Chapter I: Introduction to Accounting

Origin and development of accounting thought – Bookkeeping - Accounting, accountancy: meaning &
objectives of accounting - Functions of accounting -Accounting principles – concepts and conventions -
Accounting standards - Basis of accounting – cash system, mercantile system and hybrid system- Systems of
accounting – recording of business transactions under double entry system – journalising and ledger
accounts preparation

1.1 History and Development of Accounting

Accounting enjoys a remarkable heritage. The history of accounting is as old as civilisation. The seeds of
accounting were most likely first sown in Babylonia and Egypt around 4000 B.C. who recorded transactions
of payment of wages and taxes on clay tablets. Historical evidences reveal that Egyptians used some form of
accounting for their treasuries where gold and other valuables were kept. The in charge of treasuries had to
send day wise reports to their superiors known as Wazirs (the prime minister) and from there month wise
reports were sent to kings. Babylonia, known as the city of commerce, used accounting for business to
uncover losses taken place due to frauds and lack of efficiency. In Greece, accounting was used for
apportioning the revenues received among treasuries, maintaining total receipts, total payments and balance
of government financial transactions. Romans used memorandum or daybook where in receipts and
payments were recorded and wherefrom they were posted to ledgers on monthly basis. (700 B.C to 400
A.D). China used sophisticated form of government accounting as early as 2000 B.C. Accounting practices
in India could be traced back to a period when twenty three centuries ago. Kaulilya, a minister in
Chandragupta's kingdom wrote a book named Avthashasthra. which also described how accounting records
had to be maintained.

Luca Pacioli's, a Franciscan friar (merchant class), book Summa de Arithmetica, Geometria. Proportion at
Proportionality (Review of Arithmetic and Geometric proportions) in Venice (1494) is considered as the
first book on double entry bookkeeping. A portion of this book contains knowledge of business and book-
keeping. However, Pacioli did not claim that he was the inventor of double entry book-keeping but spread
the knowledge of it. It shows that he probably relied on then-current book-keeping manuals as the basis for
his masterpiece. In his book, he used the present day popular terms of accounting Debit (Dr.) and Credit
(Cr.). These were the concepts used in Italian terminology. Debit comes from the Italian debito which comes
from the Latin debita and debeo which means owed to the proprietor. Credit comes from the Italian credito
which comes from the Latin 'credo which means trust or belief (in the proprietor or owed by the proprietor.
In explaining double entry system, Pacioli wrote that “All entries... have to be double entries, i.e. if you
make one creditor, you must make some debtor”. He also stated that a merchants responsibility include to
give glory to God in their enterprises, to be ethical in all business activities and to earn a profit. He discussed
the details of memorandum, journal, ledger and specialised accounting procedures.

1.2 Accounting, Accountancy: Meaning & Objectives of Accounting

Accounting is the process of financially measuring, recording, summarizing and communicating the
economic activity of an organisation. It is often referred to as “the language of business” and, like any other
language, it has its own unique vocabulary and rules. However, technical accounting terms such as assets,
liabilities, equity, revenue, expense, income, entity and cash flow are widely used even outside business
world.
The American Accounting Association defines accounting as “the process of identifying, measuring, and
communicating economic information to permit informed judgements and decisions by users of the informa-
tion”. This definition highlights the following aspects:
(a) Identifying the Business Transactions. Identification of transactions is useful for proper
recording of them in books of accounting without missing any of the transactions.
(b) Measurement of Business Performance. Measurement or evaluation of business performance is
necessary to know the progress of business.
 (c) Communication of Information. Communication of information relates to reporting the results of
business to all those interested in the business. This enables them to judge the efficiency of the
business and to take suitable decisions to improve the business.

The accounting process can be explained as follows:

Accountancy: Eric Kohler defined – “Accountancy is the theory and practice of accounting”. Another
scholar F W Pixley defines it as “the discipline which analyses the art and principles of recording all
monetary transactions is known as accountancy.

1.3 Book Keeping: Meaning and Definition

The art of recording business transactions in a systematic manner is termed as bookkeeping. It is the name
given to a system which is concerned with recording and summarising business transactions accurately so as
to know the true state of affairs of a business.
Definition of Bookkeeping: R.N. Carter in his book on Advanced Accounting defines bookkeeping as “the
Science and art of correctly recording in books of accounts all those business transactions that result in the
transfer of money or money's worth”. This definition reveals the following features of book keeping.
a. It is a Science. Book Keeping is a science as it represents systematised knowledge. It is based
upon a set of well defined principles which are followed throughout so that the reason for
recording a transaction in a particular manner can be explained fully.
b. It is an Art. Book keeping is an art as it deals with a system in which human skills and ability is
involved in recording the business transaction according to principles of book keeping.
c. Money Consideration. This implies recording of all transactions which can be expressed in terms
of money.

