ACCOUNTING AS AN INFORMATION SYSTEM

WHAT IS ACCOUNTING?
A traditional definition of accounting provides that “accounting is an art of
recording, classifying and summarizing, in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character,
and interpreting the result thereof.” As per this definition, accounting is simply an
art of record keeping. It means putting into writing or in print suitable transactions
and events of financial character reasonably soon after their occurrence in the
records maintained by the organization (e.g. general journal, subsidiary books and
the ledger.) as well as their summarization for their ready reference. However does
not reflect properly the role of accounting in the modern society. The scope of
accounting is wider at present than that described in this definition.

FUNCTIONS OF ACCOUNTING
Financial accounting performs the following major functions:

(i) Maintaining systematic records: Business transactions are properly

recorded, classified under appropriate accounts and summarized into
financial statements-income statement and the balance sheet.

(ii) Communicating the financial results: Accounting is used to communicate

financial information in respect of net profits (or loss), assets, liabilities etc.,
to the interested parties.

(iii)Meeting legal needs: The provisions of various laws such as Companies

Act, Income Tax and Sales Tax Acts require the submission of various
statements, i.e., annual accounts, income tax returns, returns for sales tax
purposes and so on.

(iv) Protecting business assets: Accounting maintains proper records of

various assets and thus enables the management to exercise proper control
over them with the help of following information regarding them:

a) How much is the balance of cash in hand and cash at bank?

b) What is the position of inventories?

c) How much money is owed by the customers?

d) How much money is owing to the creditors?

 e) What is the position of various fixed assets and how these are being
used?

(v) Stewardship: In the case of limited companies, the management is

entrusted with the resources of the enterprise. The managers are expected to
act true trustees of the funds and the accounting helps them to achieve the
same.

(vi) Fixing responsibility: Accounting helps in the computation of the

profits of different departments of an enterprise. This would help in fixing the
responsibility of the departmental heads.

(vii) Forecasting: Accounting enables to forecast the future performance

and financial position using past accounting information.

(viii) Measurement: It is the basic function of the accounting data to

measure the past performance in money terms and disclose its current
financial position.

(ix) Decision making: Accounting provides the users the relevant data to
enable them make appropriate decisions in respect of investment in the
capital of the business enterprise or to supply goods on credit or lend money
etc.

(x) Evaluation: Assessing operating results (profit or loss) in relation to pre

determined goals.

(xi) Control: To identify the weakness of the operational system and

review the steps taken to check such weaknesses.

ADVANTAGES OF ACCOUTING
(i) Assistance to management: The accounting information helps the
management to plan its future activities by preparing budgets in respect of
sales, production, expenses, cash etc. Accounting helps in coordination of
various activities in different departments by providing financial details of
each department. The managerial control is achieved by analyzing in money
terms the departures from the planned activities and by taking corrective
measures to improve the situation on future.

(ii) Records rather than memory: It is not possible at all to do any business by
just remembering the business transactions which have grown in size and
complexity. Transactions, therefore, must be recorded early in the books of
 accounts so that necessary information about them is available in time and
free from bias.

(iii)Intra-period comparisons: Accounting information when recorded properly

can be used to compare the results of one year with those of previous
year(s).

(iv) Aid in legal matters: Systematically recorded accounting information

can be produced as evidence in court of law.

(v) Help in taxation matters: Income Tax and Sales Tax authorities could be
convinced about the taxable income or actual turnover (sales), as the case
may be, with the help of written records.

(vi) Sale of a business: In case, a sole trader or a partnership firm or

even a company wants to sell its business, the accounting information can be
utilized to determine proper purchase price.

LIMITATIONS OF ACCOUNTING
(i) Accounting information is expressed in terms of money. Non-monetary
events or transactions, however important they may be, are completely
omitted.

(ii) Fixed assets are recorded in the accounting records at the original
cost, that is, the actual amount spent on them plus, of course, all incidental
charges. In this way the effect of inflation (or deflation) is not taken into
consideration. The direct result of this practice is that balance sheet does not
represent the true financial position of the business.

