Accounting Module - 1Contents: S.No 1 2 3 4 5 6 7 8 9 10 11 12 Topics Introduction to Accountancy Basic Objectives of Accounting Basic Functions of Accounting End-Users of Accounting Information. Classification of Accounting Accounting Principles Accounting concepts & Accounting Conventions Systems of Accounting Book-keeping Accounting Equation Accounting Cycle Accounting Cycle - Steps during the Accounting Period Accounting cycle: Steps at the end of the accounting period Page No 2 2 3 4 4 5 7 8 10 10 13 13 13 13 1 Introduction to Accountancy Accountancy or accounting is the measurement, statement or provision of assurance about financial information primarily used by managers, investors, tax authorities and other decision makers to make resource allocation decisions within companies, organizations, and public agencies. Accounting is a service activity. Its function is to provide quantitative information primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions, and in making reasoned choices among alternative courses of action. It is also the discipline of measuring, communicating and interpreting financial activity. Accounting is also widely referred to as the "language of business". “Accounting is the art of recording, classifying and summarising in a significant manner and in terms of money transactions and events which are in part at least, of financial character and interpreting the results there of.” - American Institute of Certified Public Accountants. Luca Pacioli - "Father of Accounting". Basic Objectives of Accounting 1. Useful to present investors, creditors & other users in making rational investment, credit & other financial decisions. 2. Help to present to potential investors, creditors & other users in assessing the amounts, timing & uncertainty of prospective cash receipts. 3. About the changes in assets & liabilities, the impact of this on the business organization. 2 Basic Functions of Accounting 1. Recording: This is the basic function of accounting. It is essentially concerned with not only ensuring that all business transactions of financial character are in fact recorded but also that they are recorded in an orderly manner. Recording is done in the book “Journal”. This book may be further sub divided into various subsidiary books such as cash journal (for recording cash transactions), purchase journal (recording credit purchase transactions) etc: 2. Classifying: Classification is concerned with the systematic analysis of the recorded data, with a view to group transactions or entries of one nature at one place. The work of classification is done in the book termed as “Ledger”. This book contains on different pages individual account heads under which all financial transactions of similar nature are collected. For example, there may be separate account head for traveling expenses, printing & stationery, advertising etc. All expenses under theses heads in the ledger. This will help in finding out the total expenditure incurred under each of the above heads. 3. Summarizing: This involves presenting the classified data in a manner which is understandable and useful to the internal as well as external end- users of accounting statements. This process leads to the preparation of the following statements: (i) Trial Balance (ii) Income statement and (iii) Balance sheet. 4. Dealing with financial transactions: Accounting records only those transactions and events in terms of money which are of financial character. Transactions which are not financial character are not recorded in the books of account. For example, if a company has got a team dedicated and trusted employees, it is of great use to the business but since it is not of a financial character and capable of being expressed in terms of money, it will not be recorded in the books of the business. 5. Analyzing & Interpreting: The recorded financial data is analysed and interpreted in a manner that the end- users can make a meaningful judgment about the financial condition and profitability of the business operations. The data is also used for preparing the future plans and framing of policies for executing such plans. 6. Communicating: The accounting information after being meaningfully analysed and interpreted has to be communicated in a proper form and manner to the proper person. This is done through preparation and distribution of accounting reports, which include besides the usual income statement and the balance sheet, additional information in the form of proper accounting ratios, graphs, diagrams, funds flow statements, cash flow statements etc: 3 End-Users of Accounting Information. • • • • • • • Proprietors Managers Creditors Prospective Investors Government Employees Citizens. Classification of Accounting 1. Financial Accounting. 2. Management Accounting. Financial Accounting: It is the Original form of accounting. It is mainly confined to the preparation of financial statements for the use of outsiders like shareholders, debenture holders, banks & Financial Institutions. The financial statements i.e. the profit & loss account and the balance sheet, show them the manner in which operations of the business have been conducted during the specified period. Management Accounting: It is accounting for management i.e. accounting which provides necessary information to the management for discharging its functions. According to the chartered institute of management accountants, London, “management accounting is the application of professional information in such a way as to assist the management in the formation of policies and in the planning and control of the operations of the undertaking”. Management accounting covers various areas such as cost accounting, budgetary control, inventory control, statistical methods, internal auditing etc: 4 Accounting Principles “Accounting principles are a body of doctrines commonly associated with the theory & procedures