FOUNDATION PROGRAMME FUNDAMENTALS OF ACCOUNTING AND AUDITING

ent of capital and revenue items etc. Hence, due to
the lack of objectivity income arrived at may not be correct in certain cases.
(iv) Fixed assets are recorded at the original cost: The values of fixed assets change over time and so
there may be a great difference between the original cost and current replacement cost. Balance sheet
may not show true and fair view of the financial position on a particular date.
(v) Accounting can be manipulated: Accounting information may not be used as the only test of
managerial performance as profits can be manipulated or misrepresented.
(vi) Money as a measurement unit changes in value: The value of money does not remain stable. Unless
price level changes are considered in measurement of income, the accounting information will not
show true financial results.
REVIEW QUESTIONS
BOOK-KEEPING
Book-keeping is mainly concerned with recording of financial data relating to the business operations in a
significant and orderly manner. It is concerned with the permanent record of all transactions in a systematic
manner to show its financial effect on the business. It covers procedural aspects of accounting work and
includes record keeping function. It is the science and art of correctly recording in books of account all those
business transactions that result in the transfer of money or money’s worth. It is mechanical and repetitive.
This work of book–keeping is of clerical nature and usually entrusted to junior employees of accounts section
of a business house. Now-a-days, most of the book-keeping work is done through computers and other
electronic devices. In fact, accounting is based on a systematic and efficient book-keeping system. The main
purpose behind book-keeping is to show correct position regarding each head of income and expenditure as
well as assets and liabilities. Further, book-keeping is meant to show the effect of all the transactions made
during the accounting period on the financial position of the business.
Book-Keeping and Accounting
Book-keeping and accounting are often used interchangeably but they are different from each other.
Accounting is a broader and more analytical subject. It includes the design of accounting systems which the
book-keepers use, preparation of financial statements, audits, cost studies, income-tax work and analysis and
interpretation of accounting information for internal and external end-users as an aid to making business
1. Accounting records only those transactions and events which are of
__________character.
2. ____________ is concerned with record-keeping directed towards the
preparation of trial balance, profit and loss account and balance sheet.
3. The main functions of cost accounting are to ascertain the
_____________of a product and to help the management in the
______________________.
4. Fixed assets are recorded at _______________ cost.
5. Accounting information is expressed in terms of ___________.6 FP-FA&A
decisions. This work requires more skill, experience and imagination. The larger the firm, the greater is the
responsibility of the accountant. It can be said that accounting begins where book-keeping ends. Bookkeeping provides the basis for accounting.
The following are the points of distinction between book-keeping and accounting:
DIFFERNCE BETWEEN BOOK-KEEPING AND ACCOUNTING
SYSTEMS OF ACCOUNTING
Basically there are two systems of accounting:
Cash System of Accounting: It is a system in which accounting entries are made only when cash is received or
paid. No entry is made when a payment or receipt is merely due. In other words, it is a system of accounting in
which revenues and costs and assets and liabilities are reflected in the accounts in the period in which actual
payments or actual receipts are made in cash. It may not treat any revenue to have been earned or even sales to
have taken place unless cash is actually paid by customers. It has no relevance whether the receipts pertain to
previous period or future period. Similarly, expenses are restricted to the actual payments in cash during the
current year and it is immaterial whether the payments have been made for previous period or future period.
Cash basis of accounting is incompatible with the matching principle of income determination. Hence, the
financial statements prepared under this system do not present a true and fair view of operating results and
financial position of the organization. However, cash system of accounting is suitable in the following cases:
(i) Where the organization is very small or in the case of individuals, where it is difficult to allocate small
amounts between accounting periods; and
(ii) Where credit transactions are almost negligible and collections are uncertain e.g. accounting in case of
professionals i.e. doctors, lawyers, firms of chartered accountants/company secretaries. But while
recording expenses, they take into account the outstanding expenses also. In such a case, the
financial statement prepared by them for determination of their income is termed as Receipts and
Expenditure Account.
