Chapter 1 - Introduction To Accounting

Question:1

Define accounting.

Solution:

Accounting is a process of identifying the events of financial nature, recording them in Journal, classifying in their
respective ledgers, summarising them in Profit and Loss Account and Balance Sheet and communicating the
results to the users of such information, viz. owner/s, government, creditors, investors etc.

According to the American Institute of Certified Accountants, 1941, “Accounting is 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.”

Question:2

State what is end product of financial accounting?

Solution:

1. Income statements (Trading and/or Profit and Loss Account)− An income statement that includes Trading and
Profit and Loss Account, ascertains the financial results of a business in terms of gross (or net) profit or loss.

2. Balance Sheet− It depicts the true financial positions of a business that provides required information like
assets and liabilities of a business firm, to the users of accounting information like owners, creditors,
investors, government, etc.

Question:3

Enumerate main objectives of accounting.

Solution:

The main objectives of accounting are given below.

1. To keep a systematic record of all business transactions

2. To determine the profit earned or loss incurred during an accounting period by preparing profit and loss
account

3. To ascertain the financial position of the business at the end of each accounting period by preparing balance
sheet

4. To assist management for decision making, effective control, forecasting, etc.

5. To assess the progress and growth of business from year to year

6. To detect and prevent frauds and errors

7. To communicate information to various users

Question:4
Who are the users of accounting information?
Solution:
Users of accounting information are bifurcated in two categories as- Internal Users and External Users.

1. Internal Users
These are the users who are internal to an organisation. Such users have a direct access to the financial
statements of a business. Some of the internal users are given below.

i. Owners

ii. Management

iii. Employees and Workers

2. External Users
External users are those who are outsiders to an organisation and are interested in the financial affairs of the
business. These users do not have a direct access to the financial statements of the business. The following
parties come under the head of external users.

i. Banks and Financial Institutions

ii. Investors and Potential Investors

iii. Creditors

iv. Tax Authorities

v. Government

vi. Consumers

vii. Researchers

viii. Public

Question:5

State the nature of accounting information required by long-term lenders.

Solution:

Accounting information required by the long term lenders are repaying capacity of the business, profitability,
liquidity, operational efficiency, potential growth of business, etc.

Question:6

Who are the external users of information?

Solution:

External users of information are the individual or the organisations that have direct or indirect interest in the
business firm; however, are not a part of management. They do not have direct access to the internal data of the
firm and uses published data or reports like profit and loss accounts, balance sheets, annual reports, press
releases, etc. Some examples of external users are government, tax authorities, labour unions, etc.

Question:7

Enumerate informational needs of management.

Solution:
The informational needs of management are concerned with the activities given below.

1. Assists in decision making and business planning

2. Preparing reports related to funds, costs and profits to ascertain the soundness of the business

3. Comparing current financial statements with its own historical financial statements and of other similar firms to
assess the operational efficiency of the business.

Question:8

Give any three examples of revenues.

Solution:

Three examples of revenue are given below.

1. Sales revenue

2. Interest received

3. Dividends

Question:9

Distinguish between debtors and creditors; Profit and Gain.

Solution:

Difference between Debtors and Creditors is given below.

Basis of
Debtors Creditors
difference

Meaning Persons or organisations that Persons or organisations to

are liable to pay money to a whom the firm is liable to pay
firm are called debtors. money are called creditors.

Nature They have debit balance to They have credit balance to

the firm. the firm.

Payment Payments are received from Payments are made to them.

them.

Shown They are shown as assets in They are shown as liabilities in

the Balance sheet under the Balance Sheet under
Current Assets. Current Liabilities.

Difference between Profit and Gain is given below.

Gain− Gain is incidental to the business. They arise from irregular activities or non-recurring transactions; for
example, profit on sale of fixed assets, appreciation in value of asset, profit on sale of investment, etc.
Profit− This refers to the excess of revenue over the expense. It is normally categorised into gross profit or net
profit. Net profit is added to the capital of the owner, which increases the owner’s capital. For example, goods
 sold above its cost

Question:10

‘Accounting information should be comparable’. Do you agree with this statement? Give two reasons.

