Chapter 1

Accounting as an Information System

OBJECTIVE 1: MEANING AND DEFINITION OF ACCOUNTING

1. Meaning: Accounting owes its origin – to the origin of mankind. It is as old as money itself. In the course of evolution, this art – accounting has undergone many changes in its concept, convention and other policies and procedure. Accounting is generally referred to as the language of business. The most frequently quoted definition is the one, coined by the American Institute of Certified Public Accountants as, “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.” Over the years, so many definitions have been formulated by the professionals keeping in view with the changing socio-economic scenario.

2. Definition: The definition put forth by the American Accounting Association (AAA) has gained much significance in the present day context. The AAA defined accounting as, “the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of information.” This definition is used widely now. This definition exposes the eminent characteristic features of accounting as follows.

OBJECTIVE 2: CHARACTERISTIC FEATURES OF ACCOUNTING

1. It is a “process” not confirmed to one single event.
2. “Identifying” means identifying economic activities or accounting (business) transactions.
3. “Measuring” means such accounting activities have to be measured, quantified generally in terms of money or money value or worth.
4. “Communicating” means the results of measurement have to be communicated to all users of statement.
5. “Economic information” – means an information of economic value – information forming the art of accounting process plays a vital role.
6. “Permit informed judgements and decisions” enables the users to make informed judgements. This has to assist the users to decide their action.
7. “Users of information” – emphasis is on the users and information.

This definition thereby defines accounting as an information system. Let us analyse in detail the various terms used in this definition in the following paragraphs.

1. Identification of economic activities needs an explanation here: It should be understood that an economic event refers to the occurrence of economic consequence of any activity relevant to a particular (accounting) business activity. To illustrate, a machinery is purchased by a business enterprise for manufacturing and sale of goods. This transaction is an example for economic activity. Accounting activity varies from the cost of machinery to the production of goods, till the revenue is earned through sales. Here, the accountant plays a vital role in identifying various transactions and assessing their overall impact. The first and foremost task is the identification of such activities that an accounting really needs.
2. Measurement: After identifying the activities, they have to be measured in terms of (the value of) money. Only those transactions, which can be quantified in terms of money are taken into account in this process, that is, the accounting information systems. Non-monetary activities do not form part of an accounting system. These transactions are recorded in a planned and systematic manner following the set of rules or guidelines of accounting bodies. After analysing all business transactions, they are presented in a summarised form —“Financial Statements.”
3. Communication: The results of transactions have to reach the people (users) who are all interested in knowing such results. This is achieved by “communication.” The identification, measurement with analysis and interpretation must be transmitted to the users. Such information is transmitted in the form of financial statements (terminal stage in accounting process). The important ingredients (constituents) of financial statements are:
   1. Income Statement
   2. Balance Sheet
   3. Cash Flow Statement

As already stated, accounting is the language of business. The basic and most important function of a language is communication. In this aspect too, accounting has to act in the form of communicating information (accounting), as any language does. This process of communicating information cannot take place in vacuum. A system (medium) should facilitate the task of transmitting this information to its users, which is referred to as “Accounting Information System.”

OBJECTIVE 3: CONCEPT OF ACCOUNTING AS INFORMATION SYSTEM

One has to understand the term “System” and then “Accounting Information System.”

System: “A system is a collection of parts that work together harmoniously to achieve specific goals.” To illustrate, take “Educational Institution” (school, college or university) as a system. A system is a collection of parts as per the definition. In this system the parts are – students, staff (teachers as well as non-teaching staff), administrative heads (headmaster, principal, vice chancellor) of institution, library, controlling agencies (government, education department), and so on. These parts constitute a system. Emphasis in the definition is “to achieve specific goals.” In this example, to attain education is the specific goal. All the constituents have to work together to achieve the specific goals.

A system converts the inputs into output. In this example, students – inputs – without literacy, knowledge or skill are converted into outputs – literates, thorough knowledge, acquiring technical skills, eminent citizen in every aspect. In a system “output” determines the efficiency of such edifice.