Accrual System of Accounting: This is also known as mercantile system of accounting. It is a system in
which transactions are recorded on the basis of amounts having become due for payment or receipt. Accrual
basis of accounting attempts to record the financial effects of the transactions, events, and circumstances of
an enterprise in the period in which they occur rather than recording them in period(s) in which cash is
Book-keeping Accounting
(i) It is concerned with the recording of
transactions.
(i) It is concerned with the summarizing of the
recorded transactions.
(ii) The work of book-keeping is mainly routine
and clerical in nature and is increasingly being
done by computers.
(ii) The work of accountant requires higher
level of knowledge, conceptual
understanding and analytical skill.
(iii) Book-keeping constitutes the base for
accounting.
(iii) Accounting starts where book keeping
ends.
(iv) Book-keeping is done in accordance with
basic accounting concepts and conventions.
(iv) The methods and procedures for
accounting for analysis and interpretations
for financial reports may vary from firm to
firm.
(v) Financial statements do not form part of bookkeeping.
(v) Financial statements are prepared in
accounting process from the book-keeping
records.
(vi) Financial position of the business cannot be
ascertained through book-keeping records.
(vi) Financial position of the business is
ascertained on the basis of accounting
reports.Lesson 1  Theoretical Framework 7
received or paid by the enterprise. It recognizes that the buying, selling and other economic events that affect
enterprise’s performance often do not coincide with the cash receipts and payments of the period. The
purpose of accrual basis accounting is to relate the revenue earned to cost incurred so that reported net
income measures an enterprise’s performance during a period instead of merely listing its cash receipts and
payments. Accrual basis of accounting recognizes assets, liabilities or components of revenues and expenses
received or paid in cash in past and expected to be received or paid in cash in the future. The following are
the essential features of accrual basis:
– Revenue is recognized as it is earned irrespective of whether cash is received or not;
– Costs are matched against revenues on the basis of relevant time period to determine periodic
income, and
– Costs which are not charged to income are carried forward and are kept under continuous review. Any
cost that appears to have lost its utility or its power to generate future revenue is written off as a loss.
ACCOUNTING AS INFORMATION SYSTEM
Accounting, being the language of business, is used to communicate financial and other information to
individuals, organizations, governments etc. about various aspects of business and non-business entities. For
example, when a firm applies for a loan from a bank, it will have to submit details of its business activities in
terms of operating results (profit or loss) and the financial position (assets and liabilities). Similarly, the
shareholders or prospective investors must have financial information in order to evaluate the performance of
the management. Many laws require that extensive financial information be reported to various government
departments such as income-tax department, sales tax department, company law board and so on. Accounting
is a discipline that collects reports and interprets financial information about the activities of different
organizations. Hence, actual accounting is concerned with communicating the results of an organization.
Users of Accounting Information
Accounting is of primary importance to the proprietors and the managers. However, other persons such as
creditors, prospective investors, etc. are also interested in the accounting information.
(i) Owners/Shareholders: The primary aim of accounting is to provide necessary information to the
owners related to their business.
(ii) Managers: In large business organizations and in corporations, there is a separation of ownership and
management functions. The managers of such business houses are more concerned with the
accounting information because they are answerable to the owners.
(iii) Prospective Investors: The persons who are contemplating an investment in a business will like to
know about its profitability and financial position. They derive this information from the accounting
reports of the concern.
(iv) Creditors, Bankers and other Lending Institutions: Trade creditors, bankers and other lending
institutions would like to be satisfied that they will be paid on time. The financial statements help them
in judging such position. Banks and other lending agencies rely heavily upon accounting statements
for determining the acceptability of a loan application.
(v) Government: The Government is interested in the financial statements of business enterprise on
account of taxation, labor and corporate laws.
(vi) Employees: Employees are interested in financial statements because increase in their salaries and
wages and payment of bonus depends on the size of the profit earned.
