1.

1 Introduction to Accounting
Business entities and other organisations carry on activities which involve exchange of money
or money’s worth or economic resources. Where the volume of these activities are large in
number it is necessary that these are recorded for the purpose of taking important decisions as
to whether the activities are viable, gainful and are to be continued or not. Information about
the business and other organisations is required not only to the proprietors and managers
of business and other organisations but also to various other interested users such as the
government, investors, customers, employees and researchers.
Raising and utilising of finance for various purposes must be recorded systematically,
scientifically and uniformly. It is very important because finance is the most important resource
next to the human element for any economic activity. Hence, there is a need for principles,
methods and procedures to be followed to record all these information and to derive from
these information, the feasibility and benefit of the activities carried out. Accountancy provides
the basic theory, principles and methods to be followed to account for all financial activities
taking place in an organisation. Accounting the financial activities in a systematic way helps in
ascertaining the efficiency of performance of these activities and provides data about the state
of affairs of the organisation for further analysis and planning.
Accounting is the language of business. The most important function of a language is to
facilitate communication. The information about business entities regarding their operating
performance and financial status can be obtained from the financial information recorded in
the accounting records. This information is communicated to the interested users of business
information such as proprietors, management, investors, customers and the government.
1.2 Evolution of Accounting
In India, 23 centuries ago, Chandragupta Maurya’s Minister Kautilya wrote a book named
‘Arthashastra’, wherein some references can be traced regarding the way of maintaining
accounting records.
In the earliest days of civilisation, accounting was done by stewards who managed the
properties of wealthy people. They rendered accounts periodically to the owners of property.
The stewardship accounting is said to be the root of accounting. Records of debit and credit
were found in the 12th century itself.
 In 1494, Luca Pacioli an Italian developed double-entry book-keeping system. Due to the
industrial revolution in the 18th and 19th centuries, large scale operations were carried on
and joint stock companies emerged as an important form of organisation which required
separation of ownership from management. Hence, to safeguard the interest of owners and
investors, the business establishments required detailed information about business which
paved the way for development of comprehensive financial accounting information system.
In the 20th century, the need for analysis of financial information for managerial decision
making caused emergence of Management Accounting as a separate branch of accounting.
Though accounting was individual centric in the initial stage of evolution of accounting, it has
gradually developed into Social Responsibility Accounting in the 21st century, due to the vast
growth in business activities as a result of development in various fields. Thus, accounting has
become inevitable in the modern world for business.
1.3 Meaning and Definition of Accounting
Student activity
Think: Before the evolution of money, commodities were exchanged for commodities. In
such situations, how would people have maintained their accounts?
Accounting is the systematic process of identifying, measuring, recording, classifying,
summarising, interpreting and communicating financial information. Accounting gives
information on:
(i) the resources available
(ii) how the available resources have been employed and
(iii) the results achieved by their use.
The profit earned or loss incurred during the accounting period, value and nature of assets,
liabilities and capital can be ascertained from the information recorded in accounts.
According to the American Institute of Certified Public Accountants “Accounting is the
art of recording, classifying and summarising 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
results thereof ”.
American Accounting Association has defined accounting as “the process of identifying,
measuring, and communicating economic information to permit informed judgements and
decisions by users of the information”.
From the above definitions, the following attributes of accounting emerge:
(i) Accounting is an art. It requires the expertise and skill of accountants to design accounting
system and policies, to decide the accounting process in order to suit the requirements of
an organisation.
(ii) The transactions or events of a business must be recorded in monetary terms.
(iii) Accounting process involves recording, classifying and summarising of transactions and
analysis and interpretation of the results.
(iv) The results of such analysis must be communicated to the persons who are interested in
such information.
1.4 Accounting cycle
Accounting cycle is the sequence of steps involved in the accounting process. Accounting
cycle starts with the identification and recording of financial transactions of an organisation
and ends with the preparation of final accounts for the accounting year. The cycle continues
for the next accounting year with the opening balances of assets and liabilities which are the
closing balances of the preceding year. The steps involved are:
(i) Identifying the transactions and journalising
The first step in the accounting process is identifying the financial transactions of a business.
All the monetary transactions are recorded in the books of original entry called journals.
Recording the transactions in the journal is called journalising. Entries are made in the journals
on the basis of source documents in the chronological order, i.e., the order of occurrence of
the transactions.
