof theCharteredAccountancyCurriculumn.

(iv) social responsibility accounting Thedemandforsocialresponsibilityaccountingstemsfromincreasingsocialawarenessabouttheundesirableby-productsofeconomicactivities.As already discussed earlier, social responsibility accounting is concerned with accounting forsocialcostsincurredbytheenterpriseandsocialbenefitscreated.

(v) Human resource accounting Humanresourceaccountingisanattempttoidentify,quantifyand report investments made in human resources of an organisation that are not presently accountedforunderconventionalaccountingpractice.

HumanResource Accountingwill bediscussed in the curriculumof Final level of theCharteredAccountancyCourse.

9. users Of accOuntIng InfOrMatIOn Generallyusersof accounts are classified into two categories, (a) internalmanagement andowners;and(b)externalusersoroutsiders.Managementaccountingisconcernedwithidentifyinginformation requirements as well as methods of providing such information to management whileinformationrequirementsoftheoutsideusersaregenerallyservedbyfinancialstatements.




Followingarethevarioususersofaccountinginformation:

(i) Investors:Theyprovideriskcapitaltothebusiness.Theyneedinformationtoassesswhethertobuy,holdor sell their investment.Also theyare interested toknowtheabilityof thebusinesstosurvive,prosperandtopaydividend.Innon-corporatesector,whereownershipand management are not essentially separated, the owners still need information about performanceofthebusinessanditsfinancialpositiontodecidewhethertocontinueorshutdown.

(ii) employees: Growth of the employees is directly related to the growth of the organisation and therefore, they are interested to know the stability, continuity and growth of the enterprise and itsabilitytoprovideremuneration,retirementandotherbenefitsandtoenhanceemploymentopportunities.

(iii) Lenders: Theyareinterestedtoknowwhethertheirloan-principalandinterestwillbepaidwhendue.

(iv) suppliers and creditors:Theyarealsointerestedtoknowtheabilityoftheenterprisetopay their dues, that helps them to decide the credit policy for the relevant concern, rates to bechargedandsoon.Sometimes,theyalsobecomeinterestedinlong-termcontinuationoftheenterpriseiftheirexistencebecomesdependentonthesurvivalofthatbusiness.Suppose,small ancillary units supply their products to a big enterprise, if the big enterprise collapses, thefateofthesmallunitsalsobecomessealed.

(v) customers:Customersarealsoconcernedwiththestabilityandprofitabilityoftheenterprisebecause their functioning is more or less dependent on the supply of goods, suppose, a company produces some chemicals used by pharmaceutical companies and supplies chemicalsonthreemonthscredit.Ifallofasuddenitfacessometroubleandisunabletosupplythechemical,thecustomerswillalsobeintrouble.

(vi) government and their agencies:Theyregulatethefunctioningofbusinessenterprisesforpublic good, allocate scarce resources among competing enterprises, control prices, charge excisedutiesandtaxes,andsotheyhavecontinuedinterestinthebusinessenterprise.

(vii) Public:Thepublicatlargeisinterestedinthefunctioningoftheenterprisebecauseitmaymake a substantial contribution to the local economy in many ways including the number ofpeopleemployedandtheirpatronagetolocalsuppliers.

Management as whole is also interested in the accounts for various managerial decisions. On thebasis of the accounts,managementdetermines the effects of theirvariousdecisions on the functioning of the organisation. This helps them tomake furthermanagerial decisions.

10. reLatIOnsHIP Of accOuntIng wItH OtHer dIscIPLInesAccounting is closely related with several other disciplines and thus to acquire a good knowledge inaccountingoneshouldbeconversantwiththerelevantportionsofsuchdisciplines.Inmanycasestheyoverlapaccounting.TheAccountantshouldhaveaworkingknowledgeoftherelated



disciplines so that he can understand such overlapping areas and apply the knowledge of other disciplinesinhisownworkwhereverpossible,orhecantaketheexpertadvice.

(a) accounting and economics: Economics is viewed as a science of rational decision-making abouttheuseofscarceresources.Itisconcernedwiththeanalysisofefficientuseofscarceresourcesforsatisfyinghumanwants.Thismaybeviewedeitherfromtheperspectiveofasinglefirmorofthecountryasawhole.

Accounting is viewed as a system, which provides data to the users to permit informed judgementanddecisions.Somenon-accountingdataarealsorelevantfordecision-making.Still,accountingprovidesamajordatabase.

Accountingoverlaps economics inmany respects. It contributeda lot in improving themanagementdecision-makingprocess.But,economictheoriesinfluencedthedevelopmentofthedecision-makingtoolsusedinaccounting.

However,thereexistsawidegulfbetweeneconomistsandaccountantsconceptsofincomeand capital.Accountantsgot the ideasof value, incomeand capitalmaintenance fromeconomists,butbrushedsuitablytomakethemusableinpracticalcircumstances.Accountantsdeveloped the valuation, measurement and decision-making techniques which may owe to the economic theorems for origin but these are moulded in the work environment and suitablytemperedwithreferencetorelevance,verifiability,freedomfrombias,timeliness,comparability,reliabilityandunderstandability.

An examplemay be given to explain the nexus between accounting and economics.Economists think that value of an asset is the present value of all future earnings which can bederivedfromsuchassets.Nowthinkaboutaplantwhoseworkinglifeismorethanonehundredyears.Howcanyouestimatefuturestreamofearnings?Soaccountantsdevelopedtheworkablevaluationbasetheacquisitioncosti.e.,thepricepaidtoacquiretheassets.

At the macro-level, accounting provides the database over which the economic decision modelshavebeendeveloped;micro-leveldataarrangedbytheaccountingsystemissummeduptogetmacro-leveldatabase.

Non-overlappingzonesofaccountingarenotnegligible.Developmentof thesystemsofrecording, classifying and summarising transactions and events, harmonising the systems by uniform rules and communicating the data is essentially a non-overlapping area of accounting.

(b) accounting and statistics:Theuseofstatisticsinaccountingcanbeappreciatedbetterinthecontextofthenatureofaccountingrecords.Accountinginformationisveryprecise;itisexacttothelastpaisa.But,fordecision-makingpurposessuchprecisionisnotnecessaryandhence,thestatisticalapproximationsaresought.

Inaccounts,allvaluesareimportantindividuallybecausetheyrelatetobusinesstransactions.As against this, statistics is concerned with the typical value, behaviour or trend over a period oftimeorthedegreeofvariationoveraseriesofobservations.Therefore,whereveraneedarises for only broad generalisations or the average of relationships, statistical methods have tobeappliedinaccountingdata.




Further, inaccountancy, theclassificationofassetsandliabilitiesaswellas theheadsofincomeandexpenditurehasbeendoneaspertheneedsoffinancialrecordingtoascertainfinancialresultsofvariousoperations.Othertypesofclassificationlikethegeographicalandhistoricalonesandadhocclassificationaredonedependingonthepurposetomakesuchclassificationmeaningful.

Accountingrecordsgenerallytakeashort-termviewofeventsandareconfinedtoayearwhilestatisticalanalysisismoreusefulifalongerviewistakenforthepurpose.Forexample,tofitthetrendlinealongerperiodwillberequired.However,statisticalmethodsdousepastaccountingrecordsmaintainedonaconsistentbasis.