An accounting is also a system in the sense – an institution (business entities) with parts or elements (men, material, machinery, transactions, recording and reporting the end results) work together to attain the common goal (to enhance economic prospects).

OBJECTIVE 4: CHARACTERISTIC FEATURES OF AN ACCOUNTING SYSTEM

An accounting system consist of the following features:

1. Input: 3Ms – Men, Materials, Money – primarily.
2. Process: Accounting process – from recording of the transactions till the presentation of end results of business activities.
3. Output: Communicating accounting information, making appropriate decision on net results of operation, and so on.
4. Feedback: Feedback mechanism – from the various categories of users of accounting information.
5. Control: Revising decisions and policies based on feedback.

OBJECTIVE 5: USERS OF FINANCIAL ACCOUNTING INFORMATION

The accounting system processes the business transactions in order to provide information to various users within the enterprise and outside the entity. Now, we have to discuss who the real users are, what their needs are, and how they are met with.

The range of users of financial accounting information varies from the employees of the business to those of the public at large. These users may be broadly classified into two categories – external users and internal users.

Users who are not directly associated with the activities of the enterprises but who are directly having economic interest in such business enterprises, are external users.

External users rely extensively on financial accounting information to achieve economic benefit in the case of shareholders, creditors (suppliers of goods/services), customers, donors, employees and to perform statutory obligation in the case of government and other regulatory bodies.

Users, who are directly associated with the day to day activities of the business (managing, operating and accounting) are called internal users. Internal users generally represent the management of the business. They are usually the board of directors, in the case of companies, and owners/proprietors in the case of other enterprises. Internal users are the policy/decision making bodies, and the information they rely need not be made known to the external users. These internal reports are never published. Such information generally facilitates the policy decision, for example, price fixation of a product, introduction of a new product and the like.

The information needs of each group of users of an accounting system are:

5.1 Investors

Investors in a company are the shareholders – they are the real owners of the company. But, despite their status as owners, they are denied access to internal reports. Present investors face risk by investing inequity capital due to uncertainty of constant returns from such investment. Individual investors and institutional investors are very much interested in knowing the financial position of the company. All the investors need information to take decisions whether to buy new shares or whether to sell the shares already purchased. In order to provide the required information needs of the investors, the financial statements and other statutory reports should consist of all such information.

5.2 Suppliers and Creditors

The suppliers of goods and other services, usually known as creditors, are interested in information so as to ascertain whether the amount owing to them will be paid by the company promptly. Creditors, both short term and long term, are interested in knowing the solvency of the entities. The ability of the firm to discharge its long term liabilities (loan) on the stipulated date of maturity and to continue business activities not less than the present level in the future, is referred to as solvency. Trade creditors are interested in the liquidity of the business. The ability of the firm to meet its short term liabilities or current liabilities on the stipulated date of maturity is referred to as liquidity. The financial statements should contain the relevant information on this aspect.

5.3 Lenders

Lenders differ from creditors, though both of their amount are being utilised by the entities. Lenders lend money to business entities with the main motive to earn interest for the loan amount advanced by them. Bankers, financial institutions and individuals who extend loans are lenders. Lenders are mainly interested in knowing whether the interest will be paid at regular intervals and the principal amount will be repaid on the date of maturity. They are interested in knowing the number of times the earning is covered by the interest (known as the interest cover). Financial reports are extensively used by lenders.

5.4 Employees

Employees and trade unions are naturally interested in their personal interests like salary, overtime facilities, bonus, better service conditions and the retirement benefits. Only if the company is in a sound financial position, the employees are not only paid better salaries but also can demand more benefits. As such, they are interested in exacting opt information from the financial statements. The latest trend in the corporate sector is ESOPS (Employees Stock Option Scheme), whereby the employees are also made as shareholders of the company by allotting the shares. Under such circumstances, employees are interested in knowing the financial position of the enterprises by using the vital information provided in the financial statements.