1.4 Accounting Principles: Concepts and Conventions

Before accounting concepts and conventions are discussed, it will be appropriate to know the meaning of the
term ‘accounting principle’. In olden days when size of the business was small and less complicated, the
accounting information was felt only by the proprietor of a business. In modem days, with the growth of the
business organisations, the transactions have become more in number. Unless these transactions are re-
corded according to a definite principle by all the business enterprises it is difficult to maintain uniformity in
accounting system. Such uniformity is also necessary because many parties such as investors, creditors,
employees, government and general public are interested to know the affairs of the business. If every
business follows its own accounting practices, the final accounts may not be understandable to all such
parties. So there is a scope for misinterpreting the position of the business by all persons interested in the
business. Hence there is a need to follow a uniform accounting principles from the stage of recording the
transactions up to the stage of preparing final accounts.

1.4.1 Definition of Accounting Principles

The terminology committee of American Institute of Certified Public Accounts defines the term principles
as a general law or rule adopted or preferred as a guide to action, a settled ground or business of conduct or
practice.
In the words of A.W. Johnson accounting principles are the assumptions and rules of accounting, the
methods and procedures of accounting and the application of these rules, methods and procedures to the
actual practice of accounting.
Accounting principles are accepted by all if they possess the following characteristics:
(a) Objectivity. It must be based on facts and impartial attitude ought to have been adopted by it. If it is
so, the principle is said to possess objectivity.
(b) Application. If the application of the principle is possible, it is regarded as a good principle. In case
theoretically principle is sound but its application is difficult, then the principle has no value.
(c) Use. The principle should be such by whose ‘use’ utility of accounting record is increased. Suppose a
principle has objectivity and it is applicable also but there is no use of this principle in accountancy
record then the principle is useless.
(d) Simplicity. The principles should be simple and easily understood by all.
Accounting principles are divided into two classes. This is shown in the following chart:

1.4.2 Accounting Concepts

The term concept refers to assumptions and conditions on which accounting system is based. It denotes the
propositions on which principles are formulated. The principles are formulated on the basis of economic and
political environment of the business. There is no exhaustive list of accounting concepts. However, the
following are considered as the important accounting concepts.

1. Business Entity Concept: The concept of business entity assumes that business has a
distinct and separate entity from its owners. It means that for the purposes of accounting, the
business and its owners are to be treated as two separate entities. Keeping this in view, when a
person brings in some money as capital into his business, in accounting records, it is treated as
liability of the business to the owner. Here, one separate entity (owner) is assumed to be giving
money to another distinct entity (business unit). Similarly, when the owner withdraws any money
from the business for his personal expenses (drawings), it is treated as reduction of the owner's
capital and consequently a reduction in the liabilities of the business.
The accounting records are made in the book of accounts from the point of view of the business unit
and not that of the owner. The personal assets and liabilities of the owner are, therefore, not
considered while recording and reporting the assets and liabilities of the business. Similarly, personal
transactions of the owner are not recorded in the books of the business, unless it involves inflow or
outflow of business funds.

2. Money Measurement Concept. While preparing accounts in a business, only those

transactions which are capable of expressing in terms of money alone are recorded. Other
transactions which are not capable of measuring in terms of money consideration are outside the
purview of accounting. For example, efficient leadership is essential for the success of the business.
But leadership ability cannot be expressed in terms of money. Hence leadership aspect is ignored in
accounting. Another important aspect of tins accounting concept is that the transactions are recorded
only at their original value of money. Subsequent change in the value of money or the purchasing
power of the money is ignored. This is based on the assumption that the value of money remains
always stable and does not fluctuate from time to time. However, this assumption does not hold good
today. Recording of transactions at its original value is justified as it facilitates the addition of all
assets of the business to know the total value of assets as on a given period of time.

3. Going Concern Concept. While maintaining accounts it is presumed that the business
enterprise will continue to exist for an indefinite period of time. Tins assumption helps in two
respects. Firstly, it facilitates classification of expenditure into capital expenditure and revenue
expenditure. While capital expenditure benefits the business for a longer duration, revenue
expenditure relates to short duration. If this classification is not made, all expenditure is treated at
revenue expenditure which is not proper while preparing accounts. Secondly, because of this
assumption, fixed assets are shown at its original cost, less its depreciation.

