ROLE OF ACCOUNTING IN SOCIETY

Introduction
Accounting aims to provide financial information about an enterprise to various interested
groups for decision-making. As accounting communicates financial information for decision-
making to many parties outside the reporting business entity, it is necessary that there is
uniformity in the preparation of financial statements of different enterprises at a given point of
time. It also requires consistency in the preparation of financial statements of an enterprise
over a period of time. If every business could follow its own notion about the accounting terms
like revenue, expenses, assets, liabilities, income etc., there will be complete chaos. To have
uniformity and consistency in the preparation of financial statements, accounting operates
within a framework of “Generally Accepted Accounting Principles” (GAAP), follows a conceptual
framework and adheres to the Accounting Standards issued by the recognised regulatory body.
This is referred to as the theory base of accounting.
The term GAAP is used to describe rules or guidelines, variously called concepts, conventions,
axioms, assumptions, postulated principles, and modifying principles etc., developed for the
preparation of financial statements. Accounting principles are a body of doctrines commonly
associated with the theory and procedure of accounting, serving as an explanation of current
practices and as guide for the selection of conventions and procedures where alternatives exist.
It provides explanation for accounting practices followed by an enterprise at a given point of
time. However, it should be clearly understood that accounting theory is not and probably will
never be in a completely stable state. Accounting principles are constantly evolving and are
influenced by the following:

• Changes in the social, legal and economic environment

• Professional bodies like the Institute of Chartered Accountants of England and Wales,
the American Institute of Certified Public Accountants, International Accounting
Standards Board.

• Needs of the users of financial information

Accounting, being a man made system, should evolve and adjust itself to the changes needed
by the mankind. As a result, accounting principles are not as exact and rigid as the laws of
natural sciences. Therefore, the emphasis is on general instead of universal acceptability of
accounting principles. GAAP is not the building blocks of the accounting language. Rather,
GAAP is the pillar on which the structure of accounting rests. If we remove these principles, the
entire structure of accounting will come down. The GAAP should be understood by the makers
and the users of accounting information before analysing and interpreting financial statements.
GAAP includes the following concepts:

• Accounting entity

• Stable money measurement

• Going concern

• Accounting period

• Cost

• Revenue recognition (or realisation)

• Expenses recognition

• Matching (or accrual)

• Full, fair and adequate disclosure

• Dual aspect (or duality)

• Verifiable objectivity (neutrality and reliability)

• Materiality

• Consistency

• Conservatism

• Timeliness

• Industry practices

• Substance over form

Of these, the first four concepts are the most basic assumption on which accounting structure
rests. The next six are the basic accounting principles which help us in ascertaining the result
of a business entity. However, we are essentially operating in a social system which is bound to
be inexact. Hence, we need to be flexible in our approach. The basic knowledge needs to be
modified due to changing circumstances/situations to enhance the utility of the information
generated by the accounting system. The next six concepts serve the same purpose.

All financial statements recognise the fundamental accounting concepts of going concern,
matching (or accrual) and consistency. Financial statements should further emphasise
prudence and substance over form and materiality as considerations in the selection of
accounting policies, where accounting policies are defined as referring to the specific
accounting principles and the method of applying those principles adopted by the enterprise in
the preparation and presentation of financial statements. The end result of the application of
these accounting principles is the preparation of meaningful financial statements.
1. Accounting Entity

Accountants treat a business as distinct from the persons who own it. Then, it becomes
possible to record the transactions of the business without the proprietor also. The concept of
separate business entity is applicable for all types of organizations like sole proprietorship,
partnership etc. where the business affairs are free from the private affairs of the proprietor or
partner.

2. Money Measurement

Accounting records normally those transactions which are being expressed in monetary terms.
Measurement of business events in monetary terms helps in understanding the state of affairs
of the business in a much better way. For example, if a business owns two factory buildings,
five machines and £1,000,000 cash at bank, we cannot add these numbers so as to produce a
meaningful result. However, if we say the value of two factory buildings is £10,000,000, the
value of five machines is £500,000 and cash of £1,000,000; we can add these values and say
that the value of assets owned by the business is £11,500,000. This is definitely informative
and useful.