Solution:

Accounting information should be comparable because of the following reasons.

1. Comparable accounting information helps in inter-firm comparisons. This helps in assessing viability and
advantages of various policies adopted by different firms.

2. It also helps in intra-firm comparisons that help in determining the changes and also to ascertain the results of
various policies and plans adopted in different time periods. This also helps to figure out the errors, ascertain
growth and assist in management planning.

Question:11
What is accounting? Define its objectives.
Solution:
Accounting is a process of identifying the events of financial nature, recording them in the journal, classifying in
their respective accounts and summarising them in profit and loss account and balance sheet and communicating
results to users of such information, viz. owner, government, creditor, investors, etc.

According to American Institute of Certified Accountants, 1941, “Accounting is the 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
financial character and interpreting the results thereof.”

In 1970, American Institute of Certified Public Accountants changed the definition and stated, “The function of
accounting is to provide quantitative information, primarily financial in nature, about economic entities, that is
intended to be useful in making economic decisions.”

Objectives of Accounting:

1. Recording business transactions systematically− It is necessary to maintain systematic records of every

business transaction, as it is beyond human capacities to remember such large number of transactions.
Skipping the record of any one of the transactions may lead to erroneous and faulty results.

2. Determining profit earned or loss incurred− In order to determine the net result at the end of an accounting
period, we need to calculate profit or loss. For this purpose trading and profit and loss account are prepared. It
gives information regarding how much of goods have been purchased and sold, expenses incurred and
amount earned during a year.

3. Ascertaining financial position of the firm− Ascertaining profit earned or loss incurred is not enough; proprietor
also interested in knowing the financial position of his/her firm, i.e. the value of the assets, amount of
liabilities owed, net increase or decrease in his/her capital. This purpose is served by preparing the balance
sheet that facilitates in ascertaining the true financial position of the business.

4. Assisting management− Systematic accounting helps the management in effective decision making, efficient
control on cash management policies, preparing budget and forecasting, etc.

5. Assessing the progress of the business− Accounting helps in assessing the progress of business from year
to year, as accounting facilitates the comparison both inter-firm as well as intra-firm.

6. Detecting and preventing frauds and errors− It is necessary to detect and prevent fraud and errors,
mismanagement and wastage of the finance. Systematic recording helps in the easy detection and
rectification of frauds, errors and inefficiencies, if any.

7. Communicating accounting information to various users− The important step in the accounting process is to
communicate financial and accounting information to various users including both internal and external users
 like owners, management, government, labour, tax authorities, etc. This assists the users to understand and
interpret the accounting data in a meaningful and appropriate manner without any ambiguity.

Question:12

If the accounting information is not clearly presented, which of the qualitative characteristic of the accounting
information is violated?

Solution:

If the accounting information is not clearly presented, then the qualitative characteristics like, comparability,
reliability and understandability, are violated. This is because if the accounting information is not clearly
presented, then meaningful comparison may not be possible, as the data is not trustworthy, which may lead to
faulty conclusions.

Question:13

The role of accounting has changed over the period of time”- Do you agree?

Explain.

Solution:

The role of accounting is ever changing. While in earlier times, accounting was merely concerned with recording
the financial events, i.e. record-keeping activity; however, now-a-days, accounting is done with the rationale of not
only maintaining records, but also providing an information system that provides important and relevant information
to various accounting users. The need of this change is brought over due to the ever-changing and dynamic
business environment, which is more competitive in nature now than it was in earlier times. Further, there are
various relevant activities like decision making, forecasting, comparison, and evaluation that make these changes
in the role of accounting, inevitable.

