1.

1 INTRODUCTION

Accounting is a system meant for measuring business activities,

processing of information into reports and making the findings available
to decision-makers. The documents, which communicate these findings
about the performance of an organisation in monetary terms, are called
financial statements.

Usually, accounting is understood as the Language of Business.

However, a business may have a lot of aspects which may not be of
financial nature. As such, a better way to understand accounting could
be to call it The Language of Financial Decisions. The better the
understanding of the language, the better is the management of financial
aspects of living. Many aspects of our lives are based on accounting,
personal financial planning, investments, income-tax, loans, etc. We have
different roles to perform in life-the role of a student, of a family head, of
a manager, of an investor, etc. The knowledge of accounting is an added
advantage in performing different roles. However, we shall limit our scope
of discussion to a business organisation and the various financial aspects
of such an organisation.

When we focus our thoughts on a business organisation, many

questions (is our business profitable, should a new product line be
introduced, are the sales sufficient, etc.) strike our mind. To answer
questions of such nature, we need to have information generated through
the accounting process. The people who take policy decisions and frame
business plans use such information.

All business organisations work in an ever-changing dynamic

environment. Any new programme of the organisation or of its competitor
will affect the business. Accounting serves as an effective tool for
measuring the financial pulse rate of the company. It is a continuous
cycle of measurement of results and reporting of results to decision-
makers.

Just like arithmetic is a procedural element of mathematics, book

keeping is the procedural element of accounting. Figure 1 shows how an
accounting system operates in business and how the flow of information
occurs.

People make decision

Business transactions occur

Accountants prepare
reports to show the results
of business operations
FIG 1: THE ACCOUNTING SYSTEM
Source: Liorngren, Harrison and Robinson, Financial and Management
Accounting, Prentice Hall, New Jersey, 1994.

1.2 DEVELOPMENT OF ACCOUNTING DISCIPLINE

The history of accounting can be traced back to ancient times.

According to some beliefs, the very art of writing originated in order to
record accounting information. Though this may seem to be an
exaggeration, but there is no denying the fact that accounting has a long
history. Accounting records can be traced back to the ancient
civilizations of China, Babylonia, Greece and Egypt. Accounting was used
to keep records regarding the cost of labour and materials used in
building great structures like the Pyramids.

During 1400s, accounting grew further because the needs for

information of merchants in the Venis City of Italy increased. The first
known description of double entry book keeping was first published in
1994 by Lucas Pacioli. He was a mathematician and a friend of Leonardo
Ileda Vinci.

The onset of the industrial revolution necessitated the development

of more sophisticated accounting system, rather than pricing the goods
based on guesses about the costs. The increase in competition and mass
production of goods led to the rise of accounting as a formal branch of
study.

With the passage of time, the corporate world grew. In the

nineteenth century, companies came up in many areas of infrastructure
like the railways, steel, communication, etc. It led to a rapid growth in
accounting. As the complexities of business grew, ownership and
management of business was divorced. As such, managers had to come
up with well-defined, structured systems of accounting to report the
performance of the business to its owners.

Government also has had a lot to do with more accounting

developments. The Income Tax brought about the concept of ‘income’.
Government takes a host of other decisions, relating to education, health,
economic planning, for which it needs accurate and reliable information.
As such, the government demands stringent accountability in the
corporate sector, which forces the accounting process to be as objective
and formal as possible.

1.3 AN ACCOUNTANT’S JOB PROFILE: FUNCTIONS OF

ACCOUNTING

A man who is involved in the process of book keeping and

accounting is called an accountant. With the coming up accounting as a
specialised field of knowledge, an accountant has a special place in the
structure of an organisation, because he performs certain vital functions.
The following paragraphs examine the functions of accounting and what
role does an accountant play in discharging these functions.

An accountant is a person who does the basic job of maintaining

accounts as he is the man who is engaged in book keeping. Since the
managers would always want to know the financial performance of the
business. An accountant prepares profit and loss account which reports
the profits/losses of the business during the accounting period, Balance
Sheet, which is a statement of assets and liabilities of the business at a
point of time, is also proposed by all accountants. Since both statements
are called financial statements, the person who prepares them is called a
financial accountant.

