Introduction, Meaning and Scope of Accounting

Meaning Of Accounting

Accounting is often called the "language of business". It is a systematic process of identifying, measuring, recording, classifying, summarising, interpreting, and communicating financial information about an economic entity to various interested users. Its primary purpose is to provide information that is useful for making economic decisions.

Let's break down the key aspects of this definition:

Economic Events

Accounting deals with economic events, which are transactions or occurrences that result in a change in the financial position of an enterprise. An economic event is subject to measurement in monetary terms.

Example 1. Identifying Economic Events.

Consider a business in Delhi purchasing raw materials for ₹50,000, paying salaries of ₹20,000 to employees, and a key manager quitting the job.

Answer:

The purchase of raw materials and payment of salaries are economic events because they involve financial transactions that can be measured in monetary terms and affect the company's financial position (e.g., cash outflow, change in inventory). The key manager quitting is an event, but it is not immediately an economic event that can be measured in monetary terms for accounting purposes, although it might have future economic consequences.

Identification, Measurement, Recording And Communication

These are the core processes involved in accounting:

Identification:

Determining which transactions and events qualify as economic events relevant to the business and should be recorded. This requires understanding the nature of business activities.

Measurement:

Assigning a monetary value to the economic events. Accountants measure transactions in Rupees (₹) in the Indian context. Measurement is a critical step as it quantifies the economic effect of an event.

Recording:

Systematically documenting the identified and measured economic events in chronological order in books of accounts (like the Journal). This creates a permanent record of all transactions.

Communication:

Presenting the summarised financial information in a usable format (Financial Statements) to the intended users, explaining what the information means, and providing relevant analysis.

Organisation

Accounting is performed for a specific organisation, which can be a business enterprise (sole proprietorship, partnership, company), a non-profit organisation, or a government entity. The accounting system tracks the financial activities of this particular entity, distinct from its owners or other entities (this is the concept of Business Entity Principle, discussed later).

Interested Users Of Information

The financial information generated by accounting is used by various parties, both internal and external to the organisation. (Discussed in detail in Section I2).

In summary, accounting is the process that translates the myriad economic activities of an organisation into structured financial information that is useful for decision-making by a variety of stakeholders.

Accounting As A Source Of Information

Accounting serves as a vital information system for any organisation. It collects, processes, and reports financial data, providing insights into the economic health and performance of the entity. This information is essential for informed decision-making by users.

Qualitative Characteristics Of Accounting Information

For accounting information to be useful for decision-making, it should possess certain qualitative characteristics. These characteristics make the information relevant and reliable.

1. Reliability:

Accounting information is reliable when it is free from material error and bias and can be depended upon by users to represent faithfully that which it purports to represent or could be expected to represent. Reliability implies:

Faithful Representation: The information reflects the economic reality of the transactions and events.
Neutrality: The information is free from bias; it is not slanted to favour one group of users over another.
Verifiability: Different independent observers should be able to agree on the representational faithfulness of the accounting information (e.g., through supporting documents like bills, vouchers).

2. Relevance:

Accounting information is relevant if it is capable of influencing the economic decisions of users by helping them evaluate past, present, or future events or confirming, or correcting, their past evaluations. Relevance is achieved when information is:

Timely: Information is available to decision-makers in time to be capable of influencing their decisions.
Predictive Value: It helps users forecast future outcomes.
Confirmatory Value: It confirms or refutes prior expectations.

3. Understandability:

Information should be easily understood by users who have a reasonable knowledge of business and economic activities and accounting. While some complex information may require effort to understand, accounting aims to present it in a clear and comprehensible manner.

4. Comparability:

Financial information should be presented in a way that allows users to compare the financial statements of an enterprise over different periods (intra-firm comparison) and also compare the financial statements of different enterprises at a point in time or over a period (inter-firm comparison). Consistency in accounting policies and methods is crucial for comparability.

These characteristics are interconnected and contribute to the overall usefulness of accounting information for various users, including:

Internal Users: Management (for planning, controlling, decision-making), Employees (for job security, bonuses).
External Users: Investors (for investment decisions), Creditors (for lending decisions), Government (for taxation and regulation), Public (for overall performance and social responsibility).

Reliable, relevant, understandable, and comparable accounting information allows these users to assess the performance, financial health, and future prospects of the organisation.

Objectives Of Accounting

Accounting serves several key objectives, all centered around providing useful financial information for stakeholders. These objectives guide the accounting process and the preparation of financial statements.

