chapter 1: fundamentals of accounting

Dr. Afzalur Rahman

Introduction to Accounting

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CHAPTER AT A GLANCE (Chapter 1)Meaning and Definition of Accounting Attributes (Characteristics) of Accounting Functions of AccountingAccounting ProcessBook KeepingObjectives of Accounting Advantages of Accounting Limitations of Accounting Users of Accounting Information Systems of AccountingBasis of Accounting

Dr. Afzalur Rahman

Dr. Afzalur Rahman

MEANING AND DEFINITION OF ACCOUNTINGAccounting is an art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are of a financial character and interpreting the result thereof.

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CHARACTERISTICS OF ACCOUNTING

Transactions and events that are of financial character are recorded.

Transactions are recorded in terms of Money.

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CHARACTERISTICS OF ACCOUNTING

Choose the right option.

Q. Accounting is an art of recording, classifying and summarising

a) Financial and Non-financial transactions.

b) Financial transaction only

c) Non-financial transaction only

d) Transaction and events, which are in part at least, of financial character.

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FUNCTIONS OF ACCOUNTING

i) Recording: Recording is a process in which transactions are

recorded in the books of original entries,

i.e. in Journal Books. Journal Book is sub-divided into subsidiary

books according to the number of transactions of particular category.

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These subsidiary books are: Cash Book Purchases Book Purchases Return Book Sales Book Sales Return Book Bills Receivable Book Bills Payable Book

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Cash Book to record cash and bank transactions. Cash book may be-:

Single Column Cash Book Two Column Cash Book Three Column Cash Book

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ii) Classifying: Classification means transactions or entries of

one nature are grouped under one head of account.

The transactions recorded in ‘Journal’ or the ‘Subsidiary Books’ are classified or posted to the ‘Ledger Account’.

Ledger is the book that contains individual account heads under which all financial transactions of a similar nature are collected.

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iii) Summarizing:

Summarizing is presenting the classified data in a form that is understandable and useful to users of accounting information.

It means preparation of Trial Balance, leading to preparation of financial statements i.e. Trading and Profit and Loss Account, and Balance Sheet.

Profit and Loss Account and Balance Sheet are collectively known as’ Final Accounts or Financial Statements’.

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iv) Analysis and Interpretation:

Analysis and interpretation means analyzing and then interpreting the financial data to make a meaningful judgment of the profitability

and financial position of the business. It helps in planning for the future in a better way.

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v) Communicating Finally, the accounting function is to communicate

the financial data to the users.

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Q. Which of the following is not correct regarding classificationa) The transactions recorded in the ‘Journal’ or the

subsidiary books are classified or posted to the main book of account known as the Ledger.

b) Classification is the process of grouping transactions or entries of one nature at one place.

c) Classification involves presentation of data in a manner which is understandable and useful to internal as well as external user of accounting statements.

d) Classification contains individual account heads under which all financial transactions of a similar nature are collected

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Q. Select the Correct order of accounting processa) Identification of financial transaction, recording of

transaction, summarising, Classifying

b) Recording, identification, classification and summarising of transaction.

c) Identification, recording, classifying, summarising of transaction.

d) None of the above.

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Financial Transactions or Events

RecordingJournal1. Cash Book2. Purchase Book3. Sales Book4. Purchases Return Book5. Sales Return Book6. Bills Payable Book7. Bills Receivable Book8. Journal Proper

Classifying (Posting into Ledger)

SummarizingTrial BalanceTrading and Profit and Loss Account Balance Sheet.

Analysis and Interpretation

Communicating to the User

ACCOUNTING PROCESS

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BOOK KEEPING

Book Keeping is a part of accounting and is concerned with recording financial transactions and events in the books of accounts following accounting concepts and principles.

Thus, Book Keeping is concerned with: Identifying financial transactions and events; Measuring them in terms of money; Recording the financial transactions and events

so identified in the books of accounts; and Classifying recorded transactions and events,

i.e., posting them into Ledger accounts.

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Difference between Book keeping and Accounting

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Basis of difference Book Keeping Accounting

Scope

1) Identify transactions 2) Measuring identified

transactions 3) Recording measured

transactions 4) Classifying recorded

transactions

In addition to Book Keeping accounting involves : 1) Summarizing classified

transactions,2) analyzing summarized results,3) interpreting analyzed results and 4) communicating interpreted

information to the interested parties.

Stage Book Keeping is primary stage It is secondary stage and begins where Book - Keeping ends.

Basic Objectives

Maintain systematic record of financial transactions

Ascertain net results of operations and financial position and to communicate information to interested parties.

Dr. Afzalur Rahman

Difference between Book keeping and Accounting

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Who performs Book Keeping is done by Junior Staff

Accounting work is performed by senior staff

Knowledge LevelBook Keeper need not have higher level of knowledge than that of an accountant

Accountant is required to have higher level of knowledge than that of book - keeper

Analytical Skills Book - Keeper may or may not possess analytical skills

An accountant is required to possess analytical skills

Nature of JobThe job of a book keeper is often routine and clinical in nature

The job of an accountant is analytical in nature

Designing of Accounting System

It does not cover designing of accounts system

It covers designing of accounting system.

Supervision & Checking

The Book - Keeper does not supervise and check the work of an accountant.

An accountant supervises and checks the work of a book - keeper.

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OBJECTIVES OF ACCOUNTING

Ascertaining Profit or Loss. Ascertaining Financial Position. Facilitating Management. Providing Accounting Information to Users.

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ADVANTAGES OF ACCOUNTING

Financial Information about Business. Assistance to Management. Replaces Memory. Facilitates Comparative Study. Facilitates Settlement of Tax Liabilities. Facilitates Loans. Evidence in Court. Assistance in the Event of Insolvency. Helpful in settlement of accounts.