Accountingrecordsarebasedonhistoricalcostsoffixedassets,whilethecurrentassetsarevaluedatthecurrentvalues.Thiscreatessomeanomaloussituationswhenpricesarenotstableoveraperiodoftime.Thenewmethodsofinflationaccountingareanattempttocorrectthissituation.Thecorrectionofvaluesismadeonthebasisofthecurrentpurchasingpowerof money or the current value of the concerned assets revalued from the data of purchase till the day of recording, charging depreciation on the current value, so that the present value oftheassetisinlinewiththecurrentvalueofmoney.Allthiswouldrequiretheuseofpriceindicesorthepricedeflators,whicharebasedonstatisticalcalculationsofpricechanges.

Thefunctionalrelationsshowingmathematicalrelationsofonevariablewithoneormoreothervariablesarebasedonstatisticalwork.Theserelationsareusedwidely inmakingcost or price estimates for some estimated future values assigned to the given independent variables.Forexample,giventhefunctionalrelationoftotalcosttothepriceofaninput,theeffectofchangesinfuturepricesonthecostofproductioncanbecalculated.

Inaccountancy,anumberoffinancialandotherratiosarebasedonstatisticalmethods,whichhelpinaveragingthemoveraperiodoftime.Severalaccountingandfinancialcalculationsarebasedonstatisticalformulae.

Statisticalmethodsarehelpfulindevelopingaccountingdataandintheirinterpretation.For example, time series andcross-sectional comparisonof accountingdata isbasedonstatisticaltechniques.Now-a-daysmultiplediscriminantanalysisispopularlyusedtoidentifysymptomsofsicknessofabusinessfirm.Therefore,thestudyandapplicationofstatisticalmethodswouldaddextraedgetotheaccountingdata.

(c) accounting and Mathematics: Double Entry book-keeping can be converted in algebraic form; in fact thefirstknownbookon this subjectwaspartof a treatiseonalgebra.Thefundamental accounting equation will be discussed in detail under Dual Aspect Concept ofthischapter.

Knowledge of arithmetic and algebra is a pre-requisite for accounting computations and measurements.Calculationsofinterestandannuityaretheexamplesofsuchfundamentaluses.Whilecomputingdepreciation,findingoutinstallmentsinhire-purchaseandinstalmentspayment transactions, calculating amount to be set aside for repayment of loan and replacement of assets and calculating lease rentals, mathematical techniques are frequently used.Accountingdataarealsopresentedinratioform.



Withtheadventofthecomputer,mathematicsisbecomingavitalpartofaccounting.Insteadof writing accounts in traditional fashion, the transactions and events can be recorded in the matrix form and the rules of matrix algebra can be applied for classifying and summarising data.

Now-a-days statistics andeconometricmodels are largelyused fordevelopingdecisionmodelsfortheusersofaccounts.Also,OperationsResearchTechniquesprovidelotofdecisionmodels.Sinceaccountingismeantforprovidinginformationtotheusers,tobeeffective,accounting data should feed the information requirements of such statistical, econometric andoperationsresearchmodels.Understandingmathematicshasbecomeamusttograspthedecisionmodelsframedbystatisticians,econometriciansandtheO.R.experts.

Presentlygraphs and charts arebeing extensivelyused for communicating accountinginformation.Inadditiontostatisticalknowledge,knowledgeingeometryandtrigonometryseems to be essential to have a better understanding about the accounting communications system.

(d) accounting and Law:An economic entity operateswithin a legal environment.Alltransactions with suppliers and customers are governed by the Contract Act, the Sale of GoodsAct,theNegotiableInstrumentsAct,etc.Theentityitselfiscreatedandcontrolledbylaws.Forexample,apartnershipbusinessiscontrolledbyPartnershipAct.AcompanyiscreatedbytheCompaniesActandalsocontrolledbyCompaniesAct.

Similarly,everycountryhasasetofeconomic,fiscalandlabourlaws.Transactionsandeventsarealwaysguidedbylawsoftheland.Veryoftentheaccountingsystemtobefollowedhasbeenprescribedbythelaw.Forexample,theCompaniesActhasprescribedtheformatoffinancialstatements.

Banking,insuranceandelectricsupplyundertakingsalsohavetoproducefinancialstatementsasprescribedbytherespectivelegislationscontrollingsuchentities.

However,legalprescriptionabouttheaccountingsystemistheproductofdevelopmentsinaccountingknowledge.That is to say, legislationaboutaccounting systemcannotbeenactedunlessthereisacorrespondingdevelopmentintheaccountingdiscipline.Inthatwayaccountinginfluenceslawandisalsoinfluencedbylaw.

(e) accounting and Management:Managementisabroadoccupationalfield,whichcomprisesmany functions and encompasses application of many disciplines including those mentioned above.Accountantsarewellplacedinthemanagementandplayakeyroleinthemanagementteam.A largeportionof accounting information isprepared formanagementdecision-making.Althoughmanagementreliesonotherdatasources,accountingdataareusedasbasicsourcedocuments.Inthemanagementteam,anaccountantisinabetterpositiontounderstandanduse suchdata. Inotherwords, sinceanaccountantplaysanactive roleinmanagement,heunderstandsthedatarequirements.Sotheaccountingsystemcanbemouldedtoservethemanagementpurpose.




11. LIMItatIOns Of accOuntIng Therearecertainmisconceptionsregardingfinancialstatements.Acommonmanpresumesthatan income statement shows the correct income or loss of the enterprise and that a balance sheet depictsaperfectlytrueandfairpictureoffinancialstandingofthatenterprise.Itmustberecognisedthattheaccountingasalanguagehasitsownlimitations.Thefiguresofprofitorlossgeneratedbytheaccountingprocessaresubjecttovariousconstraintswithinwhichtheaccountingworks.Theassumptionsandconventions,onwhichtheaccountingisbased,becomethelimitationsofaccounting.Thefinancialstatementsareneverfreefromsubjectivityfactorasthesearelargelytheoutcome of personal judgement of the accountant with regard to the adoption of the accounting policies.Followingarecertaininstances:

1. Thefactorswhichmayberelevantinassessingtheworthoftheenterprisedontfindplaceintheaccountsastheycannotbemeasuredintermsofmoney.TheBalancesheetcannotreflectthevalueofcertainfactorslikeloyaltyandskillofthepersonnelwhichmaybethemostvaluableassetofanenterprisethesedays.

2. BalanceSheetshowsthepositionofthebusinessonthedayofitspreparationandnotonthe future date while the users of the accounts are interested in knowing the position of the businessinthenearfutureandalsoinlongrunandnotforthepastdate.Businessdynamicschangewithinthetime,annualreportsreachtotheultimateusers.Toresolvethis,auditorsdisclosetheeventsoccurringafterthebalancesheetdatebutbeforeapprovaloffinancialstatementsinthefinancialreports.

3. ThoughwiththeemergenceofsomeaccountingstandardslikeAS11,AS26,AS28etc.,market/fairvalueofassetsistakenintoconsiderationbutstillthereremainssomesubjectivity.Accountingignoreschangesinsomemoneyfactorslikeinflationetc.

4. Thereareoccasionswhenaccountingprinciplesconflictwitheachother.

5. Certainaccountingestimatesdependonthesheerpersonaljudgementoftheaccountant,e.g.,provision for doubtful debts, method of depreciation adopted, recording certain expenditure as revenue expenditure or capital expenditure, selection of method of valuation of inventories andthelistisquitelong.

6. Financialstatementsonlyconsiderthoseassetswhichcanbeexpressedinmonetaryterms.Humanresourcesalthoughtheveryimportantassetoftheenterprisearenotshowninthebalancesheet.Thereisnogenerallyacceptedformulaforthevaluationofhumanresourcesinmoneyterms.

