Accounting material

ACCOUNTANCY

Introduction:

                Business is an economic activity undertaken with the motive of earning profits and to maximize the wealth for the owners.  Business cannot run in isolation.  Largely, the business activity is carried out by people coming together with a purpose to serve a common cause.  This team is often referred to as an organization, which could be indifferent forms such as sole proprietorship, partnership, body corporate etc.

                The business activities require resources primarily in terms of material, labour, machineries, factories and other services.  The success of business depends on how efficiently and effectively these resources are managed.

                As the basic purpose of business is to make profit, one must keep an ongoing track of the activities undertaken in course of business.

Definitions:-

In order to understand the subject matter with clarity, let us study some of the definitions which depict the scope, content and purpose of Accounting

a)      Book-Keeping: The most common definition of book-keeping as given by J.R.Batliboi is “ Book-Keeping is an art of recording business transaction is a set of books.”

As can be seen, it is basically a record keeping function.  One must understand that not all dealings are however, recorded.

Only transactions expressed in terms of money will find place in books of accounts.  These are the transactions which will ultimately result in transfer of economic value from one person to the other.  Book-keepings is a continuous activity, routine and repetitive work, in today’s work, it is taken over by the computer systems.  Many accounting packages are available to suit different business organizations.

b)      Financial Accounting:  it is commonly termed as Accounting.  The American institute of Certified public accountants defines Accounting as “an art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are in part at lease of a financial character, and interpreting the results thereof.”

The first step in the cycle of accounting is to identify transactions that will find place in books of accounts.  Transactions having financial impact only are to be recorded.  E.g. if a businessman negotiates with the customer regarding supply of products, this will not be recorded.  The negotiation is a deal which will potentially create a transaction and will have exchange of money or money’s worth.  But unless this transaction is finally entered into, it will not be recorded in the books of accounts.

Secondly, the recording of the business transactions is done based on the Golden Rules of Accounting (which are explained later) in a systematic manner.  Transactions of similar nature are grouped together and recorded accordingly.  E.g. Sales Transactions, Purchase Transactions, Cash Transactions etc.

Thirdly, as the transactions increase in number, it will be difficult to understand the combined effect of the same by referring to individual records.  Hence, the art of accounting also involves the step of summarizing them.  With the aid of computers, this task is simplified in today’s accounting world.  The summarization will help users of the business information to understand and interpret business results.

Lastly, the accounting process provides the users with statements which will describe what has happened to the business.  Remember the two basic questions we talked about, one to know whether business has made profit or loss and the other to know the position of resources that are used by business.

It can be noted that although accounting is often referred to as an art, it is a science also.  This is because it is based on universally applicable set of rules.  However, it is not a pure science as there is possibility of different interpretation.

Difference between Book-Keeping and Accountancy:-

Sl.No.	Points of difference	Book- Keeping	Accountancy
1	Meaning	Book-keeping is considered as end.	Accountancy is considered as beginning
2	Functions	The primary stage of accounting function is called Book-Keeping	The overall accounting functions are guided by accountancy.
3	Depends	Book-keeping can provide the base of accounting	Accountancy depends on Book-keeping for its complete functions.
4	Data	the necessary data about financial performances and financial positions are taken from Book-keeping	Accountancy can take its decisions, prepare reports and statements from the data taken from Book-Keeping.
5	Recording of Transactions	Financial transaction are recorded on the basis of accounting principles, concepts and conventions.	Accountancy does not take any principles, concepts and conventions from Book-keeping.

ACCOUNTING CYCLE

When complete sequence of accounting procedure is done, which happens frequently and repeated in same directions during an accounting period, the same is called an accounting cycle.

Steps/ phases of Accounting Cycle

The steps or phases of accounting cycle can be developed as under:

a)      Recording of Transaction:- As soon as a transaction happens it is at first recorded in subsidiary book.

b)      Journal: The transactions are recorded in journal chronologically.

c)       Ledger: All journals are posted into ledger chronologically and in a classified manner.

d)      Trial Balance: After taking all the ledger account’s closing balances, a Trial balance is prepared at the end of the period for the preparations of financial statements.

e)      Adjustment Entries: All the adjustments entries are to be recorded properly and adjusted accordingly before preparing financial statements.

f)       Adjusted Trial Balance: An adjusted Trial balance may also be prepared

g)      Closing entries: All the nominal accounts are to be closed by the transferring to Trading account and Profit and Loss account.                                                                                                            

h)      Financial Statements: Financial Statement can now be easily prepared which will exhibit the true financial position and operation results.