5.5 Customers

Customers have information needs, especially when they want to develop the long term relationship with the enterprises. They would like to know about the quality of the product, price and so on. They also want to know whether the supply of goods/services will be regular without an interruption and, would like to assess the profitability of the business. The earning capacity of the firm in relation to revenue or assets or capital employed is referred to as profitability.

5.6 Government and Regulatory Services

The government and all the regulating agencies require the accounting information for the following:

1. to determine taxes, to collect taxes and to frame taxation policies,
2. to provide statistical data in assessing the national income,
3. to frame policies on the national level governing all the categories of the business enterprises,
4. to bring them under strict regulatory control, thereby eliminating unethical practises in the business entities.

5.7 Security Analysts and Advisors

Stock analysts, stock brokers, credit rating agencies rely to a great extent on the financial statements of business concerns in rendering valuable service to the investors. They act without bias in their functions and expose the results of analysis with their technical excellence. They can analyse the financial statements in a better way than the common man. Hence, the importance of accounting information system cannot be underestimated in case of security stock analysts, advisors and credit rating agencies.

5.8 Public

Business enterprises generally recruit local persons as employees, secure raw materials, other goods and services from local suppliers. Such activities inject enthusiasm among the public, kindling them to know about the enterprises. At that juncture, the financial statements might be of much help. From such point of view, information exposed in the financial statements fulfil the needs of the general public.

5.9 Management

The management of an enterprise (generally companies) is entrusted with the board of directors by the investors (shareholders). Even though, it is the responsibility of the management to prepare and present the financial statements and other reports, they themselves also have to seek the assistance of such accounting information system. Management is interested in the information provided in the financial statements in the process of planning, decision making and controlling. The preparation and presentation of the internal reports for different and special purpose financial statements is dealt by management accounting, which is a special branch of accounting. Management accounting is primarily concerned with the information needs relating to planning, decision making and controlling. But basically the management is assisted in its task by the financial statements. In evaluating the performance of an enterprise, in estimating future cash flows, the management of any enterprise rely on the financial statements and other related reports.

OBJECTIVE 6: BRANCHES OF ACCOUNTING

Globalisation has resulted in an increase in the scale of business operations. Over the years, accountants have been engaged constantly in formulating and practising different kinds of accounting. As a result, different specialised branches of accounting came into existence.

6.1 Financial Accounting

This branch of accounting is primarily concerned with the preparation and presentation of financial statements. Financial statement includes Profit and Loss Account (income statement) and Balance Sheet. Of late, a Statement of Retained Earnings and a Statement of Cash Flow are included in it. Hence, preparation of financial statement includes preparation of Profit and Loss Account, preparation of Balance Sheet, preparation of statement on retained earnings and preparation of cash flow statement. In addition, notes, schedules and explanatory material attached to the Balance Sheet also form part of the financial statements. But reports of directors, chairman’s report, analysis of financial statements are not integral part of financial accounting. In this book, it is needless to say that we are concerned only with this branch of accounting.

6.2 Cost Accounting

This is another branch of accounting. The prime objective of cost accounting is to ascertain the cost relating to products, services, departments and functions (inventory valuation), which are essential for the preparation of other branches of accounting. Cost accounting assists the task of control (cost) and decision making. A cost accounting system is used to provide the management with information about the cost of products or services being produced or sold, with the estimated cost of goods or services to be produced and sold in future, with the costs of goods or services produced and consumed within the company and with the cost of operations, processes or activities. The terminology of Chartered Institute of Management Accountants (CIMA) defines cost accounting as “the establishment of budgets, standard costs and actual costs of operations, processes, activities or products; and the analysis of variance, profitability or the social use of funds.” Cost accounting, by ascertaining inventory valuation, helps financial accounting, the other branch of accounting.

6.3 Management Accounting

Accounting designed to guide the management in its process of planning, control and decision making is referred to as management accounting. It can be said that management accounting serves the information needs of the business enterprises such as owners, and managers (otherwise known as insiders). The Institute of Cost and Management Accountants of U.K. defines management accounting as “the application of professional knowledge and skill in the preparation of accounting information in such a way as to assist the management in the formulation of policies and in the planning and controlling of the operations of the undertaking.”