7. Different accountingpolicies for the treatmentof same itemadds to theprobabilityofmanipulations.ThoughthroughvariouslawsandAccountingStandards,effortsaremadetoreducetheseoptionstominimumbutcertainlycouldnotbereducedtoone.

In nutshell, it can be said that the language of accounting has certain practical limitations and, therefore,thefinancialstatementsshouldbeinterpretedcarefullykeepinginmindallvariousfactorsinfluencingthetruepicture.



12. rOLe Of accOuntant In tHe sOcIety Thereareonlyafewtypesofprofessionintheworldwhichareheldinhighesteeminpubliceyesandthereisnodenyingthefactthattheaccountingprofessionisoneofthem.Goethehadcalledtheaccountantsprofessionasthefairestinventionofthehumanmind.Atthecoreofalltypesoflearnedprofession,thereisthedesireofpublicgoodandoffindingthebestwaytoservesociety.Bytheuseofthescienceofaccountancyandunderthespellofitsart,adynamicpatternwhich assists business in planning its future is woven by accountants out of the inert mass of non-speakingsilentfigures.Thisiswhatmakestheirprofessionaninstrumentofsocio-economicchangeandwelfareofthesociety.

Anaccountantwithhiseducation,training,analyticalmindandexperienceisbestqualifiedtoprovidemultipleneed-basedservicestotheevergrowingsociety.Theaccountantsoftodaycandofulljusticenotonlytomattersrelatingtotaxation,costing,managementaccounting,financiallay-out,companylegislationandproceduresbuttheycandelvedeepintothefieldsrelatingtofinancialpolicies,budgetarypoliciesandeveneconomicprinciples.Theareaofactivitieswhichcanbeundertakenbytheaccountantsisnotlimitedbutitcanalsocovermanyadditionalfacets.

12.1 areas Of serVIce

Thepracticeofaccountancyhascrosseditsusualdomainofpreparationoffinancialstatements,interpretationofsuchstatementsandauditthereof.Accountantsarepresentlytakingactiverolein company laws and other corporate legislation matters, in taxation laws matters (both direct andindirect)andingeneralmanagementproblems.Someoftheservicesrenderedbyaccountantstothesocietyarebrieflymentionedhereunder:

12.1.1 Maintenance of books of accounts : An accountant is able to maintain a systematic recordoffinancialtransactionsinordertoestablishthenetresultofthetransactionsenteredintoduringaperiodandtostatethefinancialpositionoftheconcernasataparticulardate.

Forthefulfillmentofthetwinobjectiveofascertainingtheprofitearnedorlosssufferedandthefinancialposition,itisnecessarythatalltransactionsberecordedinasystematicmanner,whichcanbedoneonlybyanaccountant.Propermaintenanceofbooksofaccountsassistsmanagementinplanning,decision-making,controllingfunctions.

12.1.2 statutory audit : Every limited company is required to appoint a chartered accountant orafirmofcharteredaccountantsastheirauditorwhoarestatutorilyrequiredtoreporteachyear whether in their opinion the balance sheet shows a true and fair view of the state of affairs onthebalancesheetdate,andtheprofitandlossaccountshowsatrueandfairviewoftheprofitorlossfortheyear.

Auditingisnotconfinedtotheaccountsofcompanies;otherorganisationsmayalsohavetheiraccounts audited, either because the law so requires (for example, the Co-operative Societies Act, theIncome-taxAct,etc.)orbecausetheproprietorswiselydecidedso(forexample,apartnershipfirmoranindividualtrader).

12.1.3 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 orassetsandtheoperationshavebeencarriedoutinconformitywiththeplansofmanagement.

Now-a-daysinternalauditinghasdevelopedasaservicetomanagement.Theinternalauditorconstructivelycontributes in improvingtheoperationalefficiencyof thebusinessthroughanindependentreviewandappraisalofallbusinessoperations.

12.1.4 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 thestatuteprevailing.Hecanalsoassistinavoidingorreducingtaxburdenbyproperplanningoftaxaffairs.

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 on all other aspects of taxation in which theyhaveknowledgesuperiortothatofthegeneralpublic.

12.1.5 Management accounting and consultancy services : Management accountant performs an advisoryfunction.Heislargelyresponsibleforinternalreportingtothemanagementforplanningand controlling current operations, decision-making on special matters and for formulating long-rangeplans.Hisjobistocollect,analyse,interpretandpresentallaccountinginformationwhichisusefultothemanagement.Accountantprovidesmanagementconsultancyservicesintheareasof management information system, expenditure control and evaluation of appraisal techniques fornewinvestmentsanddivestments,workingcapitalmanagement,corporateplanningetc.

12.1.6 financial advice : Manypeopleneedhelpandguidanceinplanningtheirpersonalfinancialaffairs.Anaccountantwhoknowsaboutfinances,taxationandfamilyproblemsiswellplacedtogivesuchadvice.Someoftheareasinwhichanaccountantcanrenderfinancialadviceare:

(a) Investments:An accountant can explain the significance of the formidabledocumentswhich shareholders receive from companies and help in making decisions relating to their investments.

(b) Insurance:Anaccountantcanprovideinformationtohisclientsonvariousinsurancepoliciesandhelpsinchoosingappropriatepolicy.

(c) BusinessExpansion:Asbusinessesgrow in size and complexityandmergers arebeingconsidered, accountants are in the forefront in interpreting accounts, making suggestions as to theformofschemesandthefairnessofproposalsconsideringcostandfinancialconsequencesandgenerallyadvisingtheirclients.Theyalsoadviseonhowtosetabouttheproblemofborrowingmoneyorwhetherthis isanappropriatemethodoffinance.Accountantscanrenderextremelyusefulserviceinconnectionofnegotiationswithforeigncollaborators.

(d) Investigations:Financialinvestigationsarerequiredforavarietyofpurposes.Examplesare:

(i) To ascertain thefinancialpositionof a business, for the informationof interestedparties in connection with an issue of capital, the purchase or sale of the business or a reconstructionoramalgamation.



(ii) Tohelpthemanagementtodecidewhetheritischeapertomanufactureanarticleortobuyout.

(iii) Toascertainwhyprofitshavefallen.

(iv) Toachievegreaterefficiencyinmanagement.

(v) Toascertainwhetherfraudhasoccurredandifso,itsnatureandextentandtomakesuggestionswhichwillhelptopreventarecurrence.

(vi) Tovaluebusinessesandsharesinprivatecompaniesforpurposessuchaspurchase,sale,estatedutyorwealthtaxetc.

Forsuchproblemsrequiringfinancialinvestigation,youneedanaccountant.Histaskasanindependentprofessionalistoestablishthefactsfairlyandclearlyforthebenefitof those who have to make decisions and to give advice in many areas in which he has competenceandexperience.

(e) Pensionschemes:Specialistadvicefromactuaries,insuranceagentsorinsurancecompanyisneededbeforelaunchingoramendingaprovidentfundorpensionschemeinabusiness.Butbeforemakingafinaldecision,anaccountanthastobeconsulted.Lateronhishelpmaybeneededformanagingtheschemeorobtainingtaxrelief.

12.1.7 Other services

(a) Secretarial Work : Companies, clubs, and associations indeed, virtually all organisations involvesecretarialwork.Accountantsfrequentlydothiswork.

(b) Share Registration Work : Accountants are often used by many companies to undertake the workinvolvedinregisteringsharetransfersandnewissues.

(c) Company Formation : In conjunction with legal advisers, accountants help in the formation ofacompanyoradviseagainstdoingso.

