Introduction to Accounting – Definition | Types | History

Accounting is the process of recording, summarizing, analyzing, and reporting financial transactions of a business to oversight agencies, regulators, etc. It involves tracking revenues, expenses, assets, and liabilities to provide a clear financial status of the business or individual, which helps in making informed financial decisions.

Table of Contents

1. Introduction
2. Nature and Purpose of Accounting
3. Historical Perspectives
4. New Accounting Systems
5. Origins of Accounting Principles
6. Let Us Sum Up
7. Keywords

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1. Introduction

Accounting often is called the language of business. The basic function of any language is to serve as a means of communication. In this context, the purpose of accounting is to communicate or report the results of business operations and the financial health of the organization.

The most apt definition of Accounting has been given by the ‘American Institute of Certified Public Accountants’, which is as under:

‘Accounting is an art of recording, classifying and summarizing, in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.’

Many people take book-keeping and accountancy to mean one and the same, but the two are different, Accountancy is a wider concept and includes book-keeping. Book keeping means recording the business transactions in the books of original entry and in the ledgers. It deals with recording of transactions and accounting with their interpretation. On the other hand, accountancy means the compilation of accounts in such a way that one is in a position to know the state of affairs of the business. Accounting information is derived from the record of transactions in the books of account.

Financial statements, normally, means the balance sheet, profit and loss account, statement of changes in the financial position (which may be either a fund flow statement or a cash flow statement), explanation statements, notes and schedules forming part of the financial statement. The objective of a financial statement is to provide information about the financial position, performance and changes in the financial position of an enterprise. The users of a financial statement include government authorities, e.g. income tax department, sales tax department, etc., shareholders, investors, business associates, directors, banks and financial institutions, etc.

Accounting is the language of business, communicating through the financial statements the financial results and performance of an enterprise, to various users of such financial statements. It is in the interest of all that the financial statements exhibit a ‘true and fair’ view of the state of affairs of an entity. It is the art of recording, classifying, summarizing and interpreting monetary transactions.

Any language has a set of rules called grammar. Recording of events in accounts also has its own set of rules and criteria. Such rules, are called the ‘Accounting Standards’ (AS).

2. Nature and Purpose of Accounting

A business entity, operating for profit, must keep a systematic record of the day-to-day events so that it can know about its profits/losses, assets and liabilities. Even institutions, which do not have profit earning as an objective, must keep a record of their incomes, expenditures and financial status. This purpose is achieved by keeping systematic books of account based on sound accounting principles.

Accountancy, thus, involves the following:

1. Systematic classification of business transactions, for recording them in the books of account.
2. Recording of events and transactions in the books of account, called book keeping.
3. Summarising of the recorded events, i.e. preparation of a trial balance from a ledger and, subsequently, the preparation of balance sheet and the profit and loss account, from the trial balance.
4. Interpreting the financial transactions from the recorded data and the financial statements.

2.1 Features of Accounting

• Accounting is the art of recording, classifying and summarising business transactions: It not only records the business transactions but also records them in an orderly manner. It also classifies business transactions according to their nature, before recording them in the books of account, e.g. all purchase transactions are first entered in the purchase register. This also helps to find the total purchases during a given period. Accounting also summarises the data, recorded in the books of account, and presents them in a systematic way, in the form of:

1. 1. Trial Balance
   2. Profit and Loss account
   3. Balance Sheet
   4. Cash Flow Statement

• Accounting records the transactions in terms of money: Accounting records business transactions by expressing them in terms of money. This makes the recorded data more meaningful. Events that cannot be expressed in monetary terms, are not recorded in the books of account. Events such as, a quarrel between the management and workers of a company, are not recorded in its books of accounts, though loss or monetary outflow from it, is recorded in its books of accounts.
• Accounting records only the transactions of a financial character: Accounting records only those events and transactions that are financial in nature. Let us say that a very high-speed computer is bought by a business entity for Rs. 1 lakh, but the entries in the books of account will not record the computer’s efficiency or the brand name as such, but will record only the cost price.
• Accounting also interprets the financial data: The business transactions/events, recorded in the books of account, are also interpreted by accounting. The interpretation helps in making meaningful decisions in the future. For example, a bank may study the balance sheet of an entity, before taking a credit decision.