(iii)Accounting information is sometimes based on estimates; estimates

are often inaccurate. For example, it is not possible to predict with any
degree of accuracy the actual useful life of an asset for the purpose of
depreciation expense.

(iv) Accounting information cannot be used as the only test of

managerial performance on the basis of more profits. Profit for a
period of one year can readily be manipulated by omitting such costs as
advertisement, research and development, depreciation and so on.
 (v) Accounting information is not neutral or unbiased. Accountants
calculate income as excess of revenues over expenses. But they consider
only selected revenues and expenses. They do not, for example, include cost
of such items as water or air pollution, employee’s injury etc.

(vi) Accounting like any other discipline has to follow certain

principles which in certain cases are contradictory. For example current
assets (e.g., stock of goods) are valued on the basis of cost or market price
whichever is less following the principle of conservatism. Accordingly the
current assets may be valued on the cost basis in some year and at market
price in another year. In this manner, the rule of consistency is not followed
regularly.

NATURE OF FINANCIAL ACCOUNTING PRINCIPLES

NEED FOR ACCOUNTING PRINCIPLES
Accounting information is useful to the users only if it is free from personal
judgments. It must also be consistent and comparable. Accounting is the
language of business and as we have basic rules in grammar in any language, it
is necessary that the accountants must follow a uniform set of rules or guidelines so
that the accounting information is understood in the same sense by those using it.
In the absence of specific rules, it would be difficult for the accountants to decide
how exactly a particular business transaction should be reported in the financial
statements e.g. valuation of inventories or method of depreciation. In such a
situation, each business enterprise in the same industry might develop its own
accounting rules and therefore would be free to report the accounting information in
a manner that suits it. There would be considerable confusion in financial
reporting and the accounting information would become biased,
inconsistent and consequently unreliable and incomparable. That is why
some rules and guidelines are absolutely necessary so that the accounting
information reported through. Financial statements prepared by various enterprises
in the same industry are comparable. Fortunately, the accounting profession has
developed, over the years from experience, usage and necessity, certain rules in
this regard. These rules are called accounting principles. Other terms used for
accounting principles are concepts, conventions postulates, techniques,
policies, and so on. The financial statements or external reports are the only
source by which outside users receive the financial information about the
enterprise. It is therefore necessary that they are prepared in accordance with
recognized accounting principles.

NATURE OF ACCOUNTING PRINCIPLES

The need for uniform financial reporting on the recognition of social responsibility of
accounting has brought with it, the recognition of the need for accounting
principles. But there is no unanimity regarding the nature of accounting principles.

The dictionary meaning of the word principle is: “a fundamental truth or law
as the basis of reasoning or action.” In its literary meaning therefore the term
principle is quite rigid in its application e.g. principle of gravity. The accountants
therefore use the term ‘standard’ in preference to the term principle because the
term principle generally suggests universal application of rules and a degree of
performance which is not possible in accounting. Accounting is a social science
or a human- service institution and not a physical science. When the term
‘principle’ is used in accounting, it would mean a rule of action or a rule of
conduct. Thus the essential feature of accounting principles is that they are
flexible rather than precise or rigid. They are not principles of nature but
rules of human behavior. They are not discovered and there are no
laboratory tests. Accounting principles are manmade and are derived from
experience and reason. Accounting principles are judged on their general
acceptability rather than universal acceptability to the makers and users
of financial statements. Hence they are popularly called Generally
Accepted Accounting Principles (GAAP).
The term “generally accepted” means that these principles must have solid support,
that usually comes from the professional accounting bodies. It is a technical
accounting term that describes the basic rules, concepts, conventions, and
procedures that represent accepted accounting practices at a particular time.
Accounting Principle Board (APB) in statement no.4 (1970) of the AICPA stated that :
“generally accepted accounting principles incorporate the consensus at any time as
to which economic resources and obligations should be recorded as assets and
liabilities, which changes in them should be recorded, how the recorded assets and
liabilities and changes in them should be measured, what information should be
disclosed and how it should be disclosed and which financial statements should be
prepared.”