(d) Receiverships, Liquidations, etc. : An accountant has to sometimes take on the onerous duties of liquidator when a company is being wound up or receiver when a debenture holder exercises arighttorecoveraloanonwhichtheborrowerhasdefaulted.Accountantisjustthemanforthejob.Heisalsojustthemantohelpyoutokeepinsolvencyawayifyouconsulthimintime.

(e) Arbitrations : At times, accountants are invited by parties to act as arbitrators in a dispute or settledisputesofvariouskinds.

(f) As Regards the Cost Accounts : A cost accountants job is to continuously report cost data and relatedinformationatfrequentintervalstothemanagement.

(g) Accountant and Information Services : An accountant will be effective in his role if he supplies theinformationpromptlyandinanunambiguouslanguage.Heshoulddevelopasystembywhichthereisaregularflowofinformationbothhorizontallyandvertically.

The information systemshouldbe such that comparabilityoffinancial statement ispossiblebothbusiness-wiseandyear-wiseso that itbenefitsboth themanagementandthe investors.Dependence on data from the computerised information system will put new responsibilities on anaccountantbuthisproductwillcommandgreaterattentionandrespect.




12.2 cHartered accOuntant In Industry

Anaccountant,thoughheisapartofthehighestplanningteamisnotaplannerinanindustry.Heworkswiththefunctionaldepartmentsandtranslatestheorganisationsaimsintermsoffinancialexpectations.Therefore,hehastomakeathoroughstudyofthebusinessandofindividualsinthe functionaldepartments,whether theyare engineersor salesmen.Aqualifiedaccountantwill be able to play an important role in performing important functions of a business relating to accounting,costingandbudgetarycontrol,estimatingandtreasury.

12.3 cHartered accOuntant In PubLIc sectOr enterPrIses

Bothinthedevelopedanddevelopingcountries,publicsectorenterpriseshavebecomeaspecialfeatureofthenationaleconomy.Thesystemoffinancialandbudgetarycontrolandofaccounting,auditing and reporting has, therefore, become a matter of interest and concern to the nation, and doesnotremainconfinedmerelytoalimitednumberofshareholders.Theformofaccountingfollowed by these corporations or companies is different from that of ordinary government accounting.Itisthedutyoftheaccountantstopreparetheaccountsandreportsofthesepubliccorporations in such a way that they enable the general public to know how far the items appearing inthevarioustypesofrecordsandfinancialstatementsjustifytheirexistence.

12.4 cHartered accOuntant In fraMIng fIscaL POLIcIes

Accountantshave apositive role toplay in thedeterminationofproperfiscalpolicies andadvancementoftrade,commerceandindustry.Theyshoulddevelopnewtechniquesandpreparethemselvesfornewfieldsofservicetowardstheircommitmenttotheconceptofthepublicgoodsandservices.Abusinessenterprisecanbesuccessfulinthecommercialsenseonlyifaccountingandbusinessknowledgearepooledtogether. It isasocialobligationforbothaccountants inindustryandinpracticetodisclosegreaterinformationregardingthecorporateresults.Thestateof affairs of the economy can be ascertained only when such consolidated corporate information isdisclosed.

12.5 cHartered accOuntant and ecOnOMIc grOwtH

In the present times accountants should conceive their duties as broadly as the conditions might requireanddonotrestrictthemtoonlyliteralcomplianceofthelaw.Theiraimshouldbenottoallowanyindividualtogainatthecostofthenation.Accountantshavetoacceptapositiveroleanddotheirbesttoencourageefficiencyinindividualbusinessunitsandencouragethosesocialobjectives which form the main foundation of a welfare state.

seLf exaMInatIOn QuestIOns Pick up the correct answer from the given choices:

1. Whichofthefollowingisnotasubfieldofaccounting?

(a) Managementaccounting. (b) Costaccounting.

(c) Financialaccounting. (d) Book-keeping.



2. Purposesofanaccountingsystemincludeallthefollowingexcept

(a) Interpretandrecordtheeffectsofbusinesstransaction.

(b) Classifytheeffectsoftransactionstofacilitatethepreparationofreports.

(c) Summarizeandcommunicateinformationtodecisionmakers.

(d) Dictatethespecifictypesofbusinessenterprisetransactionsthattheenterprisesmay engagein.

3. Book-keepingismainlyconcernedwith

(a) Recordingoffinancialdata.

(b) Designingthesystemsinrecording,classifyingandsummarisingtherecordeddata.

(c) Interpretingthedataforinternalandexternalusers.

(d) Noneoftheabove.

4. AllofthefollowingarefunctionsofAccountingexcept

(a) Decisionmaking. (b) Measurement.

(c) Forecasting. (d) Ledgerposting.

5. Financialstatementsarepartof

(a) Accounting. (b) Book-keeping.

(c) Alloftheabove. (d) Noneoftheabove.

6. Financialpositionofthebusinessisascertainedonthebasisof

(a) Recordspreparedunderbook-keepingprocess.

(b) Trialbalance.

(c) Accountingreports.

(d) Noneoftheabove.

7. Usersofaccountinginformationinclude

(a) Creditors/Suppliers (b) Lenders.

(c) Customers. (d) Alloftheabove.

8. Financialstatementsdonotconsider

(a) Assetsexpressedinmonetaryterms.

(b) Liabilitiesexpressedinmonetaryterms.

(c) Onlyassetsexpressedinnon-monetaryterms.

(d) Assets and liabilities expressed in non-monetary terms


9. OnJanuary1,Sohanpaidrentof`5,000.Thiscanbeclassifiedas

(a) Anevent. (b)Atransaction.

(c) Atransactionaswellasanevent. (d)Neitheratransactionnoranevent.

10. OnMarch31,2011aftersaleofgoodsworth` 2,000, he is left with the closing inventory of `10,000.Thisis

(a) Anevent. (b)Atransaction.

(c) Atransactionaswellasanevent. (d)Neitheratransactionnoranevent.

[Ans.1.(d),2.(d),3.(a),4.(d),5.(a),6.(c),7.(d),8.(d),9.(b),10.(a)]




chapter - 1

Unit 2

Accounting Concepts,Principles

and Conventions

ACCOUNTING :AN

INTRODUCTION


accounting concepts, pRinciples and conventions


Learning Objectives

After studying this unit, you will be able to :

Grasp the basic accounting concepts, principles and conventions and observe their implicationswhilerecordingtransactionsandevents.

Identifythethreefundamentalaccountingassumptions: Going Concern Consistency Accrual

If theseassumptionsare followed,nodisclosure isessential. If thesearenot followedspecificdisclosureisessentialtohighlightthedeviations.

Understand the qualitative characteristics that will help to develop the skill in course of timetopreparefinancialstatements.

1. IntrOductIOn Let us imagine a situation where you are a proprietor and you take copies of your books of account tofivedifferentaccountants.Youaskthemtopreparethefinancialstatementsonthebasisoftheaboverecordsandtocalculatetheprofitsofthebusinessfortheyear.Afterfewdays,theyarereadywiththefinancialstatementsandallthefiveaccountantshavecalculatedfivedifferentamountsofprofitsandthattoowithverywidevariationsamongthem.Guessinsuchasituationwhat impactwould it leaveonyouaboutaccountingprofession. Toavoid this, agenerallyacceptedsetofruleshavebeendeveloped.Thisgenerallyacceptedsetofrulesprovidesunityofunderstanding and unity of approach in the practice of accounting and also in better preparation andpresentationofthefinancialstatements.