(ii) Posting and balancing
Transferring the entries from the journal to the ledger is called posting. In the ledger, entries are
made in each account after classifying them under common heads. Finding the difference between
the total of the debit column and credit column of all the ledger accounts is called balancing.
(iii) Preparation of trial balance
The list of ledger balances namely trial balance is prepared as the next step. On the basis of
ledger balances the financial statements are prepared.
(iv) Preparation of trading account
Next step is preparation of trading account for a particular accounting period. All the direct
revenues and direct expenses are transferred to trading account. The balance in the trading
account is the gross profit or gross loss.
(v) Preparation of profit and loss account
Profit and loss account is prepared next for a particular accounting period. All the indirect
revenues and indirect expenses along with gross profit or gross loss are transferred to profit
and loss account. The balance in the profit and loss account is the net profit or net loss.
(vi) Preparation of balance sheet
A statement showing the balances of assets and liabilities namely balance sheet is prepared as
the final step in the accounting process. It is prepared on a particular date, normally, on the
last day of the accounting period.
The closing balances of an accounting year are taken as the opening balances for the next
accounting year. The transactions identified and recorded for the next year are followed by
posting and other steps.
The results are communicated to the users of accounting information for the purpose of
analysis and decision making.
Transactions
Journalising
Preparing Trial Balance
Preparing Trading Account
Preparing Balance Sheet
Opening Entry
Preparing Profit and loss Account
Posting and Balancing
Accounting cycle
1.5 Objectives of Accounting
Following are the objectives of accounting:
(i) To keep a systematic record of financial transactions and events
(ii) To ascertain the profit or loss of the business enterprise
(iii) To ascertain the financial position or status of the enterprise
(iv) To provide information to various stakeholders for their requirements
(v) To protect the properties of an enterprise and
(vi) To ascertain the solvency and liquidity position of an enterprise
1.6 Functions of Accounting
The main functions of accounting are as follows:
(i) Measurement
The main function of accounting is to keep systematic record of transactions, post them to the
ledger and ultimately prepare the final accounts. Accounting works as a tool for measuring the
performance of the business enterprises. It also shows the financial position of the business
enterprises.
(ii) Forecasting
With the help of the various tools of accounting, future performance and financial position of
the business enterprises can be forecasted.
(iii) Comparison
Accounting helps to compare the actual performance with the planned performance. It is also
possible to compare with the accounting policies. Through comparison of the actual financial
results of the business enterprises with projected figures and standards, effective measures can
be taken to enhance the efficiency of various operations.
(iv) Decision making
Accounting provides relevant information to the management for planning, evaluation of
performance and control. This will help them to take various decisions concerning cost, price,
sales, level of activity, etc.Decision refers to choosing a desirable course of action from alternative
courses of action.
(v) Control
As accounting works as a tool of control, the strengths and weaknesses are identified to provide
feedback on various measures adopted. It serves as a tool for evaluating compliance of business
policies and programmes.Control refers to comparison of actual performances with planned
performances,measure deviation and take corrective action.
(vi) Assistance to government
Government needs full information on the financial aspects of the business for various
purposes such as taxation, grant of subsidy, etc. Accounting provides relevant information
about the business to exercise government control on business enterprises.
1.7 Importance of Accounting
Accounting is a basic necessity for all enterprises.
Importance of accounting is enumerated as below:
(i) Systematic records
All the transactions of an enterprise which are financial in nature are recorded in a systematic
way in the books of accounts. The records are classified under common heads and summaries are
prepared.
(ii) Preparation of financial statements
Results of business operations and the financial position of the concern can be ascertained from
accounting periodically through the preparation of financial statements namely, income statement
or trading and profit and loss account and balance sheet. This helps in distribution of profits to the
owners and to provide funds for future growth of the business.
(iii) Assessment of progress
Analysis and interpretation of financial data can be done to assess the progress made in
different areas and to identify the areas of weaknesses. Management is provided with a
complete picture of the liquidity, profitability and solvency of the business.
(iv) Aid to decision making
Management of a firm has to make routine and strategic decisions while discharging its
functions. Accounting provides the relevant data to make appropriate decisions. Future policies
and programmes can be planned by the management based on the accounting data provided.
(v) Satisfies legal requirements
Various legal requirements like maintenance of Provident Fund (PF) for employees, Employees
State Insurance (ESI) contributions, Tax Deducted at Source (TDS), filing of tax returns are
properly fulfilled with the help of accounting. Preparation of accounts and financial statements
as per the legal requirements is also facilitated.