Generally accepted accounting principles include not only accounting principles but
various procedures for applying these principles. For example, the cost principle
states that the price paid (cost) for the machine must be spread over its useful or
serviceable life. There are several accepted procedures for applying this accounting
principle. We could spread the cost over the useful life in equal amounts per year
(straight line method); we could spread the cost based on the number of hours, the
machine was used each year (i.e., machine hour rate) or we could spread the cost
on the basis of number of units, the machine produced each year (units-of-
production method). Generally accepted accounting principles are, therefore,
ground rules of the accounting so that similar economic events will be reported by
everyone in the same manner. “Since everyone must follow GAAP, the result is a
consistent system of financial reporting that provides the users of financial
statements with accounting information that is reliable, understandable and
comparable to prior years among business firms.”

The development of accounting principles is an ongoing process to meeting the

changing and ever growing needs of society and to keep the reporting of accounting
information relevant to the current problems of external decision makers. The
reason is: what may have provided accounting information many years ago, may
not be sufficient or even acceptable today. The modification of existing accounting
principles and formulation of new ones are necessitated by such factors as inflation,
globalization of a business, legal and social environment etc. For example, new
accounting methods have been developed to highlight the effect of price level
changes on the financial statements. As a result of globalization, the business has
become international in nature. Multinational corporations operate throughout the
world. Attempts are being made to make the accounting practices consistent
among countries. This is a slow and evolutionary process and differences still exist.
As and when more uniformity is achieved on international basis, financial
information throughout the world will be more comparable. Similarly new provisions
are added to the Companies Act to enlarge the area of accounting information by
forcing the companies to include the statement of cash flows in addition to the two
basic financial statements.
 INSTITUTIONS THAT INFLUENCE INDIAN GAAP
Many institutions influence the development of accounting principles followed by
the accountants in the preparation and presentation of financial statements in India.
These include the following: Institute of Chartered Accountants of India (ICAI); the
Department of Company Affairs (DCA), the Securities and Exchange Board of India
(SEBI), the Central Board of Direct Taxes (CBDT), the Reserve Bank of India (RBI)
and the Comptroller and Auditor General (CAG) of India. In addition, the accounting
bodies like Financial Accounting Standard Board, U.S.A, International Accounting
Standard Board (IASB) etc. also exert major influence in the development of
accounting principles in India.

BASIC ACCOUNTING CONCEPTS

An accounting concept is a basic assumption concerning the economic environment
in which the accounting functions. It is used as a foundation for formulating various
methods and procedures for recording and presenting the business transactions.
For example it is presumed for all types of organizations that business is an
accounting entity, separate from its owners and has an indefinite life. The
procedure for charging depreciation on fixed assets is based on the assumption that
life of a business entity is longer than that of the depreciable assets and the
depreciable (fixed) assets are purchased for using in the business and there is no
intention of their immediate resale.

The literary meaning of a concept is a general idea or an opinion. An accounting

concept is therefore basically an opinion about the way the business transactions
are to be recorded. It is an assumption and not a fact and thus it is not subject to
any proof or evidence. Even then its utility has been recognized by the accounting
profession for preparing the financial statements or external reports.

Ideal concept vs. real concept: A concept may be an ideal concept or a real concept.
For example, the concept of an ‘honest person’ is an ideal concept in the prevailing
conditions. Accounting is primarily concerned with real concepts as it has to
function in the world of reality.
Original concept vs. borrowed concept: An original concept is one which is
indigenous to the accounting itself. For example, the concept of retained earnings
or capital reserve or historical cost is an original accounting concept. Borrowed
concept is one which is used in accounting but in fact it has been borrowed from
other disciplines. For example, opportunity cost concept, though used in
accounting, has been borrowed from economics.

