2.accounting overview


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2.accounting overview

  1. 1. Chapter 2 Accounting Overview What is Accounting Function? How & Why Accounting evolved? What are the different forms of Accounting? What are the Limitations of accounting? What are the different Accounting Methods and their importance? What are the basic Principles of accounting? Why a good Accounting System is important for businesses? Why an accounting system fails? What is the accounting setup in the context of business?
  2. 2. The Accounting Function For all, who are just not aware of what’s & why’s of Accounting; Accounting is just systematic counting of business transactions. This process includes storing, sorting, retrieving, summarizing, and presenting the information. Presentation of accounting information into various Reports and further its Analysis creates an altogether different environment and supports to the management in a very efficient manner to take smart business decisions. Accounting is generally called the "language of business ", because it deals with the interpretation of a company’s operations and finances. Today much of the recording, storing, and sorting aspects of accounting have been automated as a result of the advancements in computer technology. Still the necessity of accounting knowledge and information sense is, as it is appreciated. Unless the information is used for the purpose of business decision, it is only a bundle of data and all exercise for the same is futile. Accounting vs. Book-keeping Book-keeping is just an activity of overall accountancy function, it is concerned with the recording of all economic transactions of business, following the accounting principles in set of books that arises because of the transfer of money or money's worth. Whereas accounting is a comprehensive concept which extends to classifying, summarizing, presenting and even analysing accounting information. Accounting vs. Accountancy A complete set of knowledge consisting principles, postulates, assumptions, conventions, concepts and rules governing the science of recording classifying and analysing financial transactions is accounting. Whereas the actual execution and accounting practice is termed as accountancy. However, for the sake of convenience we quite often use these words as synonyms. Background of Accounting Accounting was started since the dawn of civilization, it is the basic platform on which our modern business and economics has developed. It is well evident now, that writing was developed over 5,000 years ago by the accountants. Accounting is the most ancient profession and practice, and among the most important professions in economics and business. Accountants participated in the development of towns, trade, and the concepts of wealth and numbers. Accountants invented writing, participated in the development of money and banking, invented double entry bookkeeping that fuelled the
  3. 3. development of our monetary system, brought us from the age of barter to the age of business, hoarded many Industrial Revolutions and facilitated entrepreneurs to grow and helped in developing the confidence in capital markets, and currency system. Accounting paradigms is the centre to the information revolution that is transforming the global economy. Today, a global real-time integrated information system is a reality. Forms of Accounting Accounting information is simply the means by which we measure and communicate economic events and deal with a particular practical scenario in a business.To meet the ever increasing demands made on accounting by different interested parties (such as owners, management, creditors, taxation authorities etc.) the various branches have come into existence. We have differentiated here various forms of accounting from a user's perspective, however we can never enumerate a comprehensive list for this, because of endless people deal with the business for their own kind of interests. Still some major forms of Accounting are as follows: Financial Accounting One part of accounting focuses on presenting the information in the form of general- purpose financial statements (Balance Sheet, Profit & Loss account etc.) to ascertain the result of business operations during the particular period and to state the financial position on any certain date; for the peoples outside the organisation. These external reports are prepared in accordance with generally accepted accounting principles, Accounting Standards and as per the requirements of governing statutes or Tax laws. Such part of accounting is called financial accounting. Financial Accounting again has some intrinsic parts that are processed as accounting functions. They are Inventory Inventory is commonly used to describe the goods and materials that a business holds for the ultimate purpose of resale (or repair). The body of accounting that deals with valuing and accounting for changes in inventoried assets. Changes in value can occur for a number of reasons including depreciation, deterioration, obsolescence, change in customer taste, increased demand, and decreased market supply and so on. Pay-roll Accounting