6.4 Tax Accounting

This branch of accounting is primarily related to the statutory tax provisions such as income tax, excise duties, customs duties and VAT (Value Added Tax). Accounting process relating to these items should be in conformity with the existing tax legislations.

6.5 Social Responsibility Accounting

This branch of accounting is also referred to as social accounting or social reporting. It is concerned with the social benefits derived and the costs incurred to derive such social benefits by the enterprises.

Example: Enterprises engaged in providing benefits such as health, education.

6.6 Other Branches of Accounting

Human resource accounting, and national accounting have also come into existence. They are yet to formulate the set of rules and guidelines for such types of accounting.

As students of financial accounting, the differences between financial accounting and management accounting have to be understood clearly, which are provided in the form of columns.

OBJECTIVE 7: DISTINCTION BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING

 

Differences Between Financial Accounting and Management Accounting

Basis of Distinction	Financial Accounting	Management Accounting
1. Purpose	Financial accounting pro vides information for general purpose. Its users are wide and varied.	Management accounting provides information for specific purpose. Its users are only the managers involved in that specific purpose.
2. Period of preparation	Financial statements are prepared, generally for a year.	Management accounting reports are not prepared for a year or period, but for a particular specific purpose.
3. Frequency of preparation	Financial (accounting) statements are carried out only once in a year, in general.	Management accounting reports are prepared frequently.
4. Governance	This is governed by the government, accounting and other statutory regulations.	In management accounting, no such statutory regulations exist.
5. Financial nature	Financial accounting reports can be measured or quantified in terms of money. It is entirely financial in nature.	Generally, it is not financial in nature.
6. Forecasting	Financial accounting is based on past transactions. They are backward looking, forecast cannot be made in this.	Management accounting reports, though based on past records, is forward looking. It forecasts for the future also.
7. Nature of information	Financial accounting uses information, which are objective and which can be verifiable.	Management accounting uses information, which are subjective and which cannot be verifiable.

OBJECTIVE 8: OBJECTIVES OF FINANCIAL ACCOUNTING

The Institute of Chartered Accountants of India (ICAI), issued a document under the title, “Framework for the Preparation and Presentation of Financial Statements” which describes the following as the objectives of financial statements:

1. to provide information about the financial position, performance and changes in financial position of an enterprise,
2. to provide financial accounting information to a wide range of users in making decisions,
3. to assess the stewardship of management or the accountability of management for the resources entrusted to it.

OBJECTIVE 9: GENERAL PURPOSE STATEMENT

It emphasises the preparation of four statements which are basic to financial accounting. These four statements are clubbed under the title “General Purpose Financial Statements.” They are called so because they serve the purpose of several user groups. They are:

1. Profit and Loss Account: This is also called “Income Statement.” This is a statement which matches the revenue with the expenses. This statement exposes the net result of the operations (net profit/loss) of an enterprise for a particular period. This provides information about the performance of an enterprise. The salient features, preparation and usefulness of this statement is explained in detail in Chapter 5.

2. Balance Sheet: This provides information about financial position of an enterprise. The Balance Sheet consists of three elements – equity, liabilities and assets. It provides information about economic resources that are controlled by the enterprise. It provides information on the financial structure. Liquidity and solvency of an enterprise is also revealed. The salient features, preparation and usefulness of this statement is discussed in detail in Chapter 5.

3. Statement of Retained Earnings: This is a statement that reports on the net income available for distribution of dividend, relating to public limited companies. Dividend policy is generally framed on the scrutiny of the statement of retained earnings. Out of profit earned, how much to part with, in the form of dividends and how much to retain in the company itself, has to be determined based on this report. As this is outside the scope of this book, this has not been dealt with.