Objectives of Accounting:-

The main objective of Accounting is to provide financial information to stakeholders.  This financial information is normally given via financial statements, which are prepared on the basis of Generally Accepted Accounting Principles (GAAP).  There are various accounting standards developed by professional accounting bodies all over the world.  In India, these are governed by the Institute of Chartered Accountants of India, (ICAI).  In th US, the American Institute of Certified Public Accountants (AICPA) is responsible to lay down the standards.  The financial Accounting Standards Board (FASB) is the body that sets up the International Accounting Standards.  These standards basically deal with the accounting treatment of business transactions and disclosing the same in financial statements.

The following objectives of accounting will explain the width of the application of this knowledge stream:

a)      To ascertain the amount of profit or loss made by the business i.e. to compare the income earned versus the expenses incurred and the net result thereof.

b)      To know the financial position of the business i.e. to assess what the business owns and what it owes.

c)       To provide a record for compliance with statutes and laws applicable.

d)      To enable the readers to assess progress made by the business over a period of time.

e)      To disclose information needed by different stake holders.

Let us now see which are different stakeholders of the business and what do they seek from the accounting information.  This is shown in the following table.

Stakeholder	Interest in business	Accounting Information
Owners/Investors/Existing and potential	Profit or losses	Financial statements, Cost Accounting records, management Accounting reports.
Lenders	Assessment of capability of the business to pay interest and principal of money lent.  Basically, they monitor the solvency of business	Financial statement and analysis thereof, reports forming part of accounts, valuation of assets given as security.
Customers and Suppliers	Stability and growth of the business	Financial and cash flow statements to assess ability of the business to offer better business terms and ability to supply the products and services.
Government	Whether the business is complying with various legal requirements	Accounting documents such as vouchers, extracts of books, information of purchase, sales, employee obligations etc. and financial statements.
Employees and Trader unions	Growth and profitability	Financial statements for negotiating pay packages.
Competitors	Performance and possible tie-ups in the era of mergers and acquisitions.	Accounting information to find out possible synergies.

Users of Accounting Information:-

Accounting provides information both to internal users and the external users. The internal users are all the organizational participants at all levels of the management (i.e. top, middle and lower).  Generally top level management requires information for planning, middle level management which requires information for controlling the operations.  For internal use, the information is usually provided in the form of reports, for insance Cash Budget Reports, Production Reports, Idle Time Reports, Feedback Reports, Whether to retain or replace an equipment decision reports, project appraisal report, and the like. 

There are also the external users (e.g. Banks, Creditors).  They do not have direct access to all the recors of an enterprise, they have to rely on financial statements as the source of information.  External users are basically, interested in the solvency and profitability of an enterprise.

Types of Accounting Information:-

Accounting information may be categorized in number of ways on the basis of purpose of accounting information, on the basis of measurement criteria and so on.  The various types of accounting information are given below.

I.                    Accounting information relating to financial transaction and events.

a)      Financial position: information about financial position is primarily provided in a Balance sheet

b)      Financial Performance: information about financial performance is primarily provided in a statement of profit and loss which is also known as income statement.

c)       Cash Flows: information about cash flows is provided in the financial statements by means of a cash flow statement.

II.                  Accounting information relating to cost of a product, operation or function.

III.                Accounting information relating to planning and controlling the activities of an enterprise for internal reporting.

IV.                Accounting information relating to Social Effects of business decisions.

V.                  Accounting information relating to Environment Ecology.

VI.                Accounting information relating to Human Resources.

Basic Accounting Terms:-

In order to understand the subject matter clearly, one must grasp the following common expressions always used in business accounting.

i.                     Transaction: It means an event or a business activity which involves exchange of money or money’s worth between parties.  The event can be measured in terms of money and changes the financial position of a person e.g. purchase of goods would involve receiving material and making payment or creating an obligation to pay to the supplier at a future date.  Transaction could be a cash transaction or credit.  When the parties settle the transaction immediately by making payment in cash or by cheque, it is called a cash transaction.  In credit transaction, the payment is settled at a future date as per agreement between the parties.