3. Going Concern Concept

It is assumed that the business will exist for a long time and transactions are recorded from
this point of view. Based on this concept, the accountants, while valuing assets, will not
consider the forced sale value of assets (market value), but the assets, normally, will be
reflected at the cost of acquisition minus depreciation. Similarly, depreciation is provided based
on the expected life of the assets. The concept, however, does not imply the permanent
continuance of the business. The underlying presumption is that the business will continue in
operations long enough to charge against income the cost of fixed assets over their economic
lives and to pay the liabilities when they fall due. This concept is applicable to the business as a
whole and not for a particular division or branch. Merely closing of a branch or division may not
adversely affect the ability of the enterprise to continue other businesses normally. Once the
business goes in to liquidation or becomes insolvent, this concept does not apply. In other
words, the going concern status of the concern will stand terminated from the date of
appointment of a receiver.

4. Accounting Period Concept

According to this concept, the life of a business is divided into appropriate segments of time,
say 12 months, for studying the results. While the life of a business is considered to be
indefinite, according to the going concern concept, the measurement of income and studying
the financial position of the business after a very long time would not be helpful in taking
corrective steps at the appropriate time. Therefore, it is necessary that after each segment of
time interval the management should review the performance. The segment of time interval is
called accounting period, which is usually a year. At the end of each accounting period, an
income statement and a balance sheet is prepared. The income statement discloses the profit
or loss made by the business during an accounting period. The balance sheet discloses the
state of affairs of the business as on the last date of the accounting period. The term
“conventions” includes those customs or traditions which guide the accountants while
preparing the accounting statements.
5. Cost Concept

Transactions are entered in the books of account at the amounts actually involved. An asset is
ordinarily recorded at a price at which it has been acquired. For example, a plot of land
purchased by a firm for £5,000,000 would be recorded at this value irrespective of its current
market price. Cost concept has the advantage of bringing objectivity in the presentation of the
financial statements. In the absence of this concept, the figures shown in the accounting
records would have to depend on the subjective view of a person.

6. Realization Concept

Accounting is a historical record of transactions. It only records what has happened. It does not
anticipate events, though anticipated adverse effects of events that have already occurred are
usually recorded. For example, A places an order on B for supply of certain goods. Upon receipt
of the order, B procures raw material, employs labour, and produces and delivers the goods to
A. In this case, the sale transaction will be recorded in the books of B only when the goods are
delivered and not upon the receipt of an enforceable purchase order from A.
There are certain exceptions to this concept which are as follows:

i) In the case of hire-purchase transaction, the ownership of the goods passes on to the
buyer only when the last instalment is paid, but sales are presumed to have been
made to the extent of instalments received and instalments outstanding
(instalments due but not received).

ii) In the case of contract accounts, though the contractor is liable to pay only when the
whole of contract is completed as per terms of the contract, the profit at the end of
accounting year is calculated on the basis of the work completed and certified by a
competent authority.

7. Expenses Recognition

Cost is the total outlay or expenditure on acquiring resources required for the production of
goods or rendering of services. Cost of resources utilized and lost during a particular period is
termed as the expired cost or expense and is charged to the revenue of the period to obtain
information about income. Costs of the resources remaining unutilized or unexpired at the end
of the period are carried forward to the next accounting period and are termed as assets.

8. Accrual Concept

The accrual system is a method whereby revenue and expenses are identified with specific
period of time like a month, half year or a year. It implies recording of revenue and expenses
of a particular accounting period whether they are received /paid in cash or not. Under the
cash system of accounting, the revenue and expenses are recorded only if they are actually
received /paid in cash irrespective of the accounting period to which they belong. But under
accrual method, the revenue and expenses relating to that particular accounting period only
are considered.