4. Statement of Cash Flow: Now, the preparation of cash flow statement has gained much importance. It is a summary of cash inflow and cash outflow. This is prepared on the basis of important activities of an enterprise, namely, operating, investing and financing. To provide information on changes in the financial position of an enterprise is the prime object in the preparation of cash flow statement. This is extensively dealt with in Chapter 17.

Each of the above statement provides the needed information, which may also be considered as objectives of financial statements.

As per the Federal Accounting Standards Board, the objectives are:

1. to help those making investment and credit decisions,
2. to assess the future cash flows,
3. to identify the economic resources (assets), the respective claims to those resources (liabilities) and the changes in those resources and claims.

OBJECTIVE 10: QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION OR FINANCIAL STATEMENTS

The ICAI, issued a document under the title, “Framework for the preparation of Financial Statements”, which described the qualitative characteristics of final statements under the following broad, primary qualitative characteristics:

10.1 Understandability

An essential quality of the accounting information provided in the financial statements is that, it must be readily understandable by the users. Any information is useful only if it is understandable. It is assumed that the users have adequate knowledge, at least, working knowledge of economic and accounting concepts, revealed in financial statements. However, information about complex matters that should be included in the financial statements because of its relevance for decision making needs of users, should not be excluded on the ground that may be difficult for certain users to understand.

10.2 Relevance

Accounting information must be relevant for decision making needs of the users. If accounting information is not relevant though understandable, it will be useless. Information has the quality of relevance when it influences the economic decisions of the users by helping them to evaluate past, present or future events or confirming or correcting their past evaluations. Information need not be in the form of an explicit or exact forecast, to have predictive value. The predictive value of the financial statements is increased if sufficient explanations for unknown items are enclosed along with financial statements.

Materiality: The relevance of information is affected by its nature and materiality. No material information should be omitted. “Information is material, if its misstatement (i.e., omission or erroneous statement) could influence the economic decisions of the users, taken on the basis of financial information.” “Materiality depends on the size and nature of the item or error judged in the particular circumstances of its misstatement.” Materiality provides a cut-off point (limit) rather than being a primary qualitative characteristic, which the information must possess, if it is to be useful.

10.3 Reliability

To be useful, information must be reliable. Accounting information is reliable, when it is free from material error and personal bias. Information must represent faithfully, what it intends to represent.

To be reliable, the accounting information must have the following attributes – faithful representation, substance over form, neutrality, prudence, completeness, timeliness and verifiability.

Faithful Representation: This requires that accounting information should be based on actual events. Transactions should be recorded faithfully. There may be some measurement difficulties in certain cases. In some other cases, some uncertain items are also to be recognised. The risk of error in those cases should be disclosed separately.

Substance Over Form: Transactions have to be recorded in accordance with their substance and economic reality and not merely with their legal form.

Neutrality: To be reliable, information in financial statements must be neutral, that is free from bias. Any activity should not be influenced by the whims and fancies of persons associated with such activity.

Prudence: Prudence means acting with caution in the exercise of judgements required under conditions of uncertainty. Accountants must be prudent in making judgements (estimates) while preparing statements. Exercise of prudence does not allow the creation of hidden reserves or excessive provisions, the deliberate understatement or overstatement of expenses, incomes, assets and liabilities.

Completeness: To be reliable, the information must be complete within the limits of materiality and cost. An omission can cause information to be false or misleading and hence unreliable and irrelevant. So financial statements with disclosures should be complete in the sense and should not mislead the users by providing incomplete data.

Timeliness: Any delay in the presentation of accounting information will lose its relevance. It should be presented and communicated to its users within the stipulated time, in order to avoid unforeseen events.

Verifiability: While recording transactions, care should be taken to note whether such transactions have really taken place and whether they are objective and verifiable. They should be verifiable with some original documents (source documents). True position is ascertained if any checking by way of verification is carried on periodically.