ii.                   Goods / Services:  These are tangible article or commodity in which a business deals.  These articles or commodities are either bought and sold or produced and sold.  At times, what may be classified as ‘goods’ to one business firm may not be ‘goods’ to the other firm.  E.g. for a machine manufacturing company, the machines are ‘goods’ as they are frequently made and sold.  But for the buying firm, it is not ‘goods’ as the intention is to use it as a long term resource and not sell it.  Services are intangible in nature which is rendered with or without the object of earning profits.

iii.                  Profit: The excess of Revenue Income over expenses is called profit.  It could be calculated for each transaction or for business as a whole.

iv.                 Loss: The excess of expense over income is called loss.  It could be calculated for each transaction or for business as a whole.

v.                   Asset: Asset is a resource owned by the business with the purpose of using it for generating future profits.  Assets can be tangible and intangible.  Tangible assets are the capital assets which have some physical existence.  They can, therefore, be seen, touched and felt, e.g. Plant and machinery, furniture and fittings, land and buildings, books, computers, vehicles, etc.  The capital assets which have no physical existence and whose value is limited by the rights and anticipated benefits that possession confers upon the owner are known as intangible assets.  They cannot be seen or felt although they help to generate revenue in future, e.g. Goodwill, Patents, trade-marks, copyrights, brand equity, design, intellectual property, etc.

Assets can also be classified into current assets and non-current assets.

Currents assets- an asset shall be classified as current when it satisfies any of the following:

a)      It is expected to be realized in, or is intended for sale or consumption in the company’s normal operating cycle.

b)      It is held primarily for the purpose of being traded.

c)       It is due to be realized within 12 months after the reporting date, or

d)      It is cash or cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting date.

Non-Current assets- All other assets shall be classified as Non-current assets, e.g. Machinery held for long term etc.

vi.                 Liability: It is an obligation of financial nature to be settled at a future date.  It represents amount of money that the business owes to the other parties.  E.g. when goods are bought on credit, the firm will create an obligation to pay to the supplier the price of goods on an agreed future date or when a loan is taken from bank, an obligation to pay interest and principal amount is created.  Depending upon the period of holding, these obligations could be further classified into long term on non-current liabilities and short term or current liabilities. 

Current liabilities- a liability shall be classified as current when it satisfies any of the following:

a)      It is expected to be settled in the company’s normal operating cycle.

b)      It is held primarily for the purpose of being traded,

c)       It is due to be settled within 12 months after the reporting Date, or

d)      The company does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date (Terms of a liability that could at the option of the counterparty, result in its settlement by the issue of Equity instruments do not affect its classification)

Non-current liabilities:- All other liabilities shall be classified as Non-current liabilities.  E.g. loan taken for 5 years, Debentures issued etc.

vii.               Internal Liability: These represent proprietor’s equity, i.e. all those amount which are entitle to the proprietor, e.g., Capital, Reserves, Undistributed profits, etc.

viii.             Working Capital:- In  order to maintain flows of revenue from operation, every firm needs certain amount of current assets.  For example, cash is required either to pay for expenses or to meet obligation for service received or goods purchased, etc. by a firm.  On identical reason, inventories are required to provide the link between production and sale.   Similarly, accounts receivable generate when goods are sold on credit.  Cash, bank, Debtors, Bills Receivables, closing stock, prepayments etc. represent current assets of firm.  The whole of these current assets form the working capital of a firm which is termed as Gross working capital.

Gross working capital            = Total Current Assets

= Long term internal liabilities plus long term debits plus the          current liabilities minus the amount blocked in the fixed assets.

There is another concept of working capital.  Working capital is the excess of current assets over current liabilities.  That is the amount of current assets that remain in a firm if all its current liabilities are paid.  This concept of working capital is known as net working capital which is a more realistic concept.

Working capital (Net) = Current Assets – Current Liabilities.

ix.                 Contingent Liability:  it represents a potential obligation that could be created depending on the outcome of an event. E.g. if supplier of the business files a legal suit, it will not be treated as a liability because no obligation is created immediately.  If the verdict of the case is given in favour of the supply then only the obligation is created.  Till that it is treated as a contingent liability.  Please note that contingent liability is not recorded in books of account, but disclosed by way of a note to the financial statements.

x.                   Capital: It is amount invested in the business by its owners.  It may be in the form of cash, goods or any other asset which the proprietor or partners of business invest in the business activity.  From the business point of view, capital of owners is a liability which is to be settled only in the event of closure or transfer of the business.  Hence it is not classified as a normal liability.  For corporate bodies, capital is normally represented as share capital.