Accounting is a languageof thebusiness. Financial statementspreparedby theaccountantcommunicatefinancial information to thevariousstakeholders fordecision-makingpurpose.Therefore,itisimportantthatfinancialstatementspreparedbydifferentorganizationsshouldbepreparedonuniformbasis. Alsothereshouldbeconsistencyoveraperiodoftimeinthepreparationofthesefinancialstatements.Ifeveryaccountantstartsfollowinghisownnormsandnotionsforaccountingofdifferentitemsthentherewillbeanutterconfusion.

Toavoidconfusionandtoachieveuniformity,accountingprocessisappliedwithintheconceptualframeworkofGenerallyAcceptedAccountingPrinciples(GAAPs).ThetermGAAPsisusedtodescriberulesdevelopedforthepreparationofthefinancialstatementsandarecalledconcepts,conventions, postulates, principles etc. TheseGAAPs are the backbone of the accountinginformationsystem,withoutwhichthewholesystemcannotevenstanderectly.Theseprinciplesare theground rules,whichdefine theparameters andconstraintswithinwhichaccountingreportsaregenerated.Accountingprinciplesarebasicnormsandassumptionsonwhichthewholeaccountingsystemhasbeendevelopedandestablished.Accountantalsoadherestovariousaccounting standards issued by the regulatory authority for the standardization of accounting policiestobefollowedunderspecificcircumstances.Theseconceptualframeworks,GAAPsandaccountingstandardsareconsideredasthetheorybaseofaccounting.



2. accOuntIng cOncePts Accounting conceptsdefine theassumptionson thebasisofwhichfinancial statementsof abusinessentityareprepared.Certainconceptsareperceived,assumedandacceptedinaccountingtoprovideaunifyingstructureandinternallogictoaccountingprocess.Thewordconceptmeansideaornotion,whichhasuniversalapplication.Financialtransactionsareinterpretedinthelightoftheconcepts,whichgovernaccountingmethods.Conceptsarethosebasicassumptionsandconditions,whichformthebasisuponwhichtheaccountancyhasbeenlaid.Unlikephysicalscience,accountingconceptsareonlyresultofbroadconsensus.Theseaccountingconceptslaythefoundationonthebasisofwhichtheaccountingprinciplesareformulated.

3. accOuntIng PrIncIPLes Accounting principles are a body of doctrines commonly associated with the theory and procedures of accounting serving as an explanation of current practices and as a guide for selection ofconventionsorprocedureswherealternativesexits.

Accountingprinciplesmustsatisfythefollowingconditions:

1. Theyshouldbebasedonrealassumptions;

2. Theymustbesimple,understandableandexplanatory;

3. Theymustbefollowedconsistently;

4. Theyshouldbeabletoreflectfuturepredictions;

5. Theyshouldbeinformationalfortheusers.

4. accOuntIng cOnVentIOns Accounting conventions emerge out of accounting practices, commonly known as accounting principles,adoptedbyvariousorganizationsoveraperiodoftime.Theseconventionsarederivedbyusageandpractice.Theaccountancybodiesoftheworldmaychangeanyoftheconventiontoimprovethequalityofaccountinginformation.Accountingconventionsneednothaveuniversalapplication.

In the study material, the terms accounting concepts, accounting principles and accounting conventions have been used interchangeably to mean those basic points of agreement on which financialaccountingtheoryandpracticearefounded.

5. cOncePts, PrIncIPLes and cOnVentIOns - an OVerVIew Nowweshallstudyindetailthevariousaccountingconceptsonwhichaccountingisbased.Thefollowingarethewidelyacceptedaccountingconcepts:

(a) Entity concept : Entity concept states that business enterprise is a separate identity apart from itsowner.Accountantsshouldtreatabusinessasdistinctfromitsowner.Businesstransactionsare recorded in the business books of accounts and owners transactions in his personal books ofaccounts.Thepracticeofdistinguishingtheaffairsofthebusinessfromthepersonalaffairs




oftheownersoriginatedonlyintheearlydaysofthedouble-entrybook-keeping.Thisconcepthelpsinkeepingbusinessaffairsfreefromtheinfluenceofthepersonalaffairsoftheowner.Thisbasic concept is applied to all the organizations whether sole proprietorship or partnership or corporateentities.

Entity concept means that the enterprise is liable to the owner for capital investment made by theowner.Sincetheownerinvestedcapital,whichisalsocalledriskcapitalhehasclaimontheprofitoftheenterprise.Aportionofprofitwhichisapportionedtotheownerandisimmediatelypayablebecomescurrentliabilityinthecaseofcorporateentities.

Example:Mr.Xstartedbusinessinvesting` 7,00,000 with which he purchased machinery for `5,00,000andmaintainedthebalanceinhand.Thefinancialpositionofthebusiness(whichisshownbyBalanceSheet)willbeasfollows:

balance sheet

Liability Assets ` `

Capital 7,00,000 Machinery 5,00,000

Cash 2,00,000

7,00,000 7,00,000

ThismeansthattheenterpriseowestoMr.X`7,00,000.NowifMr.Xspends` 5,000 to meet his family expenses from the business fund, then it should not be taken as business expenses andwould be charged to his capital account (i.e., his investmentwould be reduced by `5,000).Followingtheentityconcepttherevisedfinancialpositionwouldbe

balance sheet

Liability Assets ` `


Less:Drawings 5,000 6,95,000 Cash 1,95,000

6,95,000 6,95,000

(b) Money measurement concept : As per this concept, only those transactions, which can be measured in termsofmoneyare recorded.Sincemoney is themediumofexchangeand thestandard of economic value, this concept requires that those transactions alone that are capable of beingmeasuredintermsofmoneybeonlytoberecordedinthebooksofaccounts.Transactions,even if, they affect the results of the business materially, are not recorded if they are not convertible inmonetaryterms.Transactionsandeventsthatcannotbeexpressedintermsofmoneyarenotrecordedinthebusinessbooks.Forexample;employeesoftheorganizationare,nodoubt,theassets of the organizations but their measurement in monetary terms is not possible therefore, notincludedinthebooksofaccountoftheorganization.Measuringunitformoneyistakenasthecurrencyoftherulingcountryi.e.,therulingcurrencyofacountryprovidesacommondenominationforthevalueofmaterialobjects.Themonetaryunitthoughaninelasticyardstick,remainsindispensabletoolofaccounting.



It may be mentioned that when transactions occur across the boundary of a country, one may seemanycurrencies.SupposeanIndianbusinessmansellsgoodsworth` 50 lakhs at home and healsosellsgoodsworthof1lakhEurointheUnitedStates.Whatishistotalsales?` 50 lakhs plus1lakhEuro.

Thesearenotamenabletoevenarithmetictreatment.Sotransactionsaretoberecordedatuniformmonetaryuniti.e.inonecurrency.SupposeEURO1=`55.

TotalSales=`50lakhsplus55lakhs=`105lakhs.MoneyMeasurementConceptimpartstheessentialflexibilityformeasurementandinterpretationofaccountingdata.

Thisconceptignoresthatmoneyisaninelasticyardstickformeasurementasitisbasedontheimplicitassumptionthatpurchasingpowerofthemoneyisnotofsufficientimportanceastorequireadjustment.Also,manymaterialtransactionsandeventsarenotrecordedinthebooksofaccountsjustbecauseitcannotbemeasuredinmonetaryterms.Thereforeitisrecognizedbyalltheaccountantsthatthisconcepthasitsownlimitationsandinadequacies.Yetitisusedforaccountingpurposesbecauseitisnotpossibletoadoptabettermeasurementscale.

Entity and money measurement are viewed as the basic concepts on which other procedural conceptshinge.