(vi) Information to interested groups
Accounting supplies appropriate information to different interested groups like owners,
management,creditors, employees, financial institutions, tax authorities and the government.
(vii) Legal evidence
 Accounting records are generally accepted as evidence in courts of law and other legal
authorities in the settlement of disputes.
(viii) Computation of tax
Accounting records are the basic source for computation and settlement of income tax and
other taxes.
(ix) Settlement during merger
When two or more business units decide to merger, accounting records provide information
for deciding the terms of merger and any compensation payable as a consequence of merger.
1.8 Basic Accounting terminologies
Accounting is a versatile system which serves a large number of purposes in the modern
business world. Hence, the following terminologies need to be understood.
Transaction An activity which involves transfer of money or money’s worth (goods,
services, ideas) from one person to another.
Cash transaction It is a transaction which involves immediate cash receipt or immediate cash
payment.
Credit transaction It is a transaction in which cash is not received or paid immediately, but
will be received or paid later.
Account
It is the basic unit for measurement in accounting. It is used for identifying a person, or an item in
accounting. An account is opened individually for a person, asset, expense, income, etc. In ledger, an
account is a summary of transactions under a head.
Capital It is the amount invested by the owner or proprietor in an organisation.
Drawings It is the amount of cash or value of goods, assets, etc., withdrawn from the business by the
owner for the personal use of the owner.
Voucher
Any written or printed document in support of a business transaction is called a voucher. Examples: cash
receipt, invoice, cash memo, bank payin-slip, etc.
Invoice
It is a statement prepared by a seller of goods to be sent to the buyer. It shows details of quantity, price,
value, etc. of the goods and any discount given, finally showing the net amount payable by the buyer.
Goods It includes articles, things or commodities in which a business is dealing
with. Example: Furniture will be goods for those who deal in furniture.
Purchases Buying of goods with the intention of resale is called purchases.
Purchases returns or returns outward
When goods bought are returned to the suppliers, it is known as purchases
returns or returns outward.
Sales When goods meant for resale are sold, it is called sales.
Sales returns or returns inward
When goods sold are returned by the customers, it is called as sales returns
or returns inward.
Stock Unsold goods lying in a business on a particular date are known as stock.
Income It is the amount receivable or realised from sale of goods and earnings from
interest, dividend, commission, etc.
Expense It is the amount incurred in order to produce and sell the goods and services.
Solvency Solvency is the capability of a person or an enterprise to pay the debts.
Insolvency Insolvency is the incapability of a person or an enterprise to pay the debts.
Asset Any physical thing or right owned that has a monetary value is called asset.
Liability It refers to the financial obligation of the business.
Debtor A person who receives a benefit without giving money or money’s worth
immediately, but liable to pay in future or in due course of time.
Creditor A person who gives a benefit without receiving money or money’s worth
immediately but to claim in future.
Depreciation It refers to the gradual reduction in the value of fixed assets due to usage
and passage of time.
Bad debt It is a loss to the business arising out of failure of a debtor to pay the dues.
It is irrecoverable debt.
1.9 Branches of Accounting
Depending on the informational needs of various users of accounting information, several
branches or subfields of accounting have been developed.
The various branches of accounting are:
(i) Financial Accounting
 It involves recording of financial transactions and events.It is historical in nature and records are
maintained for transactions and events which have already occurred. It provides financial information to
the users for taking decisions. It is concerned with identification, recording, classifying and summarising
of financial transactions and events and ends up with the preparation of financial statements,namely,
trading and profit and loss account or income statement and balance sheet and communication of the
same to the interested users. Trading and profit and loss account shows the profit or loss made during
an accounting period and the balance sheet shows the financial position of the business as on a
particular date.
(ii) Cost Accounting
It involves the collection, recording, classification and appropriate allocation of expenditure
for the determination of the costs of products or services and for the presentation of data for
the purposes of cost control and managerial decision making.
(iii) Management Accounting
It is concerned with the presentation of accounting information in such a way as to assist
management in decision making and in the day-to-day operations of an enterprise. The
information collected from financial accounting, cost accounting, etc. are grouped, modified
and presented as per the requirements of management for discharging their functions and for
decision making.
(iv) Social Responsibility Accounting
It is concerned with presentation of accounting information by business entities and other
organisations from the view point of the society by showing the social costs incurred such
as environmental pollution by the enterprise and social benefits such as infrastructure
development and employment opportunities created by them. It arises because of corporate
social responsibility.
(v) Human Resources Accounting
It is concerned with identification, quantification and reporting of investments made in human
resources of an enterprise.
