FINANCIAL ACCOUNTING

What is Accounting ? - Meaning and Important Concepts

Accounting has been hailed by many as the “language of business”. There are many quotations like “A pen is mightier than the sword but no match for the accountant” by Jonathan Glancey which tell us about the power and importance of accounting. The text book definition of accounting states that it includes recording, summarizing, reporting and analyzing financial data. Let us try and understand the components of accounting to understand what it really means: Recording The primary function of accounting is to make records of all the transactions that the firm enters into. Recognizing what qualifies as a transaction and making a record of the same is called bookkeeping. Bookkeeping is narrower in scope than accounting and concerns only the recording part. For the purpose of recording, accountants maintain a set of books. Their procedures are very systematic. Nowadays, computers have been deployed to automatically account for transactions as they happen.

Summarizing

Recording for transactions creates raw data. Pages and pages of raw data are of little use to an organization for decision making. For this reason, accountants classify data into categories. These categories are defined in the chart of accounts. As and when transactions occur, two things happen, firstly an individual record is made and secondly the summary record is updated.

For instance a sale to Mr. X for Rs 100 would appear as:

• Sale to Mr. X for Rs 100
• Increase the total sales (summary) from 500 to 600

Reporting

Management is answerable to the investors about the company’s state of affairs. The owners need to be periodically updated about the operations that are being financed with their money. For this reason, there are periodic reports which are sent to them. Usually the frequency of these reports is quarterly and there is one annual report which summarizes the performance of all four quarters. Reporting is usually done in the form of financial statements. These financial statements are regulated by government bodies to ensure that there is no misleading financial reporting.

Analyzing

Lastly, accounting entails conducting an analysis of the results. After results have been summarized and reported, meaningful conclusions need to be drawn. Management must find out its positive and negative points. Accounting helps in doing so by means of comparison. It is common practice to compare profits, cash, sales, assets, etc with each other to analyze the performance of the business.

Objectives of Accounting

Every activity that a business firm does must be done for a reason and accounting is no exception. Accounting helps the company achieve a myriad of objectives. Here is the list of objectives that accounting helps the company to obtain.

• Permanent Record-Any business firm needs a permanent record of the transactions that it indulges in. These records could be required for internal purpose, for taxation purpose or for any other purpose. Accounting serves this function. Whenever the organization commits any resource of monetary value either within the firm or outside the firm, a record is made. This permanent record is held on for years and can be retrieved as and when need be.
• Measurement of Outcome-A business firm may indulge in numerous transactions every day. It may make profit in some of these transactions while it may make losses in some other transactions. However, the effect of all these transactions needs to be aggregated over a period of time. There must be daily, weekly and monthly reports which provides information to the organization about how well it is performing its activities. Accounting serves this purpose by providing periodic financial statements which help the firm adjust their operations accordingly.

• Creditworthiness-Firms need resources for their functioning. They do not have any capital stock at hand and need to obtain them from investors. Investors will give money to the firm only if they have reasonable assurance that the firm will be able to generate enough profit. Past accounting records help a great deal in proving this. All kinds of investors from banks to shareholders ask for past accounting details before they trust the management with their money.
• Efficient Use of Resources-Firms can also conduct useful internal analysis with the help of accounting data. Accounting records tell the firm what resources were committed to what activity and what time. These records also summarize the return that was obtained from these activities. Management can then analyze past behavior and draw lessons about how they could have performed better and used resources more efficiently.
• Projections- Accounting helps management and investors look forward. Costs and revenue growths can be projected after substantial data has been accumulated. The assumption made is that the company is likely to behave exactly as it has done in the past. Thus, analysts can make reasonable assumptions about the future based on the past record.

Limitations of Accounting

Although accounting may be heralded as being the language of the business, it is definitely not error free. This has been highlighted by the fact that accounting scams have occurred one after the other for many years. In fact, even after stricter regulation and tightening of accounting rules, accounting scams just don’t cease to stop.

As a student and practitioner of accounting, it is therefore imperative to know the limitations of accounting. Knowledge of limitations helps to factor them in and work with them. Here are the major limitations of accounting.