4. Dual Aspect Concept or Equation Concept. Under this concept, each and every transaction
is split up into two aspects. One aspect relates to receiving the benefit and other aspect relates to
giving the benefit. For example, when a machinery is bought by the business it receives the
machinery with the help of which it can produce goods or services. For having bought the
machinery, the business has to pay cash to the supplier of machinery. Thus every business
transaction involves two fold aspects and both these aspects are recorded without exception
whatsoever. This concept is based on the maxim that for every action there is always an equal and
opposite reaction. According to this concept assets of a business will be equal to liabilities and
capital. Expressed in the form of an equation:
Assets = Liabilities – Capital, or
Capital = Assets - Liabilities

5. Historical Record Concept or Realisation Concept. According to this concept the sale
proceeds of goods or services are realised only when the buyer is legally bound to pay for the
delivery of goods or rendering of service. Tins concept is based on historical events of business
transactions and therefore it is also known as historical record concept. To take an example, a
businessman receives an order on 1st January, 2004 and supplies goods on 10th January and he
receives payment on 15th January. In this transaction, the revenue from sale of goods is recorded on
10th January but neither at 1st January nor on 15th January.

6. Cost Concept. According to this concept all transactions are recorded in the books of
accounts at the cost price or purchase price. For example, if a building is bought for Rs. 75000 which
is actually worth Rs. 1,00,000 then the cost price of Rs. 75,000 will only be entered in the books of
accounts.
 7. Accounting Period Concept. Although it is assumed that the business will exist for a longer
duration it is necessary to maintain accounts with reference to a convenient period so that results are
ascertained and financial position presented for that period. Usually accounts are prepared for a
period of one year which may be a calendar year or a financial year.

8. Matching Concept. One of the objectives of every business organisation is to know its
results as on a given period of time. In order to know the profit or loss of the business the costs
incurred during a given period is matched against the revenue earned during that period. This helps
to know the profit or loss of the business during a period of time. If the revenue exceeds the cost it
represents the profit. On the other hand, if the costs exceed the revenue, it represents the loss.

1.4.3 Accounting Conventions or Doctrine of Accounts

Accounting convention refers to the customs and traditions followed by Accountants as guidelines while
preparing accounting statement. They are followed so as to make accounting information more meaningful
and clear. The important accounting conventions are as follows:
9. Doctrine of Consistency. This doctrine implies that the basis followed in different
accounting period should be same. In other words, methods adopted in one accounting year should
not be changed in another year. If a change becomes necessary, the change and its effect should be
mentioned clearly.

10. Doctrine of Disclosure. According to this doctrine all significant information about the
business should be disclosed. The accounting statement should be scrupulously honest. This doctrine
implies that the accounting records and statements conform to generally accepted accounting
principle.

11. Doctrine of Conservation. Conservation doctrine indicates that accounting information

should not show a better position than what it actually is. Further the accounting information must
include all reasons responsible for a reduction in profit or to incur losses. Such transactions relate to
provision for doubtful debts, provision for discount on debtors etc. On the other hand the prospective
profits should be ignored as it is uncertain to earn such profit.

12. Doctrine of Materiality. According to this doctrine, only transactions which are more
important to the business are recorded. Trivial transactions which do not affect the result of the
business drastically should be ignored as the cost of ascertaining such insignificant expenses is more
than such a trivial expense incurred.
1.5 Basis of Accounting
From the point of view the timing of recognition of revenue and costs, there can be two broad approaches to
accounting. These are:
a. Cash System or Cash basis
b. Mercantile system or Accrual basis
Under the cash basis, entries in the book of accounts are made when cash is received or paid and not when
the receipt or payment becomes due. Let us say, for example, if office rent for the month of December 2005,
is paid in January 2006, it would be recorded in the book of account only in January 2006.
Similarly sale of goods on credit in the month of January 2006 would not be recorded in January but say in
April, when the payment for the same is received. Thus this system is incompatible with the matching
principle, which states that the revenue of a period is matched with the cost of the same period. Though
simple, this method is inappropriate for most organisations as profit is calculated as a difference between the
receipts and disbursement of money for the given period rather than on happening of the transactions.
Under the accrual basis, however, revenues and costs are recognised in the period in which they occur
rather when they are paid. A distinction is made between the receipt of cash and the right to receive cash and
payment of cash and legal obligation to pay cash. Thus, under this system, the monitory effect of a
transaction is taken into account in the period in which they are earned rather than in the period in which
cash is actually received or paid by the enterprise. This is a more appropriate basis for the calculation of
profits as expenses are matched against revenue earned in relation thereto. For example, raw material
consumed is matched against the cost of goods sold.