9. Disclosure
Apart from the statutory obligations, good accounting practice also demands that all significant
information should be disclosed fully and fairly. The financial statements have to be prepared
honestly and should disclose the information which is of material interest to the owners,
present and potential creditors, and investors. Whether information should be disclosed or not
will depend on whether it is material. Materiality depends on the amounts involved in relation
to the assets group involved or profits. In the case of financial statements of a limited
company, the practice followed is to append the notes to the accounts and disclose significant
accounting policies. This is in pursuance of the convention of full disclosure.

10. Dual Aspect Concept

Each transaction has two aspects. With every increase in the money owned to others, there
should be an increase in assets or loss. Thus, at any time the accounting equations is as
follows:
Assets = Liabilities + Capital, or alternatively
Capital = Assets - Liabilities
For example, a proprietor brings in £100,000 in cash as capital to start a small business.
£100,000 is the capital and corresponding amount of £100,000 will appear as cash in hand
(assets).

11. Verifiable Objectivity

According to this concept, all accounting transactions should be evidenced and supported by
objective documents. These documents include invoices, contracts, correspondence, vouchers,
and bills, pass books, cheque books etc. Such supporting documents provide the basis for
making accounting entries and for verification by the auditors later on. This concept also has its
limitations. For example, it is difficult to verify internal allocation of costs to accounting periods.

12. Materiality

According to this convention, the accountant should attach importance to material details and
ignore insignificant details. This is because otherwise accounting will be unnecessarily
overburdened with minute details. The question “what constitutes material details” is left to the
discretion of the accountant. Moreover, an item may be material for one purpose while
immaterial for another. The term materiality is a subjective term. The accountant should regard
an item as material if there is a reason to believe that knowledge of it would influence decision
of the informed investor. According to Kohler, “Materiality means characteristic attaching to a
statement, fact or item whereby its disclosure or method of giving it expression would be likely
to influence the judgment of a reasonable person.”

13. Consistency

The accounting practices should remain the same from one year to another. For example,
consistency in valuing stock in trade or in the method of charging depreciation. If the stock has
been valued by adopting the principle of cost or market value, whichever is less, the same
principle has to be consistently followed year after year. Similarly, the method of charging
depreciation, either straight line or written down value method, has to be consistently followed.
This is necessary for the comparison of results. However, consistency does not mean
inflexibility.
In the case of change in law or from the point of view of improved reporting, this convention is
broken and then adequate disclosure, as to the impact on the profit due to such change, has to
be mentioned in the notes appended to the accounts.

14. Conservatism

Financial statements are usually drawn up on a conservative basis, especially in the initial
stages when the anticipated profits, which were accounted, did not materialize. This results in
less acceptability of accounting figures by the end-users. Therefore, accountants follow the rule
“anticipate no profits but provide for all possible losses.” Similarly, based on this convention,
the inventory is valued at lower of cost or market price. Necessary provision for bad and
doubtful debts is made in the books of account. Window-dressing, i.e. showing a position
better than what it is, is not permitted. It is also not proper to show a position substantially
worse than what it is. In other words, secret reserves are not permitted. Therefore, this
convention has to be applied with reasonable caution and care.

15. Timeliness

Financial reports should be timely to have any usefulness for decision makers. Timeliness in
financial reporting requires estimation of depreciation, provision for bad and doubtful debts,
provision for discount etc. to prepare the financial statements of different accounting periods.

16. Industry Practice

Sometimes, practice prevailing in a particular industry is given precedence over generally

accepted accounting principles. For example, valuation of gold on the basis of market price,
agriculture products on the basis of minimum support price determined by the government etc.

17. Substance over Form

The accounting treatment and presentation in the financial statements of transactions and
events should be governed by their substance and not merely by their legal form. Hence, when
goods are purchased on hire-purchase basis, the property in goods is transferred to the buyer
on the payment of the last instalment only. However, the buyer for all practical purpose uses
the goods as if he is the owner of the goods in question from the date of acquisition. This
aspect is reflected in the books of the buyer, normally by recording the asset at its cash price
at the time of payment of initial amount (down payment). Hence, substance should always
override the legal form – always choose substance over form.