• Subjective Measurement
  Accountants have to attach a monetary value to every event or transaction that has taken place within the organization. Sometimes the monetary value of the transaction is impossible to be ascertained. Consider the case of depreciation. Accountants can at best provide estimates of the depreciation that should have taken place given the scale of operations. However, these estimates are usually way off the mark. This makes accounting policies open to debate as well as manipulation.
  • Qualitative Factors
    Accountants try to attach a monetary value to everything. The things they cannot attach a monetary value to are not accounted for! Consider the case of goodwill. Until the organization has explicitly paid for the goodwill it purchased from another company, it cannot account for goodwill. According to accountants, the goodwill generated by the firm internally is worthless. We all know that this is not the case and therefore accounting is flawed as far as goodwill is concerned.
  • Unstable Unit of Account
    Accountants have to measure all transactions in a single unit of account. This unit of account is usually the currency that is being used in a particular country. However, it is common knowledge that the value of currencies is not stable. Inflation, deflation and such other forces make currency values dynamic. When accountants express assets purchased in last year’s rupees with the same unit as purchased by this year’s rupees, it presents a distorted image. Many companies have low book values because their assets were purchased a long time back during periods of no inflation.
  • No Information about Opportunity Cost
    Accountants provide information about what has happened. However, management would be better off if they had information about what could have happened if they used their resources in the optimum manner. This feature is also lacking in accountancy making its usefulness limited from the managerial point of view.
  Despite its limitations, the importance of accounting is unquestionable. It is difficult to imagine running a firm without accounting.

  Golden Rules of Accounting

  The Problem with Debit Credit Rules

  The system of debit and credit is right at the foundation of double entry system of book keeping. It is very useful, however at the same time it is very difficult to use in reality. Understanding the system of debits and credits may require a sophisticated employee. However, no company can afford such ruinous waste of cash for record keeping. It is generally done by clerical staff and people who work at the store. Therefore, golden rules of accounting were devised.

  Golden rules convert complex bookkeeping rules into a set of principles which can be easily studied and applied. Here is how the system is applied:

  Ascertain the Type of Account

  The types of accounts viz. real, nominal and personal have been explained in earlier articles. The golden rules of accounting require that you ascertain the type of account in question. Each account type has its rule that needs to be applied to account for the transactions. The golden rules have been listed below:

  The Golden Rules of Accounting

  1. Debit The Receiver, Credit The Giver
     This principle is used in the case of personal accounts. When a person gives something to the organization, it becomes an inflow and therefore the person must be credit in the books of accounts. The converse of this is also true, which is why the receiver needs to be debited.
  2. Debit What Comes In, Credit What Goes Out
     This principle is applied in case of real accounts. Real accounts involve machinery, land and building etc. They have a debit balance by default. Thus when you debit what comes in, you are adding to the existing account balance. This is exactly what needs to be done. Similarly when you credit what goes out, you are reducing the account balance when a tangible asset goes out of the organization.
  3. Debit All Expenses And Losses, Credit All Incomes And Gains
     This rule is applied when the account in question is a nominal account. The capital of the company is a liability. Therefore it has a default credit balance. When you credit all incomes and gains, you increase the capital and by debiting expenses and losses, you decrease the capital. This is exactly what needs to be done for the system to stay in balance.

  The golden rules of accounting allow anyone to be a bookkeeper. They only need to understand the types of accounts and then diligently apply the rules.

  Fundamental Principles of Accounting

  Following are the basic fundamental principles of Accounting: Monetary Unit Accounting needs all values to be recorded in terms of a single monetary unit. It cannot account for goods like the barter system. Assigning values to goods and items therefore becomes a problem since it is subjective. However, accounting has prescribed rules to deal with the same. Going Concern A company is said to have an eternal existence. Once it is formed, the only way to end it is by dissolution. It does not die a natural death like humans do. Hence, accountants assume the going concern principle. This principle implies that the firm will continue to do its business as usual till the end of the next accounting period and that there is no information to the contrary. Because of the going concern principle, organizations can function on credit, account for accounts receivables and payables which intend to receive or pay in the future and charge depreciation assuming that the machine will be used for many years.

  n case, the management has information that the operations will be suspended in the near future, normal accounting ceases. A special type of accounting meant for dissolution purpose is used.

  Principle Of Conservatism

  Accountants are said to be very conservative by nature. They want to hope for the best and be prepared for the worst. This is displayed in the rules that they have created for their profession. One of the central tenets of accounting is the principle of conservatism. According to this principle, when there is doubt about the amount of expected inflows and outflows, the organization must state the lowest possible revenue and the highest possible costs.
  This can be seen in the fact that accountants value inventory at lower of cost or market price. However, such conservatism helps the company be prepared for any forthcoming financial crises.

  Cost Principle

  Closely related to the principle of conservatism is the cost principle. The cost principle advocates that companies should list everything on the financial statements at the cost price. Usually assets like land and building, gold, etc appreciate. However, the accountants will not allow this appreciation to be reflected on the financial statements of the company till it is realized.
  Accountants believe that the market value of anything is just an opinion. Accountants cannot account on the basis of opinions because there are many of them. The selling price of something is a fact since someone has paid for it and the same can be verified. Hence accounting works on cost principle and therefore on facts.