1.10 Bases of Accounting
There are three bases of accounting in common usage, namely
(i) Cash basis
(ii) Accrual or mercantile basis
(iii) Mixed or hybrid basis.
 (i) Cash basis
Under cash basis of accounting, actual cash receipts and actual cash payments are recorded.
In this basis, revenue is recognised when cash is received and expenses are recognised when
cash is paid. Credit transactions are not recorded till cash is actually received or paid. Under
this basis,
(a) Any income received
(b) Any expenditure paid
(c) Any asset purchased for which cash is paid
(d) Any liability paid during the accounting period whether related to the past, present or
future is taken into account.
(ii) Accrual or mercantile basis
Under accrual basis of accounting, the revenue whether received or not, but has been earned
or accrued during the accounting period and expenses incurred whether paid or not are
recorded. In other words, revenue is recognised when it is earned or accrued and expenses are
recognised when these are incurred. Under this basis,
(a) Any income earned whether received or not
(b) Any expenditure incurred whether paid or not
(c) Any asset purchased whether cash is paid or not
(d) Any liability incurred whether paid or not during the accounting period is recorded.
Under section 128(1) of the Indian Companies Act, 2013, all the companies are required to
maintain the books of accounts according to the accrual basis of accounting.
(iii) Hybrid or mixed basis
This basis is a combination of cash basis and accrual basis of accounting. Under mixed basis of
accounting, both cash basis and accrual basis are followed. Revenues and assets are generally
recorded on cash basis whereas expenses and liabilities are generally taken on accrual basis.
1.11 Users of Accounting information
Student activity
Think: ‘Accounting is useful only to the owner of the business’ – Do you agree?
There are several persons who need the accounting information for various purposes. They
can be classified into two:
(A) Internal users and
(B) External users
Users of accounting information
Internal
i. Owners
ii. Management
iii. Employees
External
i. Creditors and financial institutions
ii. Investors
iii. Customers
iv. Tax authorities and
regulatory bodies
v. Government
vi. Researchers
vii. General public
A) Internal Users
The internal users are owners, management and employees who are within the organisation.
(i) Owners
The owners of a business provide capital to be used in the business. They are interested to
know whether the business has earned profit or not during a particular period and also its
financial position on a particular date. They want accounting reports in order to have an
appraisal of performance and also for an assessment of future prospects to ensure that they
will get their expected returns from the business and get back their capital safely.
(ii) Management
Accounting data are the basis for most of the decisions made by themanagement. The trends in sales
and purchases, relationship of expenses to the sales, efficiency of employees,comparative profitability of
different departments, capital structure and solvency position are some of the vital data required by
management for planning and controlling the business operations. Financial statements and
other reports prepared under financial accounting provide this information to the management.
Capital structure refers to the mix of a firm’s permanent long-term financing represented by debt,
preference share capital and equity shareholders’ funds.
(iii) Employees
The employees are interested in the profit earning capacity of the business which will affect
their remuneration, working conditions and retirement benefits and stability and growth of
the enterprise.
B) External users
External users are the persons who are outside the organisation but make use of accounting
information for their purposes. They are:
(i) Creditors and financial institutions
Suppliers of goods and services, commercial banks, public deposit holders and debentureholders
are included in this category. They are interested in knowing the liquidity position and repaying
capacity of the business to ensure the safety of getting the amount due to them or interest and
the principal amount.
(ii) Investors
Persons who are interested in investing their funds in an organisation should know about
the financial condition of a business unit while making their investment decisions. They are
more concerned about future earnings and risk bearing capacity of the organisation which will
affect the return to the investors.
(iii) Customers
Customers who buy and use the products and services of business enterprises are interested
in knowing the details of the products and the prices charged to them. They are interested
in knowing the stability and profitability of an enterprise to ensure continued supply of the
products or services by the enterprise.
(iv) Tax authorities and other regulatory bodies
Accounting information helps the tax authorities in computing income tax and taxes on goods
and services and other taxes to be collected from business units. Other regulatory bodies also
require information about revenues, expenses and other financial aspects of business to ensure
that the enterprises comply with statutory requirements.
(v) Government
The scarce resources of the country are used by business enterprises. Information about
performance of business units in different industries helps the government in policy
formulation for development of trade and industry, allocation of scarce resources, grant
of subsidy, etc. Government also administers prices of certain commodities. In such cases,
government agencies have to ensure that the guidelines for pricing are followed.