of accounting, serving as an explanation of current practices & as a guide for selection of conventions or procedures where alternatives exist.” Accounting principles may be defined as those rules of action or conduct which are adopted by the accountants universally while recording accounting transactions. These principles are classified into categories: 1. Accounting concepts 2. Accounting conventions Accounting concepts: The term „concepts‟ includes those basic assumptions or conditions upon which the science of accounting is based. The accounting concepts are briefly discussed as follows: 1. Separate Entity concept: The separate entity concept treats a business as distinct and completely separate from the owners. The business stands apart from other organizations as separate economic unit. It is necessary to record the business transactions separately to distinguish it from the owner's personal transactions. The concept of separate legal entity is applicable for all forms of business Organization. Example: If a person „X‟ invests Rs10, 000 into the business which will be shown as a liability in the books of the business. In case „X‟ withdraws Rs 2,000 from the business, it will be charged to him as the net amount payable by the business will be shown as Rs 8,000. 2. Going concern concept: According to this concept it is assumed that the business will continue for a fairly long time to come. There is neither the intention nor the necessity to liquidate the particular business venture in the foreseeable future. Financial statements are prepared on the assumption that the entity is a going concern, meaning it will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the normal course of operations. 5 3. Money Measurement Concept: The money measurement concept underlines the fact that in accounting, every recorded event or transaction is measured in terms of money. Using this principle, a fact or a happening which cannot be expressed in terms of money is not recorded in the accounting books. For example, if a business has got a team of dedicated and trusted employees, it is definitely an asset to the business but since their monetary measurement is not possible, they are not shown in the books of business. 4. Cost concept: In accounting, historical cost is the original monetary value of an economic item. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of acquisition. The balance sheet value of the item may therefore differ from the "true" value. For example, if a business buys a plot of land for Rs 50,000 the asset would be recorded in the books at Rs 50,000 even if its market value after a year happens to be Rs1,00,000/-. Cost concept has the advantage of bringing objectivity in the preparation of financial statements. In the absence of this concept the figures shown in the accounting records would have depended on the subjective views of a person preparing the financial statements. 5. Dual aspect concept: Dual aspect is the very foundation of the universally applicable double entry bookkeeping system and it stems from the fact that every transaction has a double (or dual) effect on the position of a business as recorded in the accounts. For example, when an asset is bought, another asset cash (or bank) is also and simultaneously decreased OR a liability such as creditors is also and simultaneously increased. Similarly, if A starts a business with a capital of Rs 1, 00,000/- there two aspects of the transaction. on one hand the business has a asset of Rs 1,00,000/- while on the other hand the business has to pay to the proprietor a sum of Rs 1,00,000/- This transaction could be expressed in the form of the following equation : Capital (Equities) = Cash (Assets) 6. Accounting Period Concept: Fixed period of time ascertained to report the financial performance of an enterprise. If this fixed equal period of time is not ascertained, the business based on the going concern concept can last a quite a long period of time which will render the analysis of the financial statement impractical. Normally, this fixed equal period may be of any length of time but periods of one year in length are the most commonly used. At the end of each accounting period an Income statement and a Balance sheet are prepared. The Income statement discloses he profit while the balance sheet depicts the financial position of the business as on the last day of the accounting period. January 1sto of a year to December31st of the same year would be termed as a calendar year. Similarly, April 1st of a year to March 31st if next year is called as the financial year. 6 7. Periodic matching of cost & revenue concept: This is based on the accounting period concept. The paramount objective of running a business is to earn profit. In order to ascertain the profit made by the business during a period, it is necessary that „revenues‟ of the period should be matched with the costs (expenses) of the period. The term matching means appropriate association of related revenues and expenses. In other words income made by the business during a period is compared with the expenditure incurred for earning that revenue. For example, if a salesman is paid commission in January 1999, for sales made by him in December 1998, the commission paid to the salesman in January 1999 for the sales made by him in December 1998. This means that revenues of December 1998 (i.e. sales) should be matched with the costs incurred for earning that revenue (i.e. salesman Commission) in December, 1998, (though paid in January 1999). 8. Realisation Concept: Revenue recognition principle is an important accounting principle, which is the main difference between cash basis accounting and accrual basis accounting. In cash basis accounting revenues are simply recognized when cash is received no matter when and how the services were performed or goods delivered. In accrual basis accounting revenues are recognized when they are (1) realized or realizable and (2) earned no matter when cash is received. Accounting Conventions: The term “Conventions” includes those customs or traditions which guide the practitioners while preparing the accounting statements. The following are the important conventions. 