(vii) Regulatory Agencies: Various Government departments and agencies such as Company Law Board,
Registrar of Companies, Tax Authorities etc. use accounting reports not only as a basis for tax assessment
but also in evaluating how well various businesses are operating under regulatory legislation.
(viii) Researchers: Accounting data are also used by the research scholars in their research in accounting
theory as well as business affairs and practices.
(ix) Customers: Customers may also have either short-term or long-term interest in the business entity to
know the profitability, liquidity and solvency position of the company.8 FP-FA&A
Characteristics of Accounting Information
The various characteristics of accounting information are as follows:
(i) Relevance: The information should be relevant in order to influence the economic decisions of users
by helping them to evaluate the events at all times. Accounting information has a bearing on decision
making by helping investors, creditors and other users to evaluate past and future events. It confirms
or corrects prior expectations. The relevance of information is affected by its nature and materiality.
(ii) Reliability: Reliability relates to the confidence in the accounting information in the sense that the
information must faithfully represent what it intends to present; it must be factual. Information should
be free from material errors and bias. The key aspects of reliability are faithful representation,
substance over form, neutrality, prudence and completeness.
(iii) Comparability: Accounting information of an enterprise is useful when it is comparable with similar
information for the same enterprise in other periods of time and similar information regarding other
enterprises at the same time. Thus, the information should be presented in a consistent manner over
time and consistent between entities to evolve users to make significant comparisons.
(iv) Understandability: Information should be readily understandable by users who are expected to have a
reasonable knowledge of business, economics and accounting and a willingness to study the
information with reasonable diligence.
(v) Timeliness: The more quickly the information is communicated or provided to the users, the more likely
it is to influence their decisions. Hence, for prompt decision-making accounting information should be
made available at appropriate time without delays.
(vi) Cost-benefit: The accounting information must be useful to most of the people who want to use it and
preparation of that useful information must not be a costly and time consuming process. The emphasis
is on cost-benefit consideration and the benefit derived from information should normally exceed the
cost of providing it.
(vii) Verifiability: Verifiability ensures the truthfulness of the recorded transactions, which can be checked
by persons other than the accountant himself.
(viii) Neutrality: Accounting information is neutral in the sense that it should be free from bias and it should
not favour one group over another. Neutrality is significant especially for the external users of
accounting information.
(ix) Completeness: Completeness means that all material information that is necessary to investors,
creditors or other users for assessing the financial position and operating results of the organization
has been disclosed in the financial statements.
ROLE OF ACCOUNTANT
The role of accountant may be summarized as under:
(i) Maintenance of Books of Accounts: The primary role of an accountant is to offer his services for
maintaining systematic records of financial transactions in order to ascertain the net profit or loss for
the accounting period and the financial position as on a particular date.
(ii) Statutory Audit: Every limited company is required to appoint a chartered accountant as an auditor
who is statutorily required to report each year whether the financial statements have been prepared in
accordance with the generally accepted accounting principles, accounting standards and legal
requirements and that they show a true and fair view of the financial position and profit and loss.
(iii) Internal Audit: In addition to statutory audit, a big company employs its own staff to conduct internal
audit to ensure that the transactions are recorded, classified and summarized in accordance with the
established accounting procedures to ensure that instructions of the management are being followed
throughout the company.
(iv) Budgeting: Budgeting means the planning of business activities before they occur. On completion of
the actual activities for a given period, the planned activities are compared with the actual activities to
find out the variation, if any.Lesson 1  Theoretical Framework 9
(v) Taxation: An accountant can handle the taxation matters of a business and can represent before the
tax authorities and settle the tax liability under the prevailing statute. He also assists in reducing the
tax burden by proper tax planning.
(vi) Investigation: Accountants are often called upon to carry out investigation to ascertain the financial
position of the business for the information of interested parties.