Question:14

Giving examples, explain each of the following accounting terms:

Fixed assets

Revenue

Expenses

Short-term liability

Capital

Solution:

Fixed assets− These are held for long term and increase the profit earning capacity of the business, over
various accounting periods. These assets are not meant for sale; for example, land, building, machinery, etc.

Revenue− It refers to the amount received from day to day activities of business, viz. amount received from
sales of goods and services to customers; rent received, commission received, dividend, royalty, interest
received, etc. are items of revenue that are added to the capital.

Capital− It refers to the amount invested by the owner of a firm. It may be in form of cash or asset. It is an
obligation of the business towards the owner of the firm, since business is treated separate or distinct from the
owner.

Capital = Assets − Liabilities.

 Expenses− Expenses are those costs that are incurred to maintain the profitability of business, likerent,
wages, depreciation, interest, salaries, etc. These help in the production, business operations and generating
revenues.

Short term liabilities− Those liabilities that are incurred with an intention to be paid or are payable within a
year; for example, bank overdraft creditors, bills payable, outstanding wages, short-term loans, etc.

Question:15

Define revenues and expenses?

Solution:

Revenues− Revenues refer to the amount received from day to day activities of the business, likesale proceeds of
goods and rendering services to the customers. Rent received, commission received, royalties and interest
received are considered as revenue, as they are regular in nature and concerned with day to day activities. It is
shown in the credit side of the profit and loss account or trading account.

Expenses− Expenses refer to those costs that are incurred to earn revenue for the business. It is incurred for
maintaining profitability of the business. It indicates the amount spent to meet short-term needs of the business. It
is shown in the debit side of the profit and loss account or trading account. For example, wages, rent paid, salaries
paid, outstanding wages, etc.

Question:16

What is the primary reason for the business students and others to familiarise themselves with the accounting
discipline?

Solution:

Every monetary transaction must be recorded in such a manner that various accounting users must understand and
interpret these results in the same manner without any ambiguity. The reasons for why business students and
others should familiarise themselves with the accounting discipline are given below.

1. It helps in learning the various aspects of accounting.

2. It helps in learning how to maintain books of accounts.

3. It helps in learning how to summarise accounting information.

4. It helps in learning how to interpret the accounting information with relative accuracy.

Question:17

What is accounting? Define its objectives.

Solution:

Accounting is a process of identifying the events of financial nature, recording them in the journal, classifying in
their respective accounts and summarising them in profit and loss account and balance sheet and communicating
results to users of such information, viz. owner, government, creditor, investors, etc.

According to American Institute of Certified Accountants, 1941, “Accounting is the 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
financial character and interpreting the results thereof.”

In 1970, American Institute of Certified Public Accountants changed the definition and stated, “The function of
accounting is to provide quantitative information, primarily financial in nature, about economic entities, that is
intended to be useful in making economic decisions.”
Objectives of Accounting:

1. Recording business transactions systematically− It is necessary to maintain systematic records of every

business transaction, as it is beyond human capacities to remember such large number of transactions.
Skipping the record of any one of the transactions may lead to erroneous and faulty results.

2. Determining profit earned or loss incurred− In order to determine the net result at the end of an accounting
period, we need to calculate profit or loss. For this purpose trading and profit and loss account are prepared. It
gives information regarding how much of goods have been purchased and sold, expenses incurred and
amount earned during a year.

3. Ascertaining financial position of the firm− Ascertaining profit earned or loss incurred is not enough; proprietor
also interested in knowing the financial position of his/her firm, i.e. the value of the assets, amount of
liabilities owed, net increase or decrease in his/her capital. This purpose is served by preparing the balance
sheet that facilitates in ascertaining the true financial position of the business.

4. Assisting management− Systematic accounting helps the management in effective decision making, efficient
control on cash management policies, preparing budget and forecasting, etc.

5. Assessing the progress of the business− Accounting helps in assessing the progress of business from year
to year, as accounting facilitates the comparison both inter-firm as well as intra-firm.