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LIMITATIONS OF ACCOUNTING

1. It is Not Fully Exact.

Accounting is based on evidences but yet estimates are also made for ascertaining profit or loss. Examples are estimating the useful life of an asset, bad debts, market price of closing stock, etc.

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2. It Ignores the Qualitative Elements.

Since accounting is confined to monetary matters only, qualitative elements like

quality of management labour force industrial relations public relations are ignored.

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3. It Ignores the Effect of Price Level Changes. Accounting statements are prepared at historical cost. Money, as a measurement unit, changes in value. Since Price Level Changes are not considered the financial statements do not show correct financial status.

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4. Accounting May Lead to Window Dressing.

The term window dressing means manipulation of accounts to conceal vital facts present better or worse financial position than actual In this situation, income statement fails to provide a true and fair view of the result of operations and the Balance Sheet fails to provide a true and fair view of the financial position of the enterprise.

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USERS OF ACCOUNTING INFORMATION

Internal Users Owners Management. Employees and Workers.

External Users Banks and Financial Institutions. Investors and Potential Investors. Creditors Government and its Authorities.

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SYSTEMS OF ACCOUNTING

The systems of recording transactions in the books of accounts are classified into two types:

(a) Double Entry System of Accounting

(b) Single Entry System of Accounting

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(a) Double Entry System of Accounting Double entry system of accounting has two aspects—

Debit and Credit. At the time of recording a transaction, it is recorded once on the debit side and again on the credit side.

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For example, at the time of cash purchases, goods are acquired and in return cash is paid.

In this transaction, two aspects are involved receiving goods paying cash.

Under the Double Entry System, both these aspects are recorded.

This system is universally applied in accounting.

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(b) Single Entry System of Accounting Single Entry System of accounting may be defined as a system, which is an incomplete double entry system. In this system, all transactions are not recorded on the double entry basis.

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BASIS OF ACCOUNTING

Transactions are recorded in the books of account following either Cash Basis of Accounting; or Accrual Basis of Accounting

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BASIS OF ACCOUNTING

Cash Basis Of Accounting

Cash Basis of Accounting is a method in which income is recorded when cash is received, and expenses are recorded when cash is paid out.

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BASIS OF ACCOUNTING


Advantages:

1. It is simple as adjustment entries are not required.

2. This approach is more objective as very few estimates and judgments are required.

3. This basis of accounting is suitable for those enterprises where most of the transactions are on a cash basis.

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BASIS OF ACCOUNTING


Disadvantages

(i) It does not give a true and fair view of the profit or

loss and the financial position of an enterprise because it ignores outstanding and prepaid expenses, accrued incomes and incomes received in advance.

(ii) It does not follow the matching principle of

accounting.

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BASIS OF ACCOUNTING


Disadvantages:

(iii) actual cash inflows and outflows are considered. Therefore there is great possibility of profit manipulation.

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BASIS OF ACCOUNTING

Accrual Basis of Accounting System of accounting is based on 'accrual concept' Revenue is recognized (recorded) when earned Expenses are recognized when incurred.

Under this system Income earned and expenditure incurred is recognised irrespective of cash received or cash paid.

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BASIS OF ACCOUNTING

Accrual Basis of Accounting

It is based on two basic accounting principles, Revenue Recognition Concept Matching Concept

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BASIS OF ACCOUNTING


Revenue Recognition Concept

Accounting rule that revenue should be recorded only when the

(1) revenue generation process has been substantially completed, and

(2) an exchange has taken place. It is a restatement of the old maxim: "Don't count your chickens until they are hatched."

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BASIS OF ACCOUNTING


Matching Concept Fundamental concept of accrual basis accounting that offsets revenue against expenses on the basis of their cause-and-effect relationship. It requires that, in measuring net income for an

accounting period, the costs incurred in that period should be matched against the revenue generated in the same period.

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BASIS OF ACCOUNTING


Advantages:

(i) It is more scientific compared to Cash Basis

(ii) This basis of accounting shows a complete picture

(iii) This system discloses correct profit or loss for a particular period and also

exhibits true financial position of the business on a particular day.

(iv) It reflects correct profit or loss during the accounting period

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BASIS OF ACCOUNTING

Disadvantages:

(i) This system is not as simple as Cash Basis of Accounting.

(ii) The accounting process under this basis is too elaborate.

(iii) A quick appraisal of the profit/loss is not possible because many adjustments are required to ascertain the true financial position of the business.

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Example

Illustration

During the financial year 2009 – 10, Ashok had cash sales of Rs. 3,90,000 and

credit sales of Rs. 1,60,000.

His expenses for the year were Rs. 2,70,000

out of which Rs. 80,000 are yet to be paid.

Find out Ashok’s income for 2009 – 10 under both the basis of Accounting.

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When Cash Basis of Accounting is followed:

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SolutionRevenue (inflow of Cash i.e. Cash Sale) 3,90,000Less: Expenses (Outflow of Cash)

(Rs.2,70,000 – Rs.80,000)1,90,000

Net Income 2,00,000

Credit sales and outstanding expenses will not be considered under Cash Basis of Accounting.

When Accrual Basis of Accounting is followed:


SolutionTotal Sales = Cash Sales (Rs.3,90,000) + Credit

Sales (Rs.1,60,000)5,50,000

Less: Total Expenses for the Year 2,70,000 Net Income 2,80,000

Note: Rs. 80,000 on account of expenses still to be paid relate to this year and hence are to be charged to the revenue of this year. Similarly, credit sales of Rs.1,60,000 is taken in the year in which sales transaction is done.

Thank You


chapter 1: fundamentals of accounting

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