Chapter I:FOUNDATION OF ACCOUNTING

1.1 Introduction
1.2 Development of accounting discipline
1.3 An accountant’s job profile: functions of accounting
1.4 Users of accounting information
1.5 Types of accounting
1.5.1 Financial accounting
1.5.2 Management accounting
1.5.3 Cost accounting
1.5.4 Distinction between financial and management accounting

Learning outcomes of the Lesson

At the end of the unit, the students must have:
1. Narrated the history of accounting (PLO 4; PI 1)
2. Synthesized the different definitions of accounting. (PLO 4: PI1)
3. Synthesized the fields of accounting. (PLO 4: PI1)
4. Compared properly the different types of business as to nature of operations (PLO 4: PI2)
5. Compared properly the forms of business organization as to ownership (PLO 4: PI1)
6. Compared properly the different users of financial information and their information needs.
(PLO 4: PI1)

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
organization 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 ours cope of discussion to a
business organization and the various financial aspects of such an organization.

When we focus our thoughts on a business organization, 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 organizations work in an ever-changing dynamic environment. Any
new program of the organization 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. Figure1shows 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

DEVELOPMENT OF ACCOUNTINGDISCIPLINE

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 labor 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.

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 specialized field of
knowledge, an accountant has a special place in the structure of an organization,
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 o fweakness 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 minimize 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 Code of Ethics for
CPA’s in the Philippines.

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
informationorexternaluse(financialaccountingfunction).Irrespectiveof the size and
degree of automation of a business, information management is a key area and
many organizations are known to have perished because they failed to recognize
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 organization.

USERS OF ACCOUNTING INFORMATION

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,t o 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 unfavorable 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 organization. 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 Philippine Securities and Exchange Commission (SEC)
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’.

National and local 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.

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.

1.4.1 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 organization.

• Financial accounting does not help in knowing the cost behavior 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 analyzed and interpreted according to the tailor-made requirements of
decision-makers.

1.4.2 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 organization as a whole as
well as its segments.

1.4.3 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 centers.
 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 analyze 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 organizational goal.

1.4.4 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, behavioral implications,
time frame, type of reports.

Table1presents a summary of distinctions between financial and

management accounting.

TABLE 1: FINANCIAL ACCOUNTING VS MANAGEMENT ACCOUNTING

Basis of distinction Financial accounting Management accounting

1. Primary user Outside parties and manager Business managers
of the business

2. Decision criterion Accounts are based on Comparison of costs

generally accepted accounting and benefits of proposed
principles action

3. Behavioral Concern about adequacy of Concern about how

implications disclosure. Behavioral reports will affect
implications are secondary employee
behavior
4. Time focus Past orientation Future orientation

5. Reports Summary reports regarding Detailed reports on

the whole entity the parts of the entity