The concepts may be distinguished within various aspects of accounting itself. For
example, some concepts are relevant to financial accounting only e.g. money
measurement concept, historical cost concept, matching concept and so on while
others are relevant to management accounting e.g. social cost, inflation accounting,
forecasting for the future and so on.

CONCEPTS FOR RECORDING BUSINESS TRANSACTIONS

VS

CONCEPTS FOR PREPARING FINANCIAL STATEMENTS

It is worth noting that certain concepts have to be adopted while recording business
transactions. The first lesson given to the students of accountancy is that business
is an accounting entity separate from its owners whether business is a sole
proprietorship or partnership firm or a joint stock company. It is because of business
entity concept, the capital of the owners is always treated as a liability in the
balance sheet of the business. Similarly historical cost concept is followed while
recording the transactions relating to assets in the books of account. For example,
when a machine whose market value is Rs.1,50,000 is purchased for Rs.70,000, the
entry for recording the purchase of machine will be made for Rs.70,000 only and
not for Rs.50,000.

Similarly certain accounting concepts are observed or followed while preparing the
financial statements. These concepts are going concern concept, accounting period
concept, realization concept and accrual or matching of costs and revenues
concept. It is because of these concepts that a business entity is presumed to have
indefinite life (going concern); final accounts are prepared for a particular
accounting period and income is measured or determined by matching costs and
revenues for the current accounting period only.

The following are some of the basic accounting concepts:

(i) The Entity or Business Entity or Accounting Entity Concept.

(ii) The Money Measurement Concept.

 (iii)The Going Concern Concept.

(iv) The Accounting Period Concept.

(v) The Cost Concept.

(vi) The Realization Concept.

(vii) The Accrual Concept.

BASIC ACCOUNTING CONVENTIONS

A `convention’ is defined as a custom or generally accepted practice based on
general consent or general agreement between parties. An accounting convention
is a rule or an accepted method or procedure or a statement of practice which is
adopted either by general agreement or by common consent which may be
expressed or implied. It is a guide to the selection or application of a procedure. For
example when a certain procedure is adopted for the valuation of ending
inventories (e.g. cost or market price whichever is lower) or depreciation of fixed
assets (e.g. straight line method) the consistency convention requires that the same
procedure should be followed from year to year unless there is something to change
it. Similarly, it is an accepted practice by general agreement among the
accountants that: “anticipate no gains but provide for all losses and if in doubt,
write it off.”

This means that the accountant must be conservative or prudent. For example it is
conservatism or prudent convention that profit or revenue should be taken into
account only when it is actually realized in money or money’ worth while provision
must be made for all anticipated losses. These procedures are based on long-
standing conventions. In accounting terminology, an accounting convention may
therefore be defined as: “a rule of practice which has been sanctioned by general
custom or usage. They are lamp posts to procedures employed in the collection,
measurement and reporting of financial data.”

The term convention has been used as synonym for terms `postulate’ and
`doctrine’ in the accounting literature though it is not necessarily the same. A
postulate means an assumption constituting the basis of a system of thought or
organized field without proof. They are usually not specifically stated because their
acceptance and use are assumed. Disclosure is necessary if they are not followed.
Doctrines, on the other hand, are rules or theories conceived by accounting
professionals for application to specific situations e.g. doctrine of consistency,
doctrine of conservatism, doctrine of materiality. It means like conventions,
doctrines are also accounting or reporting policies which are adopted by common
consent.

Following are some of the Accounting Conventions:

(i) Consistency

(ii) Prudence (Conservatism)

(iii)Materiality

(iv) Full Disclosure

1. THE ENTITY CONCEPT

An entity is something that exists separately from other things and has a
clear identity of its own. It means that an entity has a separate existence. For
accounting purposes, each business enterprise is assumed to be an
accounting unit which is separate and different from that of its owner(s),
creditors, managers, employees and other entities. According to this concept,
business and businessman are two separate and distinct accounting entities.
The owner (proprietor) is treated as a creditor for his investment in the
business. The capital of the owner is always treated as a liability, being the
amount due by the business to its owner. Each business entity is treated as
earning its own revenues, incurring its own expenses, owning its own assets
and owing its own liabilities with the result its profitability (profit and loss
account) and financial position are not affected by the personal transactions
of its proprietor, partners or share holders.