10.4 Comparability

Users of financial statements of a business enterprise must be in a position to compare the net results within the enterprise over a period of time. In order to understand the relative net results with other enterprises in the field, financial statements should be prepared in such a way to facilitate the task of comparison. But comparability can be made easy only when the enterprises use the same accounting principles and methods. Consistent application of accounting principles and methods is essential for comparison of financial statements. Hence, this aspect of consistency generally does not permit the switching of accounting methods from year to year. Suppose the method of valuation of inventory is switched over from First-In-First-Out (FIFO) Method to Weighted Average Method, comparison cannot be possible even within an enterprise over a period of time. But certain changes are necessitated when there is a change in the statutory provision. Under those circumstances, accounting policies and methods should be in tune with the existing legislations. But such changes must be disclosed in the financial statements, with reasons for such a change, and the net effect of changes on the financial position of the enterprise. To compare the financial position, net result of operations and cash flows of an enterprise within the enterprise and with other enterprises over a period of time by the users should be considered as prime qualitative characteristics of accounting information, while preparing the financial statements.

OBJECTIVE 11: FUNCTIONS OF ACCOUNTING

The major functions of financial accounting are:

1. Maintenance of Records: Maintenance of records is the basic and important function of any accounting system. Business transactions have to be recorded properly in the books of accounts, classified under appropriate accounts and finally summarised into the financial statements.

2. Communication: Informing the net results of an enterprise to its users is another important function. Accounting is used to communicate the financial information to its varied users.

3. Statutory Compliance: Statutory provisions require the submission of many statements to the concerned authorities. Financial accounting functions should comply with the legal and statutory provisions.

4. Protection of Assets: Financial accounting enables the management of an enterprise to exercise proper control over the assets of enterprise. Assets in its various forms (cash, inventories, work-in-process, fixed assets, and so on) are kept in tact as constant vigil is exercised, as accounting is a continuous process and proper recording of the transactions facilitates the function.

5. Stewardship: In companies registered under the Companies Act, 1956, the management is entrusted with enormous powers with the entire resources at their disposal. As such, they have to act as trustees of the funds with utmost faith. Accordingly, accounting should assist the management to achieve the goal.

6. Assessment of Performance: The basic function of the accounting data is the assessment of past performance and determination of the current financial position.

7. Forecast: Based on the past data, accounting enables to forecast the future performance of an enterprise.

8. Decision Making: Accounting provides the necessary data to make appropriate decisions for both management as well as the users.

9. Evaluation and Responsibility: Accounting helps in assessing profit or loss of different departments. Such evaluation in turn fixes the responsibility of the different department heads.

10. Control: Accounting helps in identifying the weak spots in the various activities of the entire enterprise and suggest remedial measures to plug the weak spots. Hence, accounting facilitates the task of control.

OBJECTIVE 12: ADVANTAGES OF ACCOUNTING

1. Useful to the Management: The accounting information is useful to the management in the following ways:

1. in the preparation of budget,
2. in planning the future course of action,
3. in co-ordinating the different departments,
4. in controlling the managerial activities.

2. Comparison: Intra-comparison, that is comparison of results within the enterprises over a period of time can be possible.

3. Taxation Authorities: Written records serve as a reliable source for taxation purposes. Taxes cannot be levied arbitrarily.

4. Legal Evidence: Written accounting information acts as an evidence in the court of law, which will be binding everyone.

5. Determination of the Price: The accounting information is an important tool to determine the price of the enterprises, in a situation of selling process.

OBJECTIVE 13: LIMITATIONS OF ACCOUNTING

1. Non-monetary Items Ignored: Accounting information is expressed in terms of money or money’s worth. Non-monetary items are ignored.

2. Original Cost: Assets, especially fixed assets, are recorded at the original cost. Actual amount incurred on them are not taken into account. Consequently, the Balance Sheet does not reflect the true financial position.

3. Profit Basis – Not Reliable: Profit may not be the sole criterion in assessing the management performance of an enterprise. Accounting information based on profit alone cannot be a reliable one because some major costs incurred on some important areas like advertisement, research and development, are omitted and all sorts of manipulation may be made.

