In an economy, each individual earns money and spends on his various needs like clothing, education, food, shelter, etc. and for investment. Not just individuals but the Government also has the same process of earning it’s revenues via taxpayers of the country and then spending the money on various developmental plans.
These two way transactions are called Economic activities. Individual transactions are generally for the personal benefits and the government transactions are for larger public benefits.
Amidst all these economic activities taking place every other second in our lives, everyone wants to keep a record of all the inflows (revenue/ income, loans) and the outflows (expenses, investments) and the profit or loss (surplus or deficit) occurring as a result of these inflows and outflows. Here’s where the process of 'accounting' comes into the picture.
Accounting process has been developed to serve the purpose of measurement of economic activities involving inflow & outflow of economic resources, which helps to develop useful information for decision making.
Even though accounting as a field of study has a universal application for any type of economic activity ranging from your birthday party to a National government's function, but to keep things in perspective, it is best identified with the recording of business transactions and other financial information about a business enterprise.
The American Institute of Certified Public Accountants(AICPA) defined accounting as, “Accounting is an art of recording, classifying, and summarizing in a significant manner and in monetary terms, transactions and events which are, in part at least, of a financial character, and interpreting the results there of.”
However, in the present situation the horizon of accounting is much broader and is not confined just to the above definition. The process of accounting doesn’t end with the interpreting the final results of the financial transactions but it has also to do with the fair and accurate communication of those accounting results to the users of the account, which ranges from the company’s own management and shareholders to its creditors and customers.
Hence, the widely accepted definition of accounting came from the American Accounting Association in 1966 which states, “The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of accounts.”
The accounting procedure has been broadly classified into the following heads-
1) Recording: Whenever a transaction takes place, it is supported by some evidence like invoice, sales bill, salary slip, etc. Based off these evidence the transactions are recorded in a book called 'Journal'. For small businesses, a single composite Journal book is sufficient to record the transactions, but in large businesses the size and magnitude of transactions is huge, so several subsidiary books are used to record transactions separately on the basis of their nature.
2) Classifying : This step involves putting all the transactions of the same nature related to a particular period at one place, to make the information easily usable. This is done in a book called as “Ledger”.
E.g. separate account may be prepared for Rent, advertising, purchase, salaries, miscellaneous expenses, etc.
3) Summarizing : This consists of preparation and presentation of the financial statements using the information from the ledger account. Generally, the following financial statements are prepared in most business enterprises-
4) Analysing : This step involves establishing relationship between the P&L account items and the Balance Sheet items. E.g. analysing the percentage and method of depreciation charged on the fixed assets.
5) Interpreting: Further, the financial data is interpreted in a way that it is easy for the users to make appropriate judgements.
E.g. Financial ratios like Gross Profit Ratio, Earning per share, Solvency ratio, Liquidity ratio, Cost of good sold per unit, etc. are calculated for better decision making.
6) Communication : This is done through preparing and publishing accounting reports, graphs, charts, fund flow statement, etc. along with the company’s period end Final Accounts.
There are two types of users of accounts-
1) Internal users:
2) External users:
Book-keeping means recording the financial transactions related to the business operations pertaining to a particular period in an orderly manner.
The process of book-keeping doesn’t include preparation of the financial statements but it’s effectiveness is measured by the accuracy of the financial statements as it is the end product.
A book-keeper's work is substantially clerical in nature. He is responsible for recording and classifying transactions in separate books for the whole entity or only a segment (a product or a function like sales). Now a days the job is fulfilled mostly through the use of machines.
|This is concerned with recording of transactions||This is concerned with summarizing of the recorded transactions|
|Book-keeping is a part of accounting process which builds the base for accounting||This is a broader concept than book-keeping|
|Financial statements are not prepared||Financial statements are prepared on the basis of the book-keeping records|
|Financial position of the business cannot be ascertained from this and hence this can’t be used for decision making||Financial position can be ascertained and decisions could be taken based on these reports.|
We will further talk about the first four sub-fields in the car coming chapters.