  4. 4. In a company, payroll is the sum of all financial records of salaries for an employee, wages, bonuses and deductions. In accounting, payroll refers to the amount paid to employees for services they provided during a certain period of time. From an accounting perspective, payroll is crucial because payroll and payroll taxes considerably affect the net income of most companies and they are subject to laws and regulations. The payroll accounting ensures that all employees are paid accurately and timely with the correct Tax and other deductions, and to ensure the TDS and other deductions are deposited in a timely manner. Tax Accounting Another part of accounting involves compliance with government regulations pertaining to income tax reporting, VAT reporting or service tax reporting etc. that’s the area we call Tax Accounting. . It is most challenging aspect of tax accounting, in which accountant has to make a tax plan by anticipating the tax effects of business transactions and structuring these transactions in a manner that will minimize the income tax burden. Management Accounting Accounting also supports to the organisational management in providing with the information needed to keep the business financially healthy, to enable the management to take appropriate decisions and effect control at appropriate time. It involves the development and interpretation of accounting information in analytical manner. These analysis and reports are not distributed outside of the company. Some of the information will originate from the recorded transactions but some of the information may be estimates and projections based on various assumptions & past history of transactional trends. This area of accounting is known as management accounting. It also includes Cost Accounting The object of cost accounting is to find out the cost of goods produced or services rendered by a business. It also helps the business in managing & controlling the costs by indicating avoidable losses and wastes. Project Accounting Project Accounting refers to the use of accounting system to track the financial progress of a project through frequent financial reports. Project accounting is a vital component of project management. It is a specialized branch of accounting with a prime focus on ensuring the financial success of
  5. 5. company projects such as the launch of a new product. Project accounting can be a source of competitive advantage for project-oriented businesses such as construction firms. Government Accounting Governmental Accounting, also known as public accounting, refers to the type of accounting information system being used in the public sector or accounting for government departments. This is a slight deviation from the financial accounting system used in the private sector. The need to have a separate accounting system for the public sector arises because of the different aims and objectives of the state owned and privately owned institutions. Governmental accounting ensures the financial position and performance of the public sector institutions are set in budgetary context since financial constraints are often a major concern of many government enterprises. Forensic Accounting Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and criminal disputes that require an assessment of the financial effects of a loss or the detection of a financial fraud. Common litigations where forensic accountants are hired include insurance claims, personal injury claims, suspected fraud and claims of professional negligence in a financial matter (e.g. business valuation). Social Accounting Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability Accounting, refers to the process of reporting implications of an organization's activities on its ecological and social environment. Social Accounting is primarily reported in the form of Environmental Reports accompanying the annual reports of companies. Social Accounting is still in the early stages of development and is considered to be a response to the growing environmental consciousness amongst the public at large. Fiduciary Accounting Fiduciary accounting lies in the notion of trust. This type of accounting is done by a trustee, administrator, executor, or anyone in a position of trust. His work is to keep the records and prepares the reports. This may be authorized by or under the jurisdiction of a court of law. The fiduciary accountant should seek out and control all property subject to the estate or trust. The concept of proprietorship that is common
  6. 6. in the usual types of accounting is non-existent or greatly modified in fiduciary accounting. Personal Accounting Accounting of all financial activities of an individual, this could include budgeting, insurance, savings, investing, debt servicing, mortgages and more. Financial planning & decisions of an individual generally involves analysing their current financial position and predicting short-term and long-term needs. Personal Accounting would also include monitoring spending, budgeting for an emergency fund, and paying down debt etc. Personal Accounting looks at how their money and future is managed. Importance of Accounting Accounting can help business owners & managers to make smart decisions through the careful analysis of financial information relating to current operations and new business opportunities. Several types of accounting tools are available for business owners to analyse and assess the strength of their company’s operations. Limitations of Accounting Financial Accounting although necessary for managing & controlling the business but it consists of some fundamental limitations. That’s why it becomes virtually unavailable for the management purposes. To overcome such scenarios we have to implement such controls so as to make it useful for the management and here the role of management accounting arises. Alternative Treatments Financial accounting permits alternative treatments. Accounting is based on concepts and it follows “generally accepted principles" but there exist more than one principle for the treatment of any one item. This permits alternative treatments within the framework of generally accepted principles. For example, the closing stock of a business may be valued by anyone of the following methods: FIFO (First-in- First- out), LIFO (Last-in-First-out), Average Price, Standard Price etc., but the results are not comparable. Untimely reporting Financial accounting does not provide timely information. Financial accounting is designed to supply information in the form of statements (Balance Sheet and Profit and Loss Account) for a period normally one year. So the information is, at best, of historical interest and only 'post-mortem' analysis of the past can be conducted. The business requires timely information at frequent intervals to enable the management to plan and take corrective action.