1. 2. 3. 4. Convention of Conservatism. Convention of Full disclosure. Convention of Consistency. Convention of Materiality. Convention of Conservatism: In the initial stages of accounting the anticipated profits which were recorded did not materialize. This resulted in less acceptability of accounting figures by the end-users. On account of this reason practitioners follow the rule „anticipate no profit but provide for all losses” while recording business transactions. In other words follow the policy of “playing safe”. On account of this convention the inventory is valued „at cost price or market price‟ whichever is less. Similarly a provision is made for possible bad & doubtful debts. 7 Convention of Full disclosure: According to this convention accounting reports should disclose fully and fairly the information they purport to represent. They should be honestly prepared and sufficiently disclose information which is of material interest to the proprietors, present and potential creditors and investors. The convention is gaining more importance because most of the businesses are run as joint stock companies where ownership is divorced from management. Convention of Consistency: According to this convention accounting practices should remain unchanged from one period to another. For example, if stock is valued at “cost or market prices whichever is less” this principal should be followed year after year. Similarly if depreciation is charged on fixed assets on diminishing balance method the same should be followed consistently. Convention of Materiality: According to this convention the accountant should attach importance to material details & ignore insignificant details. This is because otherwise accounting will be unnecessarily overburdened with minute details. The question what constitutes a material detail, is left to the discretion of the practitioner. Thus the materiality is subjective term. The practitioner should regard an item as material if there is a reason to believe that the knowledge of it would influence the decision of the informed investor. Systems of Accounting 1. Cash system of accounting 2. Accrual system of accounting • Cash system of accounting: Cash basis of accounting is a method of accounting that records financial events based on cash flows and cash position. Revenue is recognized when cash is received & expense is recognized when cash is paid. No entry is made when a payment or receipts is merely due. It does not recognize promises to pay or money or service in future. Such as receivables, payables and prepaid or accrued expenses. Example: A small business such as a fruit vendor, which buys its inventory daily for cash at a wholesale market, sells his inventory for cash, can get an accurate picture of its profits or losses using cash-basis accounting. 8 • Accrual system of accounting: Under this system of accounting it records financial events based on economic activity rather than financial activity. Under accrual accounting revenues is recorded when it is earned and realized regardless of actual payment is received. It is a system in which accounting entries are made on the basis of amounts having become due for payment or receipt. This system recognizes the fact that if a transaction or an event has occurred; its consequences cannot be avoided and therefore, should be brought into books in order to present a meaningful picture of profit & loss suffered and also of the financial position of the firm concerned. Example: A remodeling business that gives customers 90 days to pay & that procures materials on account at the lumber yard, must use the accrual method again to gain an accurate picture of its financial condition. Comparison of cash system vs Accrual system • • • Using cash basis accounting income & expenses are recognized only when cash is received or paid out. Using accrual basis accounting, receivables & payables are recognized when sale is agreed to, even though no cash has been received or paid out as yet. Cash basis accounting defers all credit transactions to a later date. It is more conservative for the seller does not record revenue until the cash receipt. In a growing company, these results in a lower income compared to accrual- basis accounting. Example for Cash & Accrual Accounting: • • • A firm closes its books on 31st December each year. A sum of Rs 5000/- has become due for payment on account of rent for the year 1990.The amount has, however been paid in January, 1991. In this case, if the firm is following cash system of accounting, no entry will be made for the rent having become due in the books of account of the firm in 1990. The entry will be made only in January 1991 when the rent is actually paid. According to mercantile system of accounting, 2 entries will be made. 1. on 31st December 1990, rent a/c will be debited while the cash account will be credited by the amount of outstanding rent. 2. In January, 1991 landlord‟s a/c will be debited while the cash a/c will be credited with the amount of rent actually paid. 9 • Book-Keeping: Book-keeping is mainly concerned with recording of financial data relating to the business operations in a significant & orderly manner. The system of Book-keeping is divided into two categories. 1. Single-entry book-keeping. 