4. Based on Estimates: At times, accounting information is based on estimates. Such information may not be accurate.

5. Rule of Consistency: Same accounting principles may not be followed, in certain cases. For example, depreciation on fixed assets is computed on Straight Line Method in one year and Written Down Value in another year. Rule of consistency may be violated which results in contradictory procedure.

OBJECTIVE 14: BASES OF ACCOUNTING

Financial statements are to be prepared in accordance with Generally Accepted Accounting Principles (GAPP). The following are the bases, which are generally accepted, in calculating profit or loss of an enterprise.

1. Cash Basis of Accounting: Under this cash system of accounting, transactions relating to actual cash receipts and actual cash payments alone are recorded and the net result is computed on this basis. Credit transactions are not at all recorded. No adjustments on items relating to outstanding expenses and accrued income are carried on. No adjustment entries are recorded. Income is computed as the excess of actual cash receipts over actual cash payments, with the help of receipts and payments account.

This system of accounting is useful for professionals and small enterprises. True profit or loss cannot be ascertained under this method because items relating to the current account period is not included for the simple reason that cash is not received in cash or not spent in cash.

2. Accrual Basis of Accounting: Under this system of accounting, items of income are recognised when they are earned and whether they are actually received in cash are not considered, that is the cash may be received on a later date. Similarly, items of expense are recognised when they are incurred and not when payments are made. They are taken into account on the basis of accounting period to which they are related. Actual cash receipts and actual cash payments are immaterial under this method. Hence, proper adjustments have to made in the calculation of net profit or loss of an enterprise. True profit or loss can be ascertained for a particular period under this system of accounting. This method can be used to all types of business enterprises. But actual cash flows are not disclosed.

There is one more method of accounting in practise, that is mixed or hybrid basis of accounting. Under this method, both cash basis of accounting and accrual basis of accounting is adopted. Under this method, items of income are recognised (recorded) on accrual basis.

Revenues are recognised in full and at the same time adequate provision for expenses are also provided under this method.

Under hybrid system of accounting, cash basis is adopted for certain items and accrual basis is followed for certain other items of transactions of an enterprise.

OBJECTIVE 15: DISTINCTION BETWEEN ACCRUAL BASIS OF ACCOUNTING AND CASH BASIS OF ACCOUNTING

 

Differences Between Accrual System of Accounting and Cash System of Accounting

Basis of Distinction	Accrual Basis of Accounting	Cash Basis of Accounting
Items appear in balance sheet	Items such as outstanding and pre-paid expenses and accrued and unaccrued incomes will appear in the balance sheet.	No such items will appear in the balance sheet under this method.
Effect of pre-paid expenses and accrued income	Income statement will reveal a relatively higher profit (income).	Income statement will show a lower profit (income).
Effect of outstanding expenses and unaccrued income	Income statement will show a relatively lower (income) profit.	Income statement will show a higher profit (income).
Statutory recognition	This method is recognised by the Companies Act.	This system of accounting is not recognised by the Companies Act.
Option: Valuation of inventory, depreciation	Under this system, the accountant has the option to choose any method.	The accountant has no liberty to choose an option.

• Accounting is the art of recording, classifying and summarising in terms of money transactions and interpreting the results thereof.
• Characteristic features: process, identification, measurement and communication.
• An accounting system consists of input, processes, output, feedback and control.
• Users of accounting information system are investors, suppliers and creditors, lenders, employees, customers, government and regulatory services, security analysts, public and management.
• Branches of accounting are financial accounting, cost accounting, management accounting, tax accounting, social responsibility accounting, human resource accounting and national accounting
• Objectives of financial accounting: to provide information about the financial position; performance and changes in the financial position; to provide financial accounting information to its users; to assess the accountability of the management; to arrive at investment and credit decisions; to assess future cash flows; to identify economic resources.
• General purpose statements: Income Statement, Balance Sheet, Statement of Retained Earnings and Statement of Cash Flow.
• Qualitative characteristics of accounting information: understandability, relevance, reliability and comparability
• Functions of accounting are maintenance of records, communication, protection of assets, statutory compliance, stewardship, forecast, decision making, evaluation and control.
• Advantages of accounting: useful to management, comparison, taxes, legal evidence and price determination.
• Limitations of accounting: non-monetary items ignored; original cost; not reliable on profit basis, estimation, rule of consistency.
• Bases of accounting: cash basis of accounting, accrual basis of accounting – distinction between cash basis and accrual basis of accounting.