1.6 Systems of Accounting

The systems of recording transactions in the book of accounts are generally classified into two types, viz.
Double entry system and Single entry system.
1.6.1 Double Entry System: Double entry system is based on the principle of "Dual Aspect" which states
that every transaction has two effects, viz. receiving of a benefit and giving of a benefit. Each transaction,
therefore, involves two or more accounts and is recorded at different places in the ledger. The basic principle
followed is that every debit must have a corresponding credit. Thus, one account is debited and the other is
credited.
Double entry system is a complete system as both the aspects of a transaction are recorded in the book of
accounts. The system is accurate and more reliable as the possibilities of frauds and misappropriations are
minimised. The arithmetic inaccuracies in records can mostly be checked by preparing the trial balance. The
system of double entry can be implemented by big as veil as small organisations.
1.6.2 Single Entry System: Single entry system is not a complete system of maintaining records of financial
transactions. It does not record two-fold effect of each and every transaction. Instead of maintaining all the
accounts, only personal accounts and cash book are maintained under this system. In fact, this is not a
system but a lack of system as no uniformity is maintained in the recording of transactions. For some
transactions, only one aspect is recorded, for others, both the aspects are recorded. The accounts maintained
under this system are incomplete and unsystematic and therefore, not reliable. The system is, however,
followed by small business firms as it is very simple and flexible.

1.7 Accounting Standards

Accounting bodies throughout the world are striving to achieve a reasonable degree of uniformity in the
accounting policies by prescribing certain accounting standards with respect to collection and presentation
of accounting information. To formulate the accounting standards, they established a committee called the
international accounting standards committee (IASC) in 1973. Accounting bodies of most of the countries,
including Institute of Chartered Accountants of India (ICAI) are the members of this body and these
members have resolved to conform to the standards developed by IASC.
Accounting standards are written statements of uniform accounting rules and guidelines or practices for
preparing the uniform and consistent financial statements and for other disclosures affecting the user of
accounting information. However, the accounting standards cannot override the provision of applicable
laws, customs, usages and business environment in the country.
1.7.1 Generally Accepted Accounting Principles (GAAP): Generally Accepted Accounting principles
refer to the rules or guidelines adopted for recording and reporting of business transactions in order to bring
uniformity in the preparation and presentation of financial statements. These principles are also referred to
as concepts and conventions. From practical view point, the various terms such as principles, postulates,
conventions modifying principles, assumptions, etc. have been used interchangeably and are referred to as
basic accounting concepts.
The Generally Accepted Accounting Principles in the form of Basic Accounting Concept have been
accepted by the accounting profession to achieve uniformity and comparability in the financial statement.
This is aimed at increasing the utility of this statement to various users of the accounting information. But
the difficulty is that GAAP permit a variety of alternative treatments for the same item. For example, various
methods of calculation of cost of inventory are permissible which may be followed by different enterprises.
This may cause problem to the external users of information, which becomes inconsistent and incomparable.
This necessitates brining in uniformity and consistency in the reporting of accounting information.
Recognising this need, the Institute of Charted Accountants of India (ICAI) constituted an Accounting
Standards Board (ASB) in April, 1977 for developing Accounting Standards. The main function of ASB is
to identify areas in which uniformity in standards is required and develop draft standards after wide
discussion with representative of the Government, public sector undertakings, industry and other
organisations. ASB gives due consideration to the International Accounting Standards as India is a member
of International Account Setting Body. ASB submits the draft of the standards to the Council of the ICAI,
which finalises them and notifies them for use in the presentation of the financial statements. ASB also
mates a periodic review of the accounting standards.
The Institute tries to persuade the accounting profession for adopting the accounting standards, so that
uniformity can be achieved in the presentation of financial statements. In the initial years the standards are
of recommendatory in nature. Once awareness is created about the requirements of a standard, steps are
taken to enforce its compliance by making them mandatory for all companies to comply with. In case of
non-compliance, the companies are required to disclose the reasons for deviations and the financial effect, if
any, arising due to such deviation.

The list of ICAI issued Accounting Standards are given below:

AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring after the Balance Sheet Date
AS 5 Net Profit or Loss for the Period, Prior Period items and Changes in Accounting Policies
AS 6 Depreciation Accounting
AS 7 Construction Contracts
AS 8 Accounting for Research and Development
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 The Effects of Changes in Foreign Exchange Rates
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 Accounting for Retirement Benefits in the Financial Statements of Employers (recently revised
and titled as 'Employee Benefits')
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Earnings Per Share
AS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income
AS 23 Accounting for Investments in associates in Consolidated Financial
Statements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in Join Ventures
AS 28 Impairment of Assets
AS 29 Provisions, Contingent Liabilities and Contingent Assets