The purposes and the objectives of accountancy can be briefly listed out as under:

• To keep a systematic record: It is very difficult to remember all the business transactions that take place. Accounting serves this purpose of record keeping, by promptly recording all the business transactions in the books of account. Accounting also records the assets (properties and possessions) and liabilities (loans and debts) of the business.
• To ascertain the results of the operations: Accounting helps in ascertaining the result, i.e. profit earned or loss suffered in a business during a particular period. For this purpose, a business entity prepares either a trading and profit and loss account or an income and expenditure account that shows the profit or loss of the business, by matching the items of revenue and expenditure of the same period.
• To ascertain the financial position of the business: In addition to profits, a businessperson must know his financial position, i.e. the availability of cash, the position of assets and liabilities, etc. This helps the businessperson to know his financial strength. Financial statements are the barometers of health of a business entity. Just as a doctor knows the health of a person by feeling his pulse, in the same way a look at the balance sheet of an organisation reveals its financial health. It also helps to ascertain the assets and liabilities, i.e. the amounts receivable from debtors and payable to creditors.
• To facilitate rational decision-making: Accounting records and the financial statements provide the financial information that helps in making rational decisions about the steps to be taken with respect to the various aspects of business. Such decisions may be in respect of:

1. 1. Should a part or product be made in the factory or, purchased from outside?
   2. What should be reasonable selling price of a product or a service?
   3. What should be the maximum discount offered to a special customer?

• To satisfy the requirements of law: Entities such as companies, societies, public trusts, etc., are compulsorily required to maintain accounts as per the law governing their operations, such as the Companies Act, Societies Act, Public Trust Act, etc., the maintenance of accounts is also compulsory under Central Goods and Services Tax Act and Income-tax Act.

2.2 Advantages of Financial Accounting

• It provides information, useful for making economic decisions.
• It serves primarily those users who have limited authority, ability or resources to obtain information and who rely on financial statements as their principal source of information about the economic activities of an enterprise.
• It provides information useful to investors and creditors, for predicting, comparing and evaluating cash flows in terms of amount, timing and related uncertainty.
• It provides users with information for predicting, comparing and evaluating the earning power of an enterprise.
• It supplies information useful in judging the management’s ability to utilise the enterprise resources effectively for achieving the primary enterprise goals.
• It provides factual and interpretive information about the transactions and other events, that are useful for predicting, comparing and evaluating the earning power of an enterprise as it discloses the basic underlying assumptions with respect to matters subject to interpretation, evaluation, prediction or estimation.

3. Historical Perspectives

The history of accounting indicates the evolutionary pattern which reflects the changing socio-economic conditions and the enlarged purposes to which accounting is applied. In the present context, there are four phases in the evolution of accounting that are distinguishable.

Stewardship Accounting: In the earlier times in history, wealthy people employed ‘stewards’ to manage their property. These stewards rendered an account of their stewardship to their owners, periodically. This notion lies at the root of financial reporting even today, which essentially involves the orderly recording of business transactions, commonly known as ‘book-keeping’!

Financial Accounting: Financial accounting dates from the development of large-scale business and the advent of the ‘Joint Stock Companies’ (a form of business which enables the public to participate by providing capital in return for shares, in the assets and the profits of the company). This form of a business organisation permits a limit to the liability of their members to the nominal value of their shares. This means that the liability of a shareholder, for the financial debts of the company, is limited to the amount he had agreed to pay on the shares he bought. He is not liable to make any further contribution in the event of the company’s failure or liquidation. As a matter of fact, the law governing the operations (or functioning) of a company in any country (for instance the Companies Act in India) gives a legal form to the doctrine of stewardship which requires that information be disclosed to the shareholders in the form of annual income statement and balance sheet.

Briefly speaking, the income statement is a statement of profit and loss made during the year of the report; and the balance sheet indicates the assets held by the firm and the monetary claims against the firm. The general unwillingness of the company directors to disclose more than the minimum information required by law, and the growing public awareness, have forced the governments in various countries of the world to extend the disclosure (of information) requirements.