(vii) Management Advisory Service: An accountant is largely responsible for internal reporting to the
management for planning, controlling, decision-making on matters for long-term plans. He provides
management consultancy services in the areas of management information systems, expenditure
control and evaluation of appraisal techniques.
(viii) Other Activities: Accountants among many other duties perform duties of arbitrator registrars for
settling of disputes, liquidators, cost accountants, etc.
ACCOUNTING PRINCIPLES, CONCEPTS AND CONVENTIONS
Accounting Principles
Accounting is often called the language of business through which a business house communicates with the
outside world. In order to make this language intelligible and commonly understood by all, it is necessary that
it should be based on certain uniform scientifically laid down standards. These standards are termed as
accounting principles.
Accounting principles have been defined as “the body of doctrines commonly associated with the theory and
procedure of accounting, serving as an explanation of current practices and as a guide for the selection of
conventions or procedures where alternatives exist”.
In short, accounting principles are guidelines to establish standards for sound accounting practices and
procedures in reporting the financial status and periodic performance of a business. These principles can be
classified into two categories (i) Accounting concepts; and (ii) Accounting conventions.
Accounting Concepts
Accounting concepts are defined as basic assumptions on the basis of which financial statements of a
business entity are prepared. They are used as a foundation for formulating various methods and procedures
for recording and presenting the business transactions. The important accounting concepts are given
below:
(i) Business Entity Concept: According to this concept, business is treated as an entity separate from its
owners. It is treated to have a distinct accounting entity which controls the resources of the concern and is
accountable thereof. Accounts are kept for a business entity as distinguished from the person(s) owning it. All
transactions of the business are recorded in the books of the business from the point of view of the business.
Transactions are also recorded between the owner and the business, for instance, when capital is provided
by the owner, the accounting record will show the business as having received so much money and as
owing to the proprietor. This concept is based on the sense that proprietors entrust resources to the
management and the management is expected to use these resources to the best advantage of the firm and
to account for the resources placed at its disposal. Hence, in accounting for every type of business
organization, be it sole tradership or partnership or joint stock company, business is treated as a separate
accounting entity.
The failure to recognize the business as a separate accounting entity would make it extremely difficult to
evaluate the performance of the business since the private transactions would get mixed with business
transaction. The overall effect of adopting this concept is:
– Only the business transactions are recorded and reported and not the personal transactions of the
owners.
– Income or profit is the property of the business unless distributed among the owners.
– The personal assets of the owners or shareholders are not considered while recording and reporting
the assets of the business entity.
(ii) Money Measurement Concept: Money measurement concept holds that accounting is a measurement10 FP-FA&A
and communication process of the activities of the firm that are measurable in monetary terms. Thus, only
such transactions and events which can be interpreted in terms of money are recorded. Events which cannot
be expressed in money terms do not find place in the books of account though they may be very important for
the business. Non-monetary events like, death, dispute, sentiments, efficiency etc. are not recorded in the
books, even though these may have a great effect. Accounting therefore, does not give a complete account of
the happenings in a business or an accurate picture of the conditions of the business. Thus, accounting
information is essentially in monetary terms and quantified.
The system of accounting treats all units of money as the same irrespective of their time dimension. This has
created doubts about the utility of the accounting data, leading to the introduction of inflation accounting.
(iii) Cost Concept: According to cost concept, the various assets acquired by a concern or firm should be
recorded on the basis of the actual amounts involved or spent. This amount or cost will be the basis for all
subsequent accounting for the assets. The cost concept does not mean that the assets will always be shown
at cost. The fixed asset will be recorded at cost at the time of its purchase but it may systematically be
reduced in its value by charging depreciation. These assets ultimately disappear from the balance sheet when
their economic life is over and they have been fully depreciated and sold as scrap. It may be noted that if
nothing has been paid for acquiring something, it would not be shown in the accounting books as an asset.
Cost concept is not much relevant for investors and other users because they are more interested in knowing
what the business is actually worth today rather than the original cost.