Accounting information serves many purposes. A part from

revealing the level of performance, it throws light on the causes of
weakness and deviation from plans (in any). In this way an accountant
becomes an important functionary who plays a vital role in the process of
management control, which is a process of diagnosing and solving a
problem. Seen from this point of view, an accountant can be referred to
as a management accountant.

Tax planning is an important area as far as the fiscal management

of a company is concerned. An accountant has a suggestive but very
specific job to do in this regard by indicating ways to minimise the tax
liability through his knowledge of concessions and incentives available
under the existing taxation framework of the country.

An accountant can influence a company even by not being an

employee. He can act as a man who verifies and certifies the authenticity
of accounts of a company by auditing the accounts. It is a strictly
professional job and is done by persons who are formally trained and
qualified for the purpose. They have an educational status and a
prescribed code of conduct like the Chartered Accountants in India and
Certified Public Accountants in USA.

Information management is another area which keeps an

accountant busy. He is the one who classifies the financial information
into information for internal use (management accounting function); and
information or external use (financial accounting function). Irrespective of
the size and degree of automation of a business, information
management is a key area and many organisations are known to have
perished because they failed to recognise this as an important function of
an accountant because information system is imperative for effective cost
control, to forecast cash needs and to plan for future growth of the
organisation.

1.4 UTILITY OF ACCOUNTING

The preceding section has just brought out the importance of

information. Effective decisions require accurate, reliable and timely
information. The need for quantity and quality of information varies with
the importance of the decision that has to be taken on the basis of that
information. The following paragraphs throw light on the various users of
accounting information and what do they do with that information.

Individuals may use accounting information to manage their

routine affairs like operating and managing their bank accounts, to
evaluate the worthwhileness of a job in an organization, to invest money,
to rent a house, etc.

Business Managers have to set goals, evaluate progress and initiate

corrective action in case of unfavourable deviation from the planned
course of action. Accounting information is required for many such
decisions—purchasing equipment, maintenance of inventory, borrowing
and lending, etc.
 Investors and creditors are keen to evaluate the profitability and
solvency of a company before they decide to provide money to the
organisation. Therefore, they are interested to obtain financial
information about the company in which they are contemplating an
investment. Financial statements are the principal source of information
to them which are published in annual reports of a company and various
financial dailies and periodicals.

Government and Regulatory agencies are charged with the

responsibility of guiding the socio-economic system of a country in such
a way that it promotes common good. For example, the Securities and
Exchange Board of India (SEBI) makes it mandatory for a company to
disclose certain financial information to the investing public. The
government’s task of managing the industrial economy becomes simplify
if the accounting information such as profits, costs, taxes, etc. is
presented in a uniform manner without any manipulation or ‘window-
dressing’.

Central and State governments levy various taxes. The taxation

authorities, therefore, need to know the income of a company to calculate
the amount of tax that the company would have to pay. The information
generated by accounting helps them in such computations and also to
detect any attempts of tax evasion.

Employees and trade unions use the accounting information to

settle various issues related to wages, bonus, profit sharing, etc.
Consumers and general public are also interested in knowing the amount
of income earned by various business houses. Accounting information
helps in finding whether or not a company is over charging or exploiting
the customers, whether or not companies are showing improved business
performance, whether or not the country is emerging from the economic
recession, etc. All such aspects draw heavily on accounting information
and are closely related to our standard of living.

1.5 TYPES OF ACCOUNTING

The financial literature classifies accounting into two broad

categories, viz, Financial Accounting and Management Accounting.
Financial accounting is primarily concerned with the preparation of
financial statements whereas management accounting covers areas such
as interpretation of financial statements, cost accounting, etc. Both these
types of accounting are examined in the following paragraphs.