xi.                 Drawings: It represents an amount of cash, goods or any other assets which the owner withdraws from business for his or her personal use. E.g. if the life insurance premium of proprietor or a partner of business is paid from the business cash, it is called drawings.  Drawings will result in reduction in the owner’s capital.  The concept of drawing is not applicable to the corporate bodies like limited companies.

xii.                Net worth: It represents excess of total assets over total liabilities of the business.  Technically, this amount is available to be distributed to owners in the event of closure of the business after payment of all liabilities.  That is why it is also termed as owner’s Equity.  A profit making business will result in increase in the owner’s equity where as losses will reduce it.

xiii.              Non- current Investments: Non-current Investments are investments which are held beyond the current period as to sale or disposal.  E.g. fixed deposit for 5 years.

xiv.              Current Investments: Current investments are investments that are by their nature readily realizable and are intended to be held for not more than one year from the date on which such investment is made. E.g. 11 months commercial paper

xv.               Debtor:  The sum of total or aggregate of the amount which the customer owe to the business for purchasing goods on credit or services rendered or in respect of other contractual obligations, is known as sundry debtors or trader debtors, or trade receivable, or book-debts or debtors.  In other words, debtors are those persons from whom a business has to recover money on account of goods sold or service rendered on credit.  These debtors may again be classified as under:

1.       Good debts: The debts which are sure to be realized are called good debts.

2.       Doubtful debts: The debts which may or may not be realized are called doubtful debts.

3.       Bad debts: The debts which cannot be realized at all are called bad debts.

It must be remembered that while ascertaining the debtors balance at the end of the period certain adjustments may have to made e.g. Bad debts, discount allowed, returns inwards, etc.

xvi.              Creditor: A creditor is a person to whom the business owes money or money’s worth. E.g. money payable to supplier of goods or provider of service.  Creditors are generally classified as current liabilities.

xvii.            Capital expenditure: This represents expenditure incurred for the purpose of acquiring a fixed asset which is intended to be used over long term for earning profits there from. E.g. amount paid to buy a computer for office use is a capital expenditure.  At times expenditure may be incurred for enhancing the production capacity of the machine.  This also will be a capital expenditure.  Capital expenditure forms part of the balance sheet.

xviii.           Revenue expenditure: This represents expenditure incurred to earn revenue of the current period.  The benefits of revenue expense get exhausted in the year of the incurrence.  E.g. repairs, insurance, salary & wages to employees, travel etc.  The revenue expenditure results in reduction in profit or surplus.  It forms part of the income statement.

xix.              Balance sheet: It is the statement of financial position of the business entity on a particular date.  It lists all assets, liabilities and capital.  It is important to note that this statement exhibits the state of affairs of the business owes to outsiders (this denotes liabilities) and to the owners (this denote capital).  It is prepared after incorporating the resulting profit/losses of income statement.

xx.               Profit and loss account or income statement: This account shows the revenue earned by the business and the expenses incurred by the business to earn that revenue.  This is prepared usually for a particular accounting period, which could be a month, quarter, a half year or a year.  The net result of the profit and loss account will show profit earned or loss suffered by the business entity.

xxi.              Trade discount: It is the discount usually allowed by the wholesaler to the retailer computed on the list price or invoice price. E.g. the list price of a TV set could be Rs.15,000.  The wholesaler may allow 20% discount thereof to the retailer.  This means the retailer will get it for Rs.12,000/- and is expected to sale it to the final customer at the list price.  Thus the trade discount enables the retailer to make profit by selling at the list price.  Trade discount is not recorded in the books of accounts.  The transactions are recorded at net values only.  In above example, the transaction will be recorded at Rs.12000/- only.

xxii.            Cash discount: This is allowed to encourage prompt payment by the debtor.  This has to be recorded in the books of accounts. This is calculated after deducting the trade discount. E.g. if list price is Rs.15,000/- on which a trade discount of 20% and cash discount of 2% apply, then first trade discount of Rs.3000/- (20% of Rs.15000/-) will be deducted and the cash discount of 2% will be calculated on Rs.12000/- (Rs.15000-Rs.3000).  Hence the cash discount will be Rs.240/- (2% of Rs.12000) and net payment will be Rs.11,760/- (Rs.12000-240).