(c) Periodicity concept :Thisisalsocalledtheconceptofdefiniteaccountingperiod.Aspergoingconcernconceptanindefinitelifeoftheentityisassumed.Forabusinessentityitcausesinconveniencetomeasureperformanceachievedbytheentityintheordinarycourseofbusiness.

Ifatextilemilllastsfor100years,itisnotdesirabletomeasureitsperformanceaswellasfinancialpositiononlyattheendofitslife.

Soasmallbutworkablefractionoftimeischosenoutofinfinitelifecycleofthebusinessentityformeasuringperformanceandlookingatthefinancialposition.Generallyoneyearperiodistakenupforperformancemeasurementandappraisaloffinancialposition.However,itmayalsobe6monthsor9monthsor15months.

Accordingtothisconceptaccountsshouldbepreparedaftereveryperiod&notattheendofthelifeoftheentity.Usuallythisperiodisonecalendaryear.InIndiawefollowfrom1stAprilofayearto31stMarchoftheimmediatelyfollowingyear.

Thus, forperformanceappraisal it isnotnecessary to look into therevenueandexpensesofanundulylongtime-frame.Thisconceptmakestheaccountingsystemworkableandthetermaccrualmeaningful.Ifonethinksofindefinitetime-frame,nothingwillaccrue.Therecannotbeunpaidexpensesandnon-receiptofrevenue.Accruedexpensesoraccruedrevenueisonlywithreferencetoafinitetime-framewhichiscalledaccountingperiod.

Thus,theperiodicityconceptfacilitatesin:

(i) Comparingoffinancialstatementsofdifferentperiods

(ii) Uniformandconsistentaccountingtreatmentforascertainingtheprofitandassetsofthebusiness

(iii) Matching periodic revenues with expenses for getting correct results of the business operations




(d) Accrual concept : Under accrual concept, the effects of transactions and other events are recognisedonmercantilebasisi.e.,whentheyoccur(andnotascashoracashequivalentisreceivedorpaid)andtheyarerecordedintheaccountingrecordsandreportedinthefinancialstatementsoftheperiodstowhichtheyrelate.Financialstatementspreparedontheaccrualbasisinformusers not only of past events involving the payment and receipt of cash but also of obligations to paycashinthefutureandofresourcesthatrepresentcashtobereceivedinthefuture.

Tounderstandaccrualassumptionknowledgeofrevenuesandexpensesisrequired.Revenueisthegrossinflowofcash,receivablesandotherconsiderationarisinginthecourseoftheordinaryactivities of an enterprise from sale of goods, from rendering services and from the use by others ofenterprisesresourcesyeildinginterest,royaltiesanddividends.Forexample,(1)Mr.Xstartedaclothmerchandising.Heinvested` 50,000, bought merchandise worth `50,000.Hesoldsuchmerchandise for ` 60,000.Customerspaidhim` 50,000 cash and assure him to pay ` 10,000 shortly.Hisrevenueis`60,000.Itaroseintheordinarycourseofclothbusiness;Mr.Xreceived` 50,000 in cash and `10,000bywayofreceivables.

Take another example; (2) an electricity supplyundertaking supplies electricity spending ` 16,00,000 for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of electricitycharges.Thisisalsorevenuewhicharosefromrenderingservices.

Lastly, (3)Mr. A invested ` 1,00,000 in a business. He purchased amachine paying`1,00,000.Hehireditoutfor`20,000annuallytoMr.B.`20,000istherevenueofMr.A;itarosefromtheusebyothersoftheenterprisesresources.

Expense is a cost relating to the operations of an accounting period or to the revenue earned duringtheperiodorthebenefitsofwhichdonotextendbeyondthatperiod.

Inthefirstexample,Mr.Xspent`50,000tobuythemerchandise;itistheexpenseofgeneratingrevenue of ` 60,000. In the second instance` 16,00,000 are the expenses.Alsowheneveranyasset isused ithas afinite life togeneratebenefit. Suppose, themachinepurchasedby Mr.Ainthethirdexamplewilllastfor10yearsonly.Then`10,000istheexpensehemet.Forthetimebeing,ignoretheideaofaccountingperiod.

Accrual means recognition of revenue and costs as they are earned or incurred and not as money isreceivedorpaid.Theaccrualconceptrelatestomeasurementofincome,identifyingassetsandliabilities.

Example:Mr.JDbuysclothingof` 50,000 paying cash ` 20,000 and sells at ` 60,000 of which customers paid only `50,000.

His revenue is ` 60,000, not ` 50,000 cash received. Expense (i.e., cost incurred forthe revenue) is ` 50,000, not ` 20,000 cash paid. So the accrual concept based profit is`10,000(RevenueExpenses).

AsperAccrualConcept:RevenueExpenses=Profit

Accrual Concept provides the foundation on which the structure of present day accounting has beendeveloped.



Alternative as per Cash basis

CashreceivedinordinarycourseofbusinessCashpaidinordinarycourseofbusiness=profit.

Revenuemaynotberealisedincash.Cashmaybereceivedsimultaneouslyor

(i) beforerevenueiscreated(A.1)

(ii) afterrevenueiscreated(A.2)

Expensesmaynotbepaidincash.Cashmaybepaidsimultaneouslyor(i)beforeexpenseismade(B.1)(ii)afterexpenseismade(B.2)

A. 1 creates a liabilitywhen cash is received in advance.A. 2 creates anasset calledTradereceivables.B.1createsanassetcalledTradeAdvancewhencashispaidinadvancewhileB.2createsaliabilitycalledpayablesorTradepayablesoroutstandingliabilities.Iftheexpensesremainunpaid inrespectofgoods, it iscalledTradepayables, if it remainsunpaidforotherexpenses,itiscalledExpensepayables.

(e) Matching concept : In this concept, all expenses matched with the revenue of that period shouldonlybetakenintoconsideration.Inthefinancialstatementsoftheorganizationifanyrevenueisrecognizedthenexpensesrelatedtoearnthatrevenueshouldalsoberecognized.

Thisconceptisbasedonaccrualconceptasitconsiderstheoccurrenceofexpensesandincomeanddonotconcentrateonactualinfloworoutflowofcash.Thisleadstoadjustmentofcertainitemslikeprepaidandoutstandingexpenses,unearnedoraccruedincomes.

Itisnotnecessarythateveryexpenseidentifyeveryincome.Someexpensesaredirectlyrelatedtotherevenueandsomearetimebound.Forexample:-sellingexpensesaredirectlyrelatedtosalesbutrent,salariesetcarerecordedonaccrualbasisforaparticularaccountingperiod.Inotherwordsperiodicityconcepthasalsobeenfollowedwhileapplyingmatchingconcept.

Mr.PK started clothbusiness.Hepurchased 10,000pcs. garments@` 100 per piece and sold 8,000pcs.@` 150per pieceduring the accountingperiod of 12months 1st Januaryto 31stDecember, 2011.Hepaid shop rent@` 3,000 permonth for 11months andpaid`8,00,000tothesuppliersofgarmentsandreceived`10,00,000fromthecustomers.

Letusseehowtheaccrualandperiodicityconceptsoperate.

PeriodicityConceptfixesupthetime-frameforwhichtheperformanceistobemeasuredandfinancialpositionistobeappraised.Here,itisJanuary2011-December,2011.Sorevenuesandexpenses are to be measured for the year 2011 and assets and liabilities are to be ascertained as on31stDecember,2011.

Accrual Concept operates to measure revenue of ` 12,00,000(arisingoutofsaleofgarments8,000Pcs` 150) which accrued during 2011, not the cash received ` 10,00,000 and also the expenses correctly.Shoprentfor12monthsisanexpenseitemamountingto`36,000,not`33,000thecashpaid.

