What accounting is, and who uses it

The classic definition — the American Institute of Certified Public Accountants (AICPA), 1941: 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.'

Three words often confused

Its origin — the Italian friar Luca Pacioli described the double-entry system in 1494, in his Summa de Arithmetica, and is called the father of accounting.

Who uses accounting information

• ›internal users — owners, managers, employees
• ›external users — banks and creditors (can the firm repay?), investors (is it profitable?), the government and tax authorities, consumers, and researchers

Qualities that make it useful

• ›reliability — free from error and bias, and verifiable
• ›relevance — available in time and helpful for decisions
• ›understandability — presented so that users can grasp it
• ›comparability — across years and across firms

Limitations — it records only what can be measured in money, uses historical cost that ignores price changes, and involves estimates (the life of a machine, the debts that will go bad).

The trap: book-keeping stops at recording; accounting begins where it ends, with analysis and interpretation.

The basic terms

Two kinds of expenditure

• ›revenue expenditure — its benefit is used up within the year (wages, repairs, carriage on goods)
• ›capital expenditure — its benefit lasts several years (buying a machine, building a shop, the cost of installing a machine)

Two kinds of discount

• ›trade discount — a reduction in the list price, given at the time of sale to traders; it is never recorded in the books
• ›cash discount — allowed for prompt payment; it is recorded, as a loss to the seller and a gain to the buyer

The trap: trade discount never enters the books, while cash discount always does — the invoice is simply written at the reduced price.

Accounting principles — the theory base

The rules on which all accounts are built are called Generally Accepted Accounting Principles (GAAP).

Bases of accounting — the cash basis records only cash received and paid; the accrual basis records income when earned and expenses when incurred, whether or not cash has moved. Businesses use the accrual basis.

Accounting standards — the Accounting Standards Board of the ICAI was set up in 1977; Ind AS, converged with international standards (IFRS), apply to larger companies in phases from 2016.

The trap: conservatism is why closing stock is valued at cost or market price, whichever is lower — an unrealised gain is ignored, but an expected loss is recorded.

The accounting equation — a worked case from Darbhanga

> Assets = Liabilities + Capital, or Capital = Assets − Liabilities

Every transaction changes at least two items, but the equation always balances — this is the dual aspect principle at work.

Worked example — Meena opens a stationery shop in Darbhanga:

At every step, assets equal liabilities plus capital.

What changes capital — capital rises with fresh capital brought in and with profit (revenue above expense); it falls with drawings and with losses and expenses. So:

> closing capital = opening capital + additional capital + profit − drawings

Three kinds of effect

• ›both sides rise — buying goods on credit (stock up, creditors up)
• ›both sides fall — paying a creditor (cash down, creditors down)
• ›one asset up, another down — buying furniture for cash; the totals do not change

The trap: drawings reduce capital, not expenses — they are not a business cost, so they never appear in the profit and loss account.

Points to Remember

• ›AICPA 1941 — recording, classifying, summarising, interpreting · Luca Pacioli, 1494 — double entry, father of accounting
• ›book-keeping — recording only · accounting — also analysis and interpretation · accountancy — the whole body of knowledge
• ›internal and external users · reliability, relevance, understandability, comparability
• ›capital — a liability to the owner · drawings reduce capital
• ›assets and liabilities — non-current and current · revenue, expense, gain
• ›revenue expenditure — benefit within the year · capital expenditure — benefit over years
• ›trade discount never recorded · cash discount recorded
• ›business entity, money measurement, going concern, accounting period, historical cost, dual aspect
• ›revenue recognition — when earned · matching · full disclosure · consistency · materiality · objectivity
• ›conservatism — no anticipated profit, provide for all losses; stock at cost or market, whichever is lower
• ›cash basis vs accrual basis
• ›ICAI Accounting Standards Board 1977 · Ind AS from 2016
• ›A = L + C · Darbhanga shop — every step balances at ₹1,30,000 to ₹1,35,000
• ›closing capital = opening + additional + profit − drawings
• ›Exam tip: for any transaction in an equation question, name the two items it touches before writing a number — if you can name only one, you have missed an effect