6. Detecting and preventing frauds and errors− It is necessary to detect and prevent fraud and errors,
mismanagement and wastage of the finance. Systematic recording helps in the easy detection and
rectification of frauds, errors and inefficiencies, if any.

7. Communicating accounting information to various users− The important step in the accounting process is to
communicate financial and accounting information to various users including both internal and external users
like owners, management, government, labour, tax authorities, etc. This assists the users to understand and
interpret the accounting data in a meaningful and appropriate manner without any ambiguity.

Question:18

Explain the factors, which necessitated systematic accounting.

Solution:

The factors that necessitated systematic accounting are given below.

1. Only financial transactions are recorded− Those events that are financial in nature are only recorded in the
books of accounts. For example, salary of an employee is recorded in the books but his/her educational
qualification is not recorded.

2. Transactions are recorded in monetary terms− Only those transactions which can be expressed in monetary
terms are recorded in the books. For example, if a business has two buildings and four machines, then their
monetary values is recorded in the books, i.e. two buildings costing Rs 2,00,000, four machines costing Rs
8,00,000. Thus the total value of assets is Rs 10,00,000.

3. Art of recording− Transactions are recorded in the order of their occurrence.

4. Classification of transaction− Business transactions of similar nature are classified and posted under their
respective accounts. For example, all the transactions relating to machinery will be posted in the Machinery
Account.

5. Summarising of data− All business transactions are summarised in the form of Trial Balance, Trading
Account, Profit and Loss Account and Balance Sheet that provides necessary information to various users.

6. Analysing and interpreting data− Systematic accounting records enable users to analyse and interpret the
accounting data in a proper and appropriate manner. These accounting data and information are presented in
form of graphs, statements, charts that leads to easy communication and understandability by various users.
Moreover, these facilitates in decision making and future predictions.
Question:19

Describe the informational needs of external users.

Solution:

There are various external users of accounting who need accounting information for decision making, investment
planning and to assess the financial position of the business. The various external users are given below.

1. Banks and other financial institutions− Banks provide finance in form of loans and advances to various
businesses. Thus, they need information regarding liquidity, creditworthiness, solvency and profitability to
advance loans.

2. Creditors− These are those individuals and organisations to whom a business owes money on account of
credit purchases of goods and receiving services; hence, the creditors require information about credit
worthiness of the business.

3. Investors and potential investors− They invest or plan to invest in the business. Hence, in order to assess the
viability and prospectus of their investment, creditors need information about profitability and solvency of the
business.

4. Tax authorities− They need information about sales, revenues, profit and taxable income in order to determine
the levy various types of tax on the business.

5. Government− It needs information to determine national income, GDP, industrial growth, etc. The accounting
information assist the government in the formulation of various policies measures and to address various
economic problems like employment, poverty etc.

6. Researcher− Various research institutes like NGOs and other independent research institutions like CRISIL,
stock exchanges, etc. undertake various research projects and the accounting information facilitates their
research work.

7. Consumer− Every business tries to build up reputation in the eyes of consumers, which can be created by the
supply of better quality products and post-sale services at reasonable and affordable prices. Business that
has transparent financial records, assists the customers to know the correct cost of production and
accordingly assess the degree of reasonability of the price charged by the business for its products and thus
helps in repo building of the business.

8. Public− Public is keenly interested to know the proportion of the profit that the business spends on various
public welfare schemes; for example, charitable hospitals, funding schools, etc. This information is also
revealed by the profit and loss account and balance sheet of the business.

Question:20

What do you mean by an asset and what are different types of assets?

Solution:

Any valuable thing that has monetary value, which is owned by a business, is its asset. In other words, assets are
the monetary values of the properties or the legal rights that are owned by the business organisations.

Fixed Assets− These are those assets that are hold for the long term and increase the profit earning capacity and
productive capacity of the business. These assets are not meant for sale, for example, land, building machinery,
etc.