1.5.1 Financial accounting

As mentioned earlier, financial accounting deals with the

preparation of financial statements for the basic purpose of providing
information to various interested groups like creditors, banks,
shareholders, financial institutions, government, consumers, etc.
Financial statements, i.e. the income statement and the balance sheet
indicate the way in which the activities of the business have been
conducted during a given period of time.

Financial accounting is charged with the primary responsibility of

external reporting. The users of information generated by financial
accounting, like bankers, financial institutions, regulatory authorities,
government, investors, etc. want the accounting information to be
consistent so as to facilitate comparison. Therefore, financial accounting
is based on certain concepts and conventions which include separate
business entity, going concern concept, money measurement concept,
cost concept, dual aspect concept, accounting period concept, matching
concept, realization concept and conventions of conservatism, disclosure,
consistency, etc. All such concepts and conventions would be dealt with
detail in subsequent lessons.
 The significance of financial accounting lies in the fact that it aids
the management in directing and controlling the activities of the firm and
to frame relevant managerial policies related to areas like production,
sales, financing, etc. However, it suffers from certain drawbacks which
are discussed in the following paragraphs.
· The information provided by financial accounting is
consolidated in nature. It does not indicate a break-up for
different departments, processes, products and jobs. As
such, it becomes difficult to evaluate the performance of
different sub-units of the organisation.
· Financial accounting does not help in knowing the cost
behaviour as it does not distinguish between fixed and
variable costs.
· The information provided by financial accounting is historical
in nature and as such the predictability of such information
is limited.

The management of a company has to solve certain ticklish

questions like expansion of business, making or buying a component,
adding or deleting a product line, deciding on alternative methods of
production, etc. The financial accounting information is of little help in
answering these questions.

The limitations of financial accounting, however, should not lead

one to believe that it is of no use. It is the basic foundation on which
other branches and tools of accounting analysis are based. It is the
source of information, which can be further analysed and interpreted
according to the tailor-made requirements of decision-makers.

1.5.2 Management accounting

Management accounting is ‘tailor-made’ accounting. It facilitates

the management by providing accounting information in such a way so
that it is conducive for policy making and running the day-to-day
operations of the business. Its basic purpose is to communicate the facts
according to the specific needs of decision-makers by presenting the
information in a systematic and meaningful manner. Management
accounting, therefore, specifically helps in planning and control. It helps
in setting standards and in case of variances between planned and actual
performances, it helps in deciding the corrective action.

An important characteristic of management accounting is that it is

forward looking. Its basic focus is one future activity to be performed and
not what has already happened in the past.

Since management accounting caters to the specific decision

needs, it does not rest upon any well-defined and set principles. The
reports generated by a management accountant can be of any duration–
short or long, depending on purpose. Further, the reports can be
prepared for the organisation as a whole as well as its segments.

1.5.3 Cost accounting

One important variant of management accounting is the cost

analysis. Cost accounting makes elaborate cost records regarding various
products, operations and functions. It is the process of determining and
accumulating the cost of a particular product or activity. Any product,
function, job or process for which costs are determined and accumulated,
are called cost centres.

The basic purpose of cost accounting is to provide a detailed break-

up of cost of different departments, processes, jobs, products, sales
territories, etc., so that effective cost control can be exercised.

Cost accounting also helps in making revenue decisions such as

those related to pricing, product-mix, profit-volume decisions, expansion
of business, replacement decisions, etc.
 The objectives of cost accounting, therefore, can be summarized in
the form of three important statements, viz, to determine costs, to
facilitate planning and control of business activities and to supply
information for short- and long-term decision. Cost accounting has
certain distinct advantages over financial accounting. Some of them have
been discussed succeedingly. The cost accounting system provides data
about profitable and non-profitable products and activities, thus
prompting corrective measures. It is easier to segregate and analyse
individual cost items and to minimize losses and wastages arising from
the manufacturing process. Production methods can be varied so as to
minimize costs and increase profits. Cost accounting helps in making
realistic pricing decisions in times of low demand, competitive conditions,
technology changes, etc.