(vi) Researchers
Researchers to carry out their research can use accounting information and make use of the
published financial statements for analysis and evaluation.
(vii) General public
From accounting information, the general public at large can get a view of the earning capacity
and stability of the enterprise as well as the social responsibility measures undertaken by the
enterprise particularly in its area of operation and also the employment opportunities provided
to the local people.
1.12 Role of an accountant
An accountant designs the accounting procedures for an enterprise. He plays several
roles in an organisation as follows:
(i) Record keeper
The accountant maintains a systematic record of financial transactions. He also prepares the
financial statements and other financial reports.
(ii) Provider of information to the management
The accountant assists the management by providing financial information required for
decision making and for exercising control.
(iii) Protector of business assets
The accountant maintains records of assets owned by the business which enables the
management to protect and exercise control over these assets. He advises the management
about insurance of various assets and the maintenance of the same.
(iv) Financial advisor
The accountant analyses financial information and advises the business managers regarding
investment opportunities, strategies for cost savings, capital budgeting, provision for future
growth and development, expansion of enterprise, etc.
 (v) Tax manager
The accountant ensures that tax returns are prepared and filed correctly on time and payment
of tax is made on time. The accountant can advise the managers regarding tax management,
reducing tax burden, availing tax exemptions, etc.
(vi) Public relation officer
The accountant provides accounting information to various interested users for analysis as per
their requirements.

Points to remember
• Accounting is termed as the language of the business.
• There are various branches of accounting such as financial accounting, cost
accounting, management accounting, social responsibility accounting and human
resource accounting.
• There are three bases of accounting namely cash basis, accrual or mercantile basis
and mixed or hybrid basis.
• There are several persons who need the accounting information - internal users
and external users.
• Accountants have several roles and responsibilities.

Self-examination questions
I Multiple choice questions
Choose the correct answer
1. The root of financial accounting system is
(a) Social accounting (b) Stewardship accounting
(c) Management accounting (d) Responsibility accounting
2. Which one of the following is not a main objective of accounting?
(a) Systematic recording of transactions
(b) Ascertainment of the profitability of the business
(c) Ascertainment of the financial position of the business
(d) Solving tax disputes with tax authorities
3. Which one of the following is not a branch of accounting?
(a) Financial accounting (b) Management accounting
(c) Human resources accounting (d) None of the above.
4. Financial position of a business is ascertained on the basis of
(a) Journal (b) Trial balance
(c) Balance Sheet (d) Ledger
5. Who is considered to be the internal user of the financial information?
(a) Creditor (b) Employee (c) Customer (d) Government
Answers
1 (b) 2 (d) 3 (d) 4 (c) 5 (b)
II Very short answer questions
1. Define accounting.
2. List any two functions of accounting.
3. What are the steps involved in the process of accounting?
4. Who are the parties interested in accounting information?
5. Name any two bases of recording accounting information.
III Short answer questions
1. Explain the meaning of accounting.
2. Discuss briefly the branches of accounting.
3. Discuss in detail the importance of accounting.
4. Why are the following parties interested in accounting information?
(a) Investors (b) Government
5. Discuss the role of an accountant in the modern business world.
A Self-Help Group (SHG) is an informal, self-managed voluntary group of
5-20 individuals, who come together to address their common problems and
are generally engaged in credit and savings activities operating on principles of
mutuality and solidarity. Most SHG members are minimally educated. Regardless, every SHG
should be aware of the status of its outstanding loans to members, the status of its loans from
external institutions and the member payments due. Book-keeping is a difficult task for SHGs.
Now, discuss on the following points:
How do SHGs maintain their accounting?
Do you think that financial accounting system is suitable for all businesses?
To explore further
Can each business unit follow its own way for maintaining accounting records?
Will it serve the requirements of different users of accounting information?
Reference
1. M C Shukla, T S Grewal and S C Gupta, Advanced Accounts, 19th ed., 2017, S.Chand Publishing, New
Delhi.
2. R L Gupta and V K Gupta, Financial Accounting, 11th ed., 2014, Sultan Chand and Sons, New Delhi.
3. S P Jain and K L Narang, Advanced Accountancy Vol – I, 2016, Kalyani Publishers, New Delhi.
4. Dalston L Cecil and Jenitra L Merwin, Financial Accounting, 3rd ed., 2017, Learntech Press, Trichy.
5. Fundamentals of Accounting, 2017, The Institute of Chartered Accountants of India, New Delhi.