  7. 7. Personal Judgements Financial accounting is influenced by personal judgments. Although the 'Convention of objectivity' is respected in accounting but to record certain events estimates have to be made which requires personal judgment. It is very difficult to expect accuracy in future estimates and objectivity suffers. For example, in order to determine the amount of depreciation to be charged every year for the use of fixed asset. In some cases it is required estimation and the income disclosed by accounting is not authoritative but 'approximation'. Ignorance of important non-monetary information Financial accounting does not consider those transactions of non- monetary in nature. For example, extent of competition faced by the business, technical innovations possessed by the business, loyalty and efficiency of the employees; changes in the value of money etc. are the important matters in which management of the business is highly interested but accounting is not tailored to take note of such matters. Thus any user of financial information is, naturally, deprived of vital information which is of non-monetary character. Doesn’t provide analysis The information supplied by the financial accounting is in reality aggregates of the financial transactions during the course of the year. Of course, it enables to study the overall results of the business the information is required regarding the cost, revenue and profit of each product but financial accounting does not provide such detailed information product- wise. Doesn’t discloses the present value In financial accounting the position of the business as on a particular date is shown by a statement known as 'Balance Sheet'. In Balance Sheet the assets are shown on the basis of "Continuing Entity Concept. Thus it is presumed that business has relatively longer life and will continue to exist indefinitely, hence the asset values are 'going concern values.' The 'realized value' of each asset if sold to-day can't be known by studying the balance sheet. Accounting Methods Officially, there are two types of accounting methods, which dictate how the company's transactions will be recorded in the company's financial books: Cash-basis accounting and Accrual accounting
  8. 8. The key difference between the two types is how the company records cash coming into and going out of the business. Within that simple difference lies a lot of room for error or manipulation. In fact, many of the major companies involved in financial scandals have gotten in trouble because they played games with the nuts and bolts of their accounting method. Cash-basis accounting In cash-basis accounting, companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands or, more likely, in a bank account. In cash-basis accounting, cash earnings include cheques, credit-card receipts, or any other form of revenue from customers. Smaller companies/ professionals & some sole proprietor retailers use cash-basis accounting because the system is easier for them to use on their own, meaning they don't have to hire a proper accounting staff. Accrual accounting If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. That is, the company records revenue when it earns it, even if the customer hasn't paid yet. Expenses are also handled in the same way. The company records any expenses when they're incurred, even if it hasn't paid for the supplies yet. All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP). Why method matters The accounting method a business uses can have a major impact on the total revenue the business reports as well as on the expenses that it subtracts from the revenue to get the bottom line or say their profits. Here's how: Cash-basis accounting: Expenses and revenues aren't carefully matched on a month-to-month basis. Expenses aren't recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren't recognized until the cash is actually received. However, cash- basis accounting excels in tracking the actual cash available. Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it's spending to operate each month and how much profit it is making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn't paid out until the next month. Revenues are recorded in the month the project is complete
  9. 9. or the product is shipped, even if the company hasn't yet received the cash from the customer. Accounting Concept and Principles Accounting Concepts and Principles are a set of broad conventions that have been devised to provide a basic framework for financial reporting. As financial reporting involves significant professional judgments by accountants, these concepts and principles ensure that the users of financial information are not mislead by the adoption of accounting policies and practices that go against the spirit of the accountancy profession. Accountants must actively consider whether the accounting treatments adopted are consistent with the accounting concepts and principles. Following is a list of the major accounting concepts and principles: Relevance Financial accounting information should be such that the users need it and it is expected to affect their decisions. Reliability The information should be accurate and must give out a true and fair view. Matching Concept In order to reach accurate net income figure, the expenses incurred to earn the revenues recognized during the accounting period should be recognized in the same time period Time Period Concept Although businesses intend to continue in long-term, it is always necessary to account for their performance and position based on certain time periods. Neutrality Accounting Information should be unbiased in nature and presented with full integrity. Faithful Representation Information presented in the financial statements should faithfully represent the transaction and events that occurred during a period. Prudence Accounting transactions and other events are sometimes uncertain but we have to report them. To make estimates requiring judgment to counter the uncertainty we always provide for losses but not income.
  10. 10. Completeness Complete financial information relevant to the business and financial decision making needs of the users, should be provided. Therefore, information must be complete in all material respects. Money Measurement Concept In accounting we can communicate only those business transactions and other events which can be expressed in monetary units. Comparability Accounting information is comparable when accounting standards and policies are applied consistently from one period to another and from one region to another. Consistency Concept The concept of consistency means that accounting methods once adopted must be applied consistently in future. Understandability Information presented in financial reports to be concise, complete and clear in presentation. The information should be presented so as to facilitate the user of the information. Materiality Financial statements are prepared to help the users with their decisions. Hence, all such information which has the ability to affect the decisions of the users of financial statements is material and this property of information is called materiality. Going Concern Financial statements are prepared assuming that the company intends to continue its business and is able to do so for an unseen future. Accruals Business transactions are recorded when they occur and not when the related payments are received or made. Business Entity
  11. 11. In accounting we treat a business or an organization and its owners as two separately identifiable parties. Substance over Form While accounting for business transactions and other events, we measure and report the economic impact of an event instead of its legal form. Revenue Recognition Concept Revenue is to be recognized only when the rewards and benefits