The importance attached to financial accounting statements can be traced to the need of the society to mobilise the savings and channel them into profitable investments. Investors, whether they are large or small, must be provided with reliable and sufficient information in order to be able to make efficient investment decisions. This is the most significant social purpose of financial accounting.

Cost Accounting: The industrial revolution in England presented a challenge to the development of accounting as a tool of industrial management. Costing techniques saw development as guides to management actions. The increasing awareness on the part of entrepreneurs and industrial managers for using scientific principles of management, in the wake of the scientific management movement, led to the development of cost accounting. Cost Accounting is concerned with the application of costing principles, methods and techniques for ascertaining the costs, with a view to controlling them, and assessing the profitability and efficiency of the enterprise.

Management Accounting: The advent of management accounting was the next logical step in the developmental process. The practice of using accounting information as a direct aid to management, is a phenomenon of the twentieth century, particularly of the last thirty-forty years. The genesis of modern management, with its emphasis on detailed information for decision-making, provides a tremendous impetus to the development of management accounting.

Management accounting is concerned with the preparation and presentation of accounting, and controlling information, in a form that assists management in the formulation of policies and in decision-making on the various matters connected with routine or the non-routine operations of a business enterprise. It is through the techniques of management accounting that the managers are supplied with information, that they need for achieving objectives for which they are accountable. Management accounting has thus, shifted the focus of accounting from recording and analysing financial transactions to using the information for decisions affecting the future. In this sense, management accounting has a vital role to play in extending the horizons of modern business. While the reports emanating from financial accounting are subject to the conceptual framework of accounting, internal reports, routine or non-routine, are free from such constraints.

Social Responsibility Accounting: Social responsibility accounting is a new phase in the development of accounting, and owes its birth to increasing social awareness that has been particularly noticeable over the last two decades or so. Social responsibility accounting widens the scope of accounting by considering the social effects of business decisions, in addition to the economic effects. Several social scientists and social workers, all over the world, have been drawing the attention of their governments and the people in their countries, to the dangers posed to the environment and ecology by the unbridled industrial growth. The role of business in society is increasingly coming under greater scrutiny. The managements are being held responsible for not only efficient conduct of business, as expressed in profitability, but also for what it contributes to the social well-being and progress. There is a growing feeling that the concepts of growth and profit, as measured in traditional balance sheets and income statements, are too narrow to reflect the social responsibility aspects of a business.

Human Resource Accounting: Back in 1964, the first attempt to include figures on human capital, in the balance sheet, was made by Hermansson, that later came to be known as ‘Human Resource Accounting’ (HRA). However, there had been a great socio-economic shift in the 1990s with the emergence of ‘Knowledge Economy’, a distinctive shift towards the recognition of human and intellectual capital in contrast to the physical capital. ‘Human Resource Accounting’ is a branch of accounting that seeks to report and emphasise the importance of the human resources (knowledgeable, trained, loyal and committed employees) in a company’s earning process and total assets. It is ‘the process of identifying and measuring data about human resources and communicating this information to interested parties. In simple words, it involves accounting for the investment in people and the replacement costs as well as accounting for the economic values of people to an organisation. Generally, the methods used for valuing and accounting of human resources are based either on costs or on economic value of the human resources. However, providing adequate and valid information on human assets (capital), which are outside the concept of ownership, in figures, is very difficult. Nevertheless, HRA is a managerial tool that provides valuable information to the top management to take decisions regarding the adequacy of human resources and thus encouraging managers to consider the investment in the workforce in a more positive way.

Inflation Accounting: Inflation accounting is concerned with the adjustment in the value of assets (current and fixed) and of profits, in the light of changes in the price level. In a way, it is concerned with the overcoming of limitations that arise in financial statements because of the cost assumption (that is, recording of the assets at their historical or original cost) and the assumption of a stable monetary unit. It, thus, aims at correcting the distortions in the reported results caused by price level changes. Generally, rising prices during inflation have the distorting influence of overstating the profit. Various approaches have been suggested to deal with this problem.