Should the accountant treat ` 10,00,000 as expenses for purchase of merchandise ? And should he treat `1,64,000asprofit?(Revenue` 12,00,000-Merchandise `10,00,000.ShopRent`36,000).ObviouslytheanswerisNo.Matchinglinksrevenuewithexpenses.




RevenueExpenses=Profit

Butthisunqualifiedequationmaycreatemisconception.Itshouldbedefinedas:

PeriodicProfit=PeriodicRevenueMatchedExpenses

Fromtherevenueofanaccountingperiodsuchexpensesaredeductedwhichareexpendedtogeneratetherevenuetodetermineprofitofthatperiod.

Inthegivenexamplerevenuerelatestoonlysaleof8,000pcs.ofgarments.Sothecostof8,000pcsofgarmentsshouldbetreatedasexpenses.

Thus,Profit = Revenue ` 12,00,000

Less :Expenses:

Merchandise `8,00,000

ShopRent `36,000 `8,36,000

`3,64,000

Assets

Inventory(2,000pcs` 100) ` 2,00,000

Tradereceivables ` 2,00,000

Cash(CashReceipts` 10,00,000 cash payments `8,33,000) ` 1,67,000

` 5,67,000

Liabilities:

TradePayables ` 2,00,000

ExpensePayables `3,000

Capital(forProfit) `3,64,000

` 5,67,000

Thus, accrual, matching and periodicity concepts work together for income measurement and recognition of assets and liabilities.

(f) Going Concern concept :Thefinancialstatementsarenormallypreparedontheassumptionthatanenterpriseisagoingconcernandwillcontinueinoperationfortheforeseeablefuture.Hence,itisassumedthattheenterprisehasneithertheintentionnortheneedtoliquidateorcurtailmateriallythescaleofitsoperations;ifsuchanintentionorneedexists,thefinancialstatementsmayhavetobepreparedonadifferentbasisand,ifso,thebasisusedisdisclosed.

Thevaluationof assetsof abusiness entity isdependenton this assumption. Traditionally,accountantsfollowhistoricalcostinmajorityofthecases.

SupposeMr.Xpurchasedamachineforhisbusinesspaying` 5,00,000 out of ` 7,00,000 invested byhim.Healsopaidtransportationexpensesandinstallationchargesamountingto`70,000.Ifheisstillwillingtocontinuethebusiness,hisfinancialpositionwillbeasfollows:



balance sheet

Liability ` Assets `


Cash 1,30,000

7,00,000 7,00,000

Nowifhedecidestobackoutanddesirestosellthemachine,itmayfetchmorethanorlessthan `5,70,000.Sohisfinancialpositionshouldbedifferent.Ifgoingconcernconceptistaken,increase/decreaseinthevalueofassetsintheshort-runisignored.Theconceptindicatesthatassetsarekeptforgeneratingbenefitinfuture,notforimmediatesale;currentchangeintheassetvalueisnotrealisableandsoitshouldnotbecounted.

(g) Cost concept : Bythisconcept,thevalueofanassetistobedeterminedonthebasisofhistoricalcost,inotherwords,acquisitioncost.Althoughtherearevariousmeasurementbases,accountantstraditionallypreferthisconceptintheinterestsofobjectivity.Whenamachineisacquiredbypaying ` 5,00,000, following cost concept the value of the machine is taken as `5,00,000.It ishighlyobjectiveandfreefromallbias.Othermeasurementbasesarenotsoobjective.Currentcostofanassetisnoteasilydeterminable.Iftheassetispurchasedon1.1.1995andsuchmodelisnotavailableinthemarket,itbecomesdifficulttodeterminewhichmodelistheappropriateequivalenttotheexistingone.Similarly,unlessthemachineisactuallysold,realisablevaluewillgiveonlyahypotheticalfigure.Lastly,presentvaluebaseishighlysubjectivebecausetoknowthevalueoftheassetonehastochasetheuncertainfuture.

However,thecostconceptcreatesalotofdistortiontooasoutlinedbelow:

(a) Inaninflationarysituationwhenpricesofallcommoditiesgouponanaverage,acquisitioncostlosesitsrelevance.Forexample,apieceoflandpurchasedon1.1.1995for` 2,000 may cost ` 1,00,000ason1.1.2011.Soiftheaccountantmakesvaluationofassetathistoricalcost,theaccountswillnotreflectthetrueposition.

(b) Historicalcost-basedaccountsmaylosecomparability.Mr.Xinvested` 1,00,000 in a machine on1.1.1995whichproduces`50,000cashinflowduringtheyear2011,whileMr.Yinvested `5,00,000inamachineon1.1.2005whichproduced`50,000cashinflowsduringtheyear.Mr.Xearnedattherate20%whileMr.Yearnedattherate10%.Whoismore-efficient?Sincetheassetsarerecordedatthehistoricalcost,theresultsarenotcomparable.Obviouslyitisacorollaryto(a).

(c) Manyassetsdonothaveacquisitioncosts.Humanassetsofanenterpriseareanexample.Thecostconceptfailstorecognisesuchassetalthoughitisaveryimportantassetofanyorganization.

Manyothercontroversial issueshavearisen infinancialaccountingthatrevolvesaroundthecostconceptwhichwillbediscussedattheadvancedstage.However,lateronweshallseethatinmanycircumstances, thecostconvention isnot followed.Seeconservatismconcept foranexample,whichwillbediscussedlateroninthisunit.




(h) Realisation concept :Itcloselyfollowsthecostconcept.Anychangeinvalueofanassetistoberecordedonlywhenthebusinessrealisesit.Whenanassetisrecordedatitshistoricalcostof ` 5,00,000 and even if its current cost is ` 15,00,000 such change is not counted unless there is certaintythatsuchchangewillmaterialise.

However,accountantsfollowamoreconservativepath.Theytrytocoverallprobablelossesbutdonotcountanyprobablegain.Thatistosay,ifaccountantsanticipatedecreaseinvaluetheycountit,butifthereisincreaseinvaluetheyignoreituntilitisrealised.Economistsarehighlycriticalabouttherealisationconcept.Accordingtothem,thisconceptcreatesvaluedistortionandmakesaccountingmeaningless.

Example:Mr.Xpurchasedapieceoflandon1.1.1995paying`2,000.Itscurrentmarketvalueis`1,02,000on31.12.2011.Shouldtheaccountantshowthelandat` 2000 following cost concept and ignoring `1,00,000valueincreasesinceitisnotrealised?Ifhedoesso,thefinancialpositionwouldbe:

balance sheet

Liability ` Asset `

Capital 2,000 Land 2,000

2,000 2,000

Is it not proper to show it in the following manner?

balance sheet

Liabilities ` Asset `

Capital 2,000 Land 1,02,000

Unrealised Gain 1,00,000

1,02,000 1,02,000

Now-a-daystherevaluationofassetshasbecomeawidelyacceptedpracticewhenthechangeinvalue is ofpermanentnature.Accountants adjust suchvalue change through creationofrevaluation(capital)reserve.

Thusthegoingconcern,costconceptandrealizationconceptgivesthevaluationcriteria.

(i) Dual aspect concept :Thisconceptisthecoreofdoubleentrybook-keeping.Everytransactionoreventhastwoaspects:

(1) ItincreasesoneAssetanddecreasesotherAsset;

(2) ItincreasesanAssetandsimultaneouslyincreasesLiability;

(3) ItdecreasesoneAsset,increasesanotherAsset;

(4) ItdecreasesoneAsset,decreasesaLiability.