(iv) Going Concern Concept: Business transactions are recorded on the assumption that the business
will continue for a long-time. There is neither the intention nor the necessity to liquidate the particular
business venture in the foreseeable future. Therefore, it would be able to meet its contractual obligations
and use its resources according to the plans and pre-determined goals. It is on this concept that a
clear distinction is made between assets and expenses. Transactions are recorded in such a manner that the
benefits likely to accrue in future from money spent now or the future consequences of the events occurring now
are also taken into consideration. It is because of this concept that fixed assets are valued on the basis of cost
less proper depreciation keeping in mind their expected useful life ignoring fluctuations in the prices of these
assets.
However, if it is certain that a business will continue for a limited period, then the accounting records will be
kept on the basis of expected life of the business and there will be no need for such detailed accounting
information as to revenue and capital expenditure.
When an enterprise liquidates a branch or one segment of its operations, the ability of the enterprise to
continue as a going concern is not impaired. But the enterprise will not be considered as a going concern if it
goes into liquidation or it has become insolvent. If the assumption of the going concern is not valid, the
financial statements should clearly state this fact.
(v) Dual Aspect Concept: This concept is based on double entry book-keeping which means that accounting
system is set up in such a way that a record is made of the two aspects of each transaction that affects the
records. The recognition of the two aspects to every transaction is known as dual aspect concept. Modern
financial accounting is based on dual aspect concept. One entry consists of debit to one or more accounts
and another entry consists of credit to some other one or more accounts. However, the total amount debited
is always equal to the total amount credited. Therefore, at any point of time total assets of a business are
equal to its total liabilities. Liabilities to outsiders are known as liabilities, but a liability to owners is referred to
as capital. Thus, this concept expresses the relationship that exists among assets, liabilities and the capital in
the form of an accounting equation which is as follows:
Assets = Liabilities + Capital, or
Capital = Assets – Liabilities
Since accounting system requires recording of the two aspects of each transaction, this concept shows the
effect of each transaction on them. Assets and liabilities are two independent variables and capital is the
dependent variable, for it is the difference between assets and liabilities. Any change in any one of these
three, must lead to a change in any of the other two.
(vi) Realisation Concept: According to this concept revenue is recognised only when a sale is made. Unless
money has been realised i.e., cash has been received or a legal obligation to pay has been assumed by the
customer, no sale can be said to have taken place and no profit can be said to have arisen. It preventsLesson 1  Theoretical Framework 11
business firms from inflating their profits by recording incomes that are likely to accrue i.e. expected incomes
or gains are not recorded.
(vii) Accrual Concept: Every transaction and event affects, one or more or all the three aspects viz., assets,
liabilities and capital. Normally all transactions are settled in cash but even if cash settlement has not taken
place, it is proper to record the transaction or the event concerned into the books. This concept implies that
the income should be measured as a difference between revenues and expenses rather than the difference
between cash received and disbursements. Business transactions are recorded when they occur and not
when the related payments are received or made. This concept is called accrual basis of accounting and it is
fundamental to the usefulness of financial accounting information.
It is not necessary that there is an immediate settlement in cash for any transaction or event therefore
accrued revenues and costs are recognized as they are earned and incurred and recorded in the financial
statements of the period. On the basis of this concept, adjustment entries relating to outstanding and prepaid
expenses and income received in advance etc. are made. They have their impact on the profit and loss
account and the balance sheet.
(viii) Accounting Period Concept: It is customary that the life of the business is divided into appropriate
parts or segments for analyzing the results shown by the business. Each part or segment so divided is known
as an accounting period. It is an interval of time at the end of which the income or revenue statement and
balance sheet are prepared in order to show the results of operations and changes in the resources which
have occurred since the previous statements have been prepared. Normally, the accounting period consists
of twelve months.
(ix) Revenue Match Concept: This concept is based on accounting period concept. In order to determine the