Maintenance Of Records Of Business Transactions

One of the fundamental objectives of accounting is to maintain a systematic and complete record of all financial transactions and events of the business. This involves recording transactions chronologically in journals and then transferring them to ledgers.

Keeping records prevents reliance on memory, which can be unreliable, especially in businesses with numerous transactions.
It provides a basis for summarising information and preparing financial statements.
Detailed records are essential for auditing and complying with legal requirements (like the Companies Act, Income Tax Act in India).

Maintaining accurate records is the foundation upon which all other accounting objectives are built.

Calculation Of Profit And Loss

A major objective is to determine the profitability of the business over a specific period (usually a financial year, which in India runs from April 1st to March 31st). This is achieved by preparing the Profit and Loss Account (or Income Statement).

The Profit and Loss Account matches the revenues earned during the period against the expenses incurred to earn those revenues.

$Profit\ or\ Loss = Total\ Revenue - Total\ Expenses$

Knowing the profit or loss is crucial for owners to assess performance, for investors to evaluate potential returns, and for management to make operational decisions.

Depiction Of Financial Position

Another key objective is to present a true and fair view of the financial position of the business at a specific point in time. This is achieved by preparing the Balance Sheet.

The Balance Sheet shows the relationship between the business's Assets, Liabilities, and Owner's Equity (Capital) at a particular date.

Assets = Liabilities + Owner's Equity

Assets: Resources owned by the business that are expected to provide future economic benefits (e.g., cash, inventory, buildings, machinery).
Liabilities: Obligations of the business to external parties (creditors) that need to be settled in the future (e.g., loans, accounts payable).
Owner's Equity: The owners' claim on the assets of the business after deducting liabilities (Capital + Reserves - Drawings - Loss + Profit).

The Balance Sheet helps users understand the business's financial structure, its solvency (ability to pay long-term debts), and liquidity (ability to pay short-term debts).

Providing Accounting Information To Its Users

Ultimately, the goal is to make the processed financial information available to the interested users in a clear, concise, and understandable manner to aid their decision-making. This involves preparing and distributing financial statements and other relevant reports.

This objective connects directly to the 'communication' aspect of the definition of accounting and the 'users of information' concept, ensuring that the generated information fulfills its purpose of informing stakeholders.

Role Of Accounting

Beyond its basic definition and objectives, accounting plays several crucial roles in the functioning of businesses, the economy, and society. Its role has expanded significantly with the increasing complexity of business and regulatory environments.

1. Role as a Language of Business:

Accounting provides a standardised way to describe and communicate the financial activities of an enterprise. This allows stakeholders (owners, managers, investors, creditors) to understand the financial health and performance of different businesses using a common framework.

2. Role in Decision-Making:

Accounting information is indispensable for various economic decisions.

Management: Uses internal accounting information (management accounting) for planning, budgeting, controlling operations, setting prices, and evaluating performance.
Investors: Use financial statements to decide whether to buy, hold, or sell shares or invest in a business.
Creditors: Use financial information to assess the creditworthiness of a business before lending money.
Government: Uses accounting data for taxation purposes (e.g., calculating income tax, GST) and formulating economic policies.

3. Role in Measurement and Reporting:

Accounting provides methods for measuring the results of economic activities and reporting them in a structured format (Financial Statements). This involves concepts like revenue recognition, expense matching, and asset valuation.

4. Role in Stewardship:

In larger organisations, management is entrusted with the resources provided by owners (shareholders). Accounting reports help owners evaluate how effectively management has utilised these resources. This is the stewardship role.

5. Role in Compliance and Regulation:

Accounting ensures that businesses comply with various legal and regulatory requirements related to financial reporting, taxation, and corporate governance. In India, this involves adhering to the Companies Act, Income Tax Act, and accounting standards issued by institutions like the Institute of Chartered Accountants of India (ICAI).

6. Role in Information System Development:

Accountants are involved in designing and implementing financial information systems (manual or computerised) that capture and process financial data efficiently.

7. Role in Auditing:

External auditors examine financial statements prepared by the company's accountants to ensure they present a true and fair view according to accounting standards and regulations. Accounting provides the basis for the audit.

The role of accounting is thus multifaceted, providing essential information for decision-making, ensuring accountability, facilitating compliance, and supporting various economic functions within an organisation and the broader economy.