2. Double-entry book-keeping. Single entry System: Simple system for recording accounting information in which transactions are recorded only once, and not twice as debits and credits of 'double entry bookkeeping' system. Used primarily in simple applications such as checkbook balancing or in very small (cash-based) businesses. It does not require keeping of journals or ledgers, but is not compatible with the provisions of GAAP. According to Kohler, “It is a system of book-keeping in which as a rule only records of cash & personal accounts are maintained, it is always an incomplete double entry.” This system has been developed by some business houses, who for their convenience keep only some essential records. Double – entry System: The double-entry bookkeeping (or double-entry accounting) system was first described by the Italian mathematician Luca Pacioli. It is the basis of the standard system used by businesses to record financial transactions. This system is called double-entry (concept of duality) because each transaction is recorded in at least two accounts. Each transaction results in at least one account being debited and at least one account being credited, with the total debits of the transaction equal to the total credits. For example, if firm „x‟ sells an item to firm „y‟ and firm „y‟ pays firm „x‟ by cheque, the bookkeeper of the firm „x‟ would credit the account called "Sales" and debit the account called "Bank". Conversely, the bookkeeper of firm „y‟ would debit the account called "Purchases" and credit the account called "Bank". Accounting Equation: The relationship between the assets, the liabilities and the equity can be represented algebraically by what is commonly known as an accounting equation. Equity = Assets – Liabilities. The equation is more commonly written as Assets = Liabilities + Equity. The accounting equation signifies that assets of a business are always equal to that of outside liabilities and proprietor's equity. It means the accounting equation should always be in balance. Whatever fund‟s are raised by the business, either through capital or business operations or from outsiders will be tied up in one or the other form of uses (assets). 10 Examples: Let‟s assume that Mr. “K” forms a sole proprietorship. On December 1, 2006, “K” invests personal funds of $10,000 to start ABC. The effect of this transaction on ABC‟s accounting equation is: Assets = Liabilities + Owner‟s Equity No effect + $ 10,000 $10,000 = Here assets increase by $10,000 and so does ABC owner's equity. As a result, the accounting equation will be in balance. You can interpret the amounts in the accounting equation to mean that ABC has assets of $10,000 and the source of those assets was the owner, “K”. Alternatively, you can view the accounting equation to mean that AB Chas assets of $10,000 and there are no claims by creditors (liabilities) against the assets. As a result, the owner has a claim for the remainder or residual of $10,000. This transaction is recorded in the asset account Cash & the owner‟s equity account “K” Capital. The general journal entry to record the transactions in these accounts is: Date Dec. 1, 2006 Particulars Cash a/c Dr Debit $10,000 $10,000 Credit K‟s Capital a/c 11 Example 2 The accounting equation (or basic accounting equation) for a corporation is Assets = Liabilities + Stockholders’ Equity Let‟s assume that members of the „X” family form a corporation called Accounting Software, Inc. (ASI). On December 1, 2006, several members of the “X” family invest a total of $10,000 to start ASI. In exchange, the corporation issues a total of 1,000 shares of common stock. (The stock has no par value and no stated value.) The effect on the corporation‟s accounting equation is: Assets $10,000 = = Liabilities + Stockholders‟ Equity No Effect + $10,000 Here, ASI‟s assets increase by $10,000 and stockholders‟ equity increases by the same amount. As a result, the accounting equation will be in balance. The accounting equation tells us that ASI has assets of $10,000 and the source of those assets was the stockholders. Alternatively, the accounting equation tells us that the corporation has assets of $10,000 and the only claim to the assets is from the stockholders (owners). This transaction is recorded in the asset account Cash and in the stockholders' equity account Common Stock. The general journal entry to record the transaction is: Date Dec. 1, 2006 Particulars Cash a/c Debit $ 10,000 $ 10,000 Credit Common Stock a/c After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASI‟s financial position at the end of December 1, 2006: Accounting Software, Inc, Balance Sheet as on December 1st 2006. Assets Cash Total Assets Amount $ 10,000 $ 10,000 Liabilities Common Stock Total liabilities + Stock Holder’s Equity Amount $ 10,000 $ 10,000 12 Accounting Cycle The Accounting Cycle is a series of steps which are repeated every reporting period. The process starts with making accounting entries for each transaction and goes through closing the books. Accounting Cycle - Steps During the Accounting Period • Identify the transaction - through an original source document (such as an invoice, receipt, Bank cheque, deposit slip, purchase order) which provides details like date, amount, description (account or business purpose), and name of other party. Analyze the Transactions : Determine which accounts are affected Make Journal entries – record the transaction in the journal as both a debit & credit – journals are kept in chronological order – journals may include Sales journal, purchase journal, cash receipts journal, cash payments journal, and the general journal Post to Ledger – transfer the journal entries to ledger accounts – ledger is kept by account – ledger accounts may be T-account form or include balances • • • Accounting cycle : Steps at the end of the accounting period • • • Trial Balance – this is a calculation to verify the sum of the debits equals the sum of the credits. If there is a unbalanced trial balance the error has to fixed. Adjusting entries – prepare and post accrued and deferred items to journals and ledger accounts. Financial statements – prepare income statement, balance sheet, statement of retained earnings, statement of cash flows etc: 13