Current Assets− Assets that can be easily converted into cash or cash equivalents are termed as current assets.
These are required to run day to day business activities; for example, cash, debtors, stock, etc.

Tangible Assets− Assets that have physical existence, i.e., which can be seen and touched, are tangible assets;
for example, car, furniture, building, etc.

Intangible Assets− Assets that cannot be seen or touched, i.e. those assets that do not have physical existence,
are intangible assets; for example, goodwill, patents, trade mark, etc.

Liquid Assets− Assets that are kept either in cash or cash equivalents are regarded as liquid assets. These can be
converted into cash in a very short period of time; for example, cash, bank, bills receivable, etc.

Fictitious Assets− These are the heavy revenue expenditures, the benefit of whose can be derived in more than
one year. They represent loss or expense that are written off over a period of time, for example, if advertisement
expenditure is Rs 1,00,000 for 5 years, then each year Rs 2,00,000 will be written off.

Question:21

Explain the meaning of gain and profit. Distinguish between these two terms.

Solution:

Profit− Excess of revenue over expense is known as profit. It is normally categorised into gross profit or net profit.
It increases the owner’s capital as it is added to the capital at the end of each accounting period. For example,
goods costing Rs 1, 00,000 is sold at Rs 1,20,000, then the sale proceeds of Rs 1,20,000 is the revenue and
1,00,000 is the expense to generate this revenue. Hence, accounting profit of Rs 20,000 (i.e. Rs 1,20,000 − Rs
1,00,000) is the difference between the revenue and expense that is earned by the business.

Gain− It arises from irregular activities or non-recurring transactions. In other words, a gain is a result of
transactions that are incidental to the business, other than operating transactions. For example, an old machinery
of book value Rs 20,000 is sold at Rs 25,000. Hence, the gain is Rs 5,000 (i.e. Rs 25,000 − Rs 20,000). Here, the
sale of the old machinery is an irregular activity; so, the difference is termed as gain

Thus, in other words the only difference between profit and gain is that profit is the excess of revenue over expense
and gain arises from other than operating transactions.

Question:22

Explain the qualitative characteristics of accounting information.

Solution:

The following are the qualitative characteristics of accounting information:

1. Reliability− It means that the user can rely on the accounting information. All accounting information is
verifiable and can be verified from the source document (voucher), viz. cash memos, bills, etc. Hence, the
available information should be free from any errors and unbiased.

2. Relevance− It means that essential and appropriate information should be easily and timely available and any
irrelevant information should be avoided. The users of accounting information need relevant information for
decision making, planning and predicting the future conditions.

3. Understandability− Accounting information should be presented in such a way that every user is able to
interpret the information without any difficulty in a meaningful and appropriate manner.

4. Comparability− It is the most important quality of accounting information. Comparability means accounting
information of a current year can be comparable with that of the previous years. Comparability enables intra-
firm and inter-firm comparison. This assists in assessing the outcomes of various policies and programmes
 adopted in different time horizons by the same or different businesses. Further, it helps to ascertain the growth
and progress of the business over time and in comparison to other businesses.

Question:23

Describe the role of accounting in the modern world.

Solution:

The role of accounting has been changing over the period of time. In the modern world, the role of accounting is not
only limited to record financial transactions but also to provide a basic framework for various decision making,
providing relevant information to various users and assists in both short run and long run planning. The role of
accounting in the modern world are given below.

1. Assisting management− Management uses accounting information for short term and long term planning of
business activities, to predict the future conditions, prepare budgets and various control measures.

2. Comparative study− In the modern world, accounting information helps us to know the performance of the
business by comparing current year’s profit with that of the previous years and also with other firms in the
same industry.

3. Substitute of memory− In the modern world, every business incurs large number of transactions and it is
beyond human capability to memorise each and every transaction. Hence, it is very necessary to record
transactions in the books of accounts.

4. Information to end user− Accounting plays an important role in recording, summarising and providing relevant
and reliable information to its users, in form of financial data that helps in decision making.