Accounting Standards or Financial Reporting Standards

Accounting communicates the financial results of business to various parties by means of
financial statements which have to exhibit a “true and fair” view of the state of affairs. Like any
other language, accounting also has complex set of rules. However, these rules have to be
used with a reasonable degree of flexibility in response to specific circumstances of the
business and also in line with the changes in the economic environment, social needs, legal
requirement and technological developments. Thus, these rules, though not rigid, cannot be
applied arbitrarily. They normally operate within the boundary of rationality.
Accounting standards are defined as the policy documents issued by a recognized expert
accounting body relating to various aspects of measurement, treatment and disclosure of
accounting transactions and events.
Systems of Bookkeeping
Bookkeeping, as explained earlier, is an art of recording pecuniary or business transactions
in a regular and systematic manner. The recording of transactions may be done according
to any of the following two systems:

1. Single Entry System

This is a system of bookkeeping in which, as a rule, only records of cash and personal accounts
are maintained. It is always incomplete, varying with circumstances. Since all records are not
kept, it is not reliable and can only be suitable for small business firms.

2. Double Entry System

Every transaction in accounting is considered as having two aspects. Double entry system is
the name given for recognising both the aspect of any business transaction as per prescribed
set of rules. For example, £1,000 in cash received from Gerrard. This is a transaction having
the following two aspects:
(i) Business Receiving Cash £1,000
(ii) Gerrard Giving Cash £1,000

As per the prescribed rules followed for accounting, one aspect is given a DEBIT effect and
other aspect is given a CREDIT effect of equivalent amount.

The above system of accounting is known as double entry system. The system implies that
a transaction is entered twice to account for the two fold aspect of a transaction.

Both the aspects are equal in monetary terms in opposite directions. If one is debit, the other
one will be credit. If one is credit, then the other one will be debit. Both debit and credit
aspects should be equal in monetary terms.
Thus, double entry system is a system of accounting which gives the two fold aspects of any
monetary business transaction, according to certain prescribed rules.

Main Features of Double Entry System

1. Both the aspects of the transaction, i.e. debit as well as credit are to be recorded.

2. Since one aspect is debited with equal amount and the other aspect is credited, the total of
debit effects should agree with total of the credit effects. This is done by preparing a trial
balance to test the arithmetical accuracy.

Stages of Double Entry System of Accounting

st
1 stage Recording transactions in journal and subsidiary books
nd
2 stage Posting in ledger (classified group)
rd
3 stage Preparation of trial balance
th
4 stage Preparation of final accounts
th
5 stage Management accounting
Summary
Accounting is the language of business. Accounting is the art of recording, classifying and
summarising meaningfully the transactions and events which are of financial character and
interpreting the results thereof.
Basic accounting concepts are the ground rules for financial accounting. These concepts are
vital for the understanding of the process of accounting.
A financial statement comprises a balance sheet, a profit and loss statement and the schedule
and notes forming part thereof.
The accounting equation shows the relationship of different elements of a balance sheet.

Questions

1. Write short notes on the following:

• Fundamental accounting assumptions

• Going concern concept
• Periodicity concept

2. Accounting period assumption is made to provide timely information to the user of

accounting information. Explain it clearly, stating the nature of information provided by
financial statements of an accounting period.
3. State whether the following statements are true or false:

a. Accounting entity is recognised by law.

b. Accounting records changes in the level of prices and non-monetary events.

c. Full disclosure requires disclosure of insignificant information.

d. Revenue increases capital.

e. Revenue is recognised when it is earned, irrespective of cash inflow.

f. Assets are always equal to liabilities plus capital.

g. Purchasing power of money and level of prices are inversely related.

h. Income statement reports income on historical cost basis.

i. Cost of fixed assets becomes expense over the period of its use.

j. Income is excess of revenue over cost.

k. Cost is expense over the period of its use.

l. Income is excess of revenue over cost.

m. Cost and expense are same.

n. Recognition of an expense is related to outflow of cash.