Alternatively:

(5) ItincreasesoneLiability,decreasesotherLiability;

(6) ItincreasesaLiability,increasesanAsset;

(7) ItdecreasesLiability,increasesotherLiability;

(8) ItdecreasesLiability,decreasesanAsset.

Example :

balance sheet

Liabilities ` Assets `


BankLoan 75,000 Cash 1,00,000

OtherLoan 75,000

3,00,000 3,00,000

Transactions :

(a) A new machine is purchased paying ` 50,000 in cash(b) A new machine is purchased for ` 50,000 on credit, cash is to be paid later on(c) Cash paid to repay bank loan to the extent of ` 50,000(d) Raisedbankloanof` 50,000 to pay off other loan

Effect of the Transactions :

(a) Increase in machine value and decrease in cash balance by `50,000.

balance sheet (1 & 3)



BankLoan 75,000 Cash 50,000

OtherLoan 75,000

3,00,000 3,00,000

(b) Increase in machine value and increase in Creditors by `50,000.




Creditors for machinery 50,000 Cash 1,00,000

BankLoan 75,000

OtherLoan 75,000

3,50,000 3,50,000




(c) Decrease in bank loan and decrease in cash by `50,000:




BankLoan 25,000 Cash 50,000

OtherLoan 75,000

2,50,000 2,50,000

(d) Increase in bank loan and decrease in other loan by `50,000:




BankLoan 1,25,000 Cash 1,00,000

OtherLoan 25,000

3,00,000 3,00,000

Soeverytransactionandeventhastwoaspects.

Thisgivesbasicaccountingequation:

Equity(E)+Liabilities(L)=Assets(A)

or

Equity(E)=Assets(A)Liabilities(L)

Or,Equity+LongTermLiabilities+CurrentLiabilities=FixedAssets+CurrentAssets

Or,Equity+LongTermLiabilities=FixedAssets+(CurrentAssetsCurrentLiabilities)

Or,Equity=FixedAssets+WorkingCapitalLongTermLiabilities

Whateverisreceivedasfundsiseitherexpended(Expenses)DebitedtoProfit&LossAccount

Or Lost Losses are transferred to Capital Account

Or saved Shown on the Assets side of the Balance Sheet

Therefore,Capital+Income/Profits+Liabilities=Expenses+NetLoss+Assets

Or,Capital+IncomeExpenses+NetProfits=AssetsLiabilities

Sincethenetprofit/lossistransferredtoequity,theneteffectis

equity + Liabilities = assets



Illustration :

Developtheaccountingequationfromthefollowinginformation:-

april 01, 2010 March 31, 2011Particulars ` `

Capital 1,00,000 ? 12%BankLoan 1,00,000 1,00,000

TradePayables 75,000 70,000

FixedAssets 1,25,000 1,10,000

TradeReceivables 75,000 80,000

Inventory 70,000 80,000

Cash&Bank 5,000 6,000

Findtheprofitfortheyear&theBalancesheetason31/3/2011.

solution :

for the year ended april 01, 2010 :

Equity=Capital ` 1,00,000

Liabilities=BankLoan+TradePayables

` 1,00,000 + `75,000=` 1,75,000

Assets=FixedAssets+TradeReceivables+Inventory+Cash&Bank

` 1,25,000 + ` 75,000 + ` 70,000 + `5,000=` 2,75,000

Equity+Liabilities=Assets

` 1,00,000 + `1,75,000=2,75,000

for the year ended april 01, 2011 :

Assets=` 1,10,000 + `80,000+`80,000+`6,000=` 2,76,000

Liabilities=` 1,00,000 + `70,000=` 1,70,000

Equity=Assets-Liabilities=` 2,76,000 `1,70,000=` 1,06,000

Profits=NewEquity-OldEquity=` 1,06,000 `1,00,000=` 6,000

(j) Conservatism : Conservatism states that the accountant should not anticipate income and shouldprovideforallpossiblelosses.Whentherearemanyalternativevaluesofanasset,anaccountantshouldchoosethemethodwhichleadstothelesservalue.Lateronweshallseethatthe golden rule of current assets valuation - cost or market price whichever is lower originated fromthisconcept.




TheRealisationConceptalsostatesthatnochangeshouldbecountedunlessithasmaterialised.TheConservatismConceptputsafurtherbrakeonit.Itisnotprudenttocountunrealisedgainbutitisdesirabletoguardagainstallpossiblelosses.

Forthisconceptthereshouldbeatleastthreequalitativecharacteristicsoffinancialstatements,namely,

(i) Prudence,i.e.,judgementaboutthepossiblefuturelosseswhicharetobeguarded,aswellasgainswhichareuncertain.

(ii) Neutrality,i.e.,unbiasedoutlookisrequiredtoidentifyandrecordsuchpossiblelosses,aswell as to exclude uncertain gains,

(iii) Faithful representation of alternative values.

Many accounting authors, however, are of the view that conservatism essentially leads to understatement of income and wealth and it should not be the basis for the preparation of financialstatements.

(k) Consistency :Inordertoachievecomparabilityofthefinancialstatementsofanenterprisethroughtime,theaccountingpoliciesarefollowedconsistentlyfromoneperiodtoanother;achangeinanaccountingpolicyismadeonlyincertainexceptionalcircumstances.

Theconceptofconsistencyisappliedparticularlywhenalternativemethodsofaccountingareequallyacceptable.Forexampleacompanymayadoptanyofseveralmethodsofdepreciationsuchaswritten-down-valuemethod,straight-linemethod,etc.Likewisetherearemanymethodsforvaluationofinventories.Butfollowingtheprincipleofconsistencyitisadvisablethatthecompany should follow consistently over years the same method of depreciation or the same methodofvaluationofInventorieswhichischosen.Howeverinsomecasesthoughthereisnoinconsistency,theymayseemtobeinconsistentapparently.IncaseofvaluationofInventoriesifthe company applies the principle at cost or market price whichever is lower and if this principle accordingly results in the valuation of Inventories in one year at cost price and the market price intheotheryear,thereisnoinconsistencyhere.Itisonlyanapplicationoftheprinciple.

Buttheconceptofconsistencydoesnotimplynon-flexibilityasnottoallowtheintroductionofimprovedmethodofaccounting.

Anenterpriseshouldchangeitsaccountingpolicyinanyofthefollowingcircumstancesonly:

a. TobringthebooksofaccountsinaccordancewiththeissuedAccountingStandards.

b. Tocompliancewiththeprovisionoflaw.

c. Whenunderchangedcircumstancesitisfeltthatnewmethodwillreflectmoretrueandfairpictureinthefinancialstatement.

(l) Materiality: Materiality principle permits other concepts to be ignored, if the effect is notconsideredmaterial.Thisprincipleisanexceptionoffulldisclosureprinciple.Accordingtomaterialityprinciple,alltheitemshavingsignificanteconomiceffectonthebusinessoftheenterpriseshouldbedisclosedinthefinancialstatementsandanyinsignificantitemwhichwillonly increase the work of the accountant but will not be relevant to the users need should not bedisclosedinthefinancialstatements.



Thetermmaterialityisthesubjectiveterm.Itisonthejudgement,commonsenseanddiscretionoftheaccountantthatwhichitemismaterialandwhichisnot.Forexamplestationarypurchasedby the organization though not used fully in the accounting year purchased still shown as an expenseofthatyearbecauseofthematerialityconcept.Similarlydepreciationonsmallitemslikebooks,calculatorsetc.istakenas100%intheyearofpurchasethoughusedbytheentityfo

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