The accounting entity is not necessarily a separate legal entity in some

cases. For example, a sole trader cannot legally separate his business affairs
from his personal assets if he/she fails to pay his/her creditors. Similarly a
partnership firm is not a legal entity with the result the partners are jointly
and severally (individually) liable for the debts of the firm.

It is only a limited liability company (popularly called a joint stock company)

that is treated as a legal entity distinct or separate from its shareholders. In
accounting however every type of business organization (or even not-for-
profit organization) be it a sole tradership firm or a partnership firm, is
treated a separate accounting or economic entity. Thus the assumption of
separate entity is to be made even when the separate entity is not
recognized by law in some cases. The entity concept therefore makes a
fictional distinction between owners and the business which is not recognized
at law in some cases.

According to some authors, this concept is also known as the concept of an

`Enterprise’ and is one of the central concepts of accounting. The enterprise
 or business is the focus of accounting attention. Accounts are kept,
transactions are analyzed and financial statements are prepared from the
point of view of the enterprise or the business. In fact, the application of
accounting principles is based on the identification of business or enterprise,
which enters into transactions with the insiders and outsiders. An account is
kept for the owners (insiders) like other persons (the outsiders).

The entity concept may be applied to the whole enterprise as one unit or even to
the part of the business enterprise. For example, in the case of a departmental
store having different departments for different products, the books of account can
be maintained either for all departments as one unit or separately for each of its
activity, say production of Bicycles, Motor cycles, Tyres and Cars, the accounts may
be maintained either for the company as a whole or separately for each activity to
enable the company to measure the profit of each activity.

Patton and Littleton explain the entity concept as follows:

“ The business undertaking is generally conceived of as an entity or institution in its

own right separate and distinct from the parties who furnish the funds and it has
become almost axiomatic (self evident) that the business accounts and statements
are those of the entity rather than those of the proprietor, partners, investors or
other parties or groups concerned.”

The entity concept has proved extremely useful in keeping business transactions
free from the effect of private transactions. Suppose Hema Malini owns a boutique,
namely: Gloria Fashions; separate accounting records would be maintained for the
Gloria Fashions. When Hema Malini invests capital in her boutique business Gloria
Fashions, her account is credited and when she withdraws money or profit of
business for personal use, her account is debited. Her capital will remain a business
liability. Hema may own a car, jewellery, a house and a farmhouse and she may
have borrowed money from a bank for financing her car. These assets and liability
would not find any entry in the accounts of her boutique business for accounting
purpose. In addition, if she owns a Beauty Parlor or a book shop, she would have to
maintain separate record for each of her business.

Impact of entity concept: The overall effect of adopting this concept is:

(i) Only the transactions of business are recorded and reported and not the
personal transactions of the owner(s)

(ii) Income or profit is property of the business unless distributed to the owners.

(iii)The personal assets of owners or shareholders are not taken into

consideration while considering the assets of the business enterprise.

(iv) The capital of the business is considered as a liability of the business to its
owner(s); drawings and losses are regarded as reductions of this liability
 while profits and capital introduced are regarded as an increase in this
liability.

(v) The accounts do not make it clear to the creditors especially for a sole
proprietorship and partnership firm, what actual assets are available to
meet their claims or what other liabilities must be met out of the assets.

(vi) This concept has enabled the development of responsibility accounting so

that it is possible to know not only the profit or loss of the business
enterprise on the whole but also of the various divisions and departments.
For example, if a textile mill also makes ready-made garments and sells
them, it could be possible to know the profit (or loss) of the cloth
manufacturing unit separately from that of ready-made garments unit.
What is required is that cloth should be transferred to the ready-made
garments unit at its market price.