Account: A record of financial transactions which is kept for sorting the accounting information into similar groups.

Accounting: A process of identifying, recording, summarising and reporting (accounting economic) information to specified users.

Accounting Information System: A set of records, procedures and equipment that routinely deal with the events affecting the financial performance and position of the entity and communicating this to decision makers.

Accounting Period: The period of time over which profits are computed. Normal accounting period is a year, fiscal or financial year which starts from Apr 1, and ends on Mar 31, of the following year or calendar year.

Accrual Basis of Accounting: It is an accounting system (method) whereby the revenues and expenses are recorded at the time the transaction has taken place and not at the time when the cash is paid. This is also known as mercantile basis of accounting.

Cash Basis of Accounting: It is another accounting system whereby the transactions are recorded when actual receipts or actual payments occur. This is suitable only for the individuals.

 

Anthony R.N. and J.S. Reece, Accounting Principles, Richard D. Irwin Inc.

 

I. State whether the following statements are True or False

1. Accounting information is useful only to the management.
2. Accounting is the language of business.
3. Accounting involves communication.
4. Financial statements are the channel of accounting communication.
5. If the transaction cannot be translated in monetary terms, it is not considered as part of the accounting information system.
6. Information needs of accounting are not required for owners of small business enterprises.
7. Most of the needs of the accounting information are met from unpublished internal reports by the management.
8. Under cash basis of accounting, credit transactions are not at all recorded in the books of account.
9. Under accrual basis of accounting, revenue is recognised only when cash is actually received.
10. Under cash basis of accounting, no adjustments are made for outstanding expenses and accrued income.

Answers

1. False	2. True	3. True	4. True	5. True
6. False	7. True	8. True	9. False	10. True

 

II. Fill in the blanks with suitable words

1. The information generated by final reports of an enterprise is generally known as __________ information.
2. The two broad categories of users of the financial accounting information are __________ and __________.
3. Ability of the firm to meet its long term obligations is referred to as __________.
4. Ability of the firm to meet its short term obligations is referred to as __________.
5. The major internal user of the accounting information is __________ of an enterprise.
6. Consistency __________ the switching of accounting methods from year to year.
7. Under cash basis of accounting __________ transactions are not recorded.
8. Under accrual basis of accounting, revenues are recognised when they are __________.
9. Under hybrid basis of accounting, revenues are recognised on __________ basis while expenses are recorded on __________ basis.
10. Under accrual basis of accounting, outstanding expenses and unaccrued income will affect the Profit and Loss Account showing a __________ profit.

Answers

 

1. Financial Accounting
2. External and Internal
3. Solvency
4. Liquidity
5. The Management
6. Does not permit
7. Credit
8. Earned
9. Cash basis and accrual basis
10. Lower

1. Define accounting.
2. What is an accounting information system?
3. What are the broad purposes of an accounting system?
4. What are the important financial characteristics which are of common interest to users of information?
5. What are the categories of users of financial accounting information? Give two examples to each category of users.
6. What are the branches of accounting?
7. What is meant by hybrid basis of accounting?
8. Explain the cash basis of accounting.
9. What is accrual basis of accounting? Mention two advantages of accrual basis of accounting.
10. Distinguish between the accrual basis of accounting and the cash basis of accounting.

1. What is an accounting information system? Elucidate the salient features of an accounting system?
2. Explain the information needs of different types of user groups in detail.
3. What are the qualitative characteristics of an accounting information? Explain each such characteristic in detail.
4. What are the functions of financial accounting? What are its advantages? Explain its limitations.
5. Distinguish between the management accounting and the financial accounting.