Various alternative courses of action can be properly evaluated

with the help of data generated by cost accounting. It would not be an
exaggeration if it is said that a cost accounting system ensures maximum
utilization of physical and human resources. It checks frauds and
manipulations and directs the employer and employees towards
achieving the organisational goal.

1.5.4 Distinction between financial and management

accounting

Financial and management accounting can be distinguished on a

variety of basis like, users of information, criterion for decision making,
behavioural implications, time frame, type of reports.

Table 1 presents a summary of distinctions between financial and

management accounting.
 TABLE 1: FINANCIAL ACCOUNTING VS MANAGEMENT ACCOUNTING
Basis of Financial accounting Management
distinction accounting
1. Primary user Outside parties and manager Business managers
of the business
2. Decision Accounts are based on Comparison of costs
criterion generally accepted and benefits of
accounting principles proposed action
3. Behavioural Concern about adequacy of Concern about how
implications disclosure. Behavioural reports will affect
implications are secondary employee
behaviour
4. Time focus Past orientation Future orientation
5. Reports Summary reports regarding Detailed reports on
the whole entity the parts of the entity
Source: Horngren, Harrison and Robinson, Financial and Management
Accounting, Prentice Hall, New Jersey, 1994.

1.6 SUMMARY

Accounting can be understood as the language of financial

decisions. It is an ongoing process of performance measurement and
reporting the results to decision-makers. The discipline of accounting can
be traced back to very early times of human civilization. With the
advancement of industry, modern day accounting has become formalized
and structured. A person who maintains accounts is known as the
accountant. He is engaged in multifarious activities like preparing
financial statements, facilitating the control process, tax planning,
auditing and information management. The information generated by
accountant is used by various groups like, individuals, managers,
investors, creditors, government, regulatory agencies, taxation
authorities, employees, trade unions, consumers and general public.
Depending upon purpose and method, accounting can be of broadly two
types– financial accounting and management accounting. Financial
accounting is primarily concerned with the preparation of financial
statements mainly for outsiders. It is based on certain well-defined
concepts and conventions and helps in framing broad financial policies.
However, it suffers from certain limitations which are taken care of by the
other branch of accounting, viz.; management accounting. Management
accounting is meant to help in decision-making by analyzing and
interpreting the information generated by financial accounting. As such,
management accounting is futuristic and decision-oriented. The methods
of management accounting are not very exact as they have to be varied
according to the requirements of the decision. Cost accounting is an
important aspect of management accounting. It emphasizes on cost
determination, aiding the planning and control process and supplying
information for short- and long-run decisions. The basic differences
between financial and management accounting arises due to differences
in users of information, differences in time frame and type of reports
generated. The criterion for decision making and the behavioural
implications of both types of accounting are also different.

1.7 KEYWORDS

Accrual: Recognition of revenues and costs as they are earned or

incurred. It includes recognition of transaction relating to assets and
liabilities as they occur irrespective of the actual receipts or payment.

Cost: The amount of expenditure incurred on or attributable to a

specified article, product or activity.

Expenses: A cot relating to the operations of an accounting period.

Revenue: Total amount received from sales of goods/services.

Income: Excess of revenue over expenses.

 Loss: Excess of expenses over revenue.

Capital: Generally refers to the amount invested in an enterprise

by its owner.

Fund: An account usually of the nature of a reserve or provision

which is represented by specifically Ear Market Assets.

Gain: A monetary benefit, profit or advantage resulting from a

transaction or group of transactions.

Investment: Expenditure on assets held to earn interest, income,

profit or other benefits.

Liability: The financial obligation of an enterprise other than

owners’ funds.

Net Profit: The excess of revenue over expenses during a particular

accounting period.

1.8 SELF ASSESSMENT QUESTIONS

1. Define accounting. What purpose is served by accounting?

2. Discuss the role and activities of an accountant.

3. What are the various interested parties which use accounting

information? How is such information used?

4. Explain the different types of accounting.

5. Differentiate Financial Accounting and Management

Accounting in detail.