4. New Accounting Systems

Value Accounting: A product is a result of various individual contributions. Value accounting is used to evaluate and capture these individual contributions, whether this contribution is tangible or intangible and is normally mentioned as a % for each contributor. Value accounting helps in ensuring that every contributor gets his due share in the future revenue generated through the product. Example: If 5 workers are picking tea leaves and putting these in the same basket, the contribution of each is tracked through the value accounting system. This is helpful in deciding the share of revenue of each individual on selling the leaves in the market. Various value evaluation processes can be used in value accounting.

Fair Value Accounting: Fair value accounting takes into account the current market value of certain assets and liabilities. Fair value of an asset is the estimated price at which an asset can be sold under current market conditions. Similarly, the fair market value of a liability is the estimated amount at which a liability can be settled under current market condition. The measurement of fair value under this accounting method is not concerned with the intention of the holder of the asset or liability to hold it or not. Under this method of accounting, various approaches can be used for deriving the fair value. Some of these are; Market approach, Income approach, Cost approach. Fair value accounting is also known as current value accounting. Presently, this method of accounting does not enjoy wide degree of acceptance due to the issues like increased cost and delays, non-availability of reliable information and doubts about the accuracy of available information.

5. Origins of Accounting Principles

Accountancy and book keeping are as old as money itself. The Greeks, Romans, Egyptians and Babylonians had well-developed records and maintained a good system of record keeping and control. In the thirteenth and fourteenth centuries, there was a tremendous development of commerce in Italy, where the modern system of book keeping took birth. In 1494, at Venice, Luca De Bargo Pacioli, an Italian monk, published his book called Summa that contained a section on the ‘Double Entry’ book keeping. He gave birth to the modern concept of book keeping and accounts. In the latter part of the fifteenth century, there was an increase in use of Pacioli’s work on accounting because of increased trade, and the necessity of merchants to record transactions.

Later, in the sixteenth and seventeenth centuries, there were attempts in England and Holland to design the rules for double entry and the preparation of financial statements/reports and independent ledger accounts. In the nineteenth century, the industrial revolution, and in the twentieth century the two world wars, revised the form of accounting and reporting to the forms still in use till date.

In India also, accountancy and book keeping were practised in a scientific form twenty centuries ago. During the regime of King Chandragupta, Kautilya, one of his ministers, wrote a book on accountancy, named the ‘Arthashashtra’. In India, the old method of accounting, called the ‘Nama’ method, is still in use. It is also called the ‘Mahajani’, ‘Marwari’ or the ‘Deshi’ method.

6. Let Us Sum Up

Accounting is an important service activity in business and is concerned with the collecting, recording, evaluating and communicating the results of past events. The history of accounting development reflects its changing role in response to the changing business and social needs. An entity operating for profits keeps a systematic record of its day-to-day events so that it can ascertain its profits/losses, assets and liabilities through accounting. Accounting is defined as the art of recording of business transactions in an analytical form and involves the preparation of financial statements. Accounting is also concerned with interpreting the results of an enterprise from its financial statements. Accounting records the financial transactions in terms of money. Accountancy follows a set of concepts, conventions and principles. Accounting is important as it provides a systematic record of the business transactions, ascertains its results, facilitates rational decision-making and satisfies the requirements of law in case of entities like companies, etc. With the emergence of management accounting, the focus of accounting has been shifting from a mere recording of transactions to that of aiding the management in decisions.

7. Keywords

Accounting: An art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events, that are, in part at least, of a financial character and interpreting the results thereof.

Financial Statements: A set of documents that shows the results of business operations during a period, how the results were achieved and the position of assets and liabilities on a given date. It normally means the balance sheet, profit and loss account, statement of changes in the financial position (which may be either a fund flow statement or a cash flow statement), explanatory statements, notes and relative schedules forming part of financial statements.

Accounting Standards: The policy documents issued by the recognised expert accountancy body relating to the various aspects of measurement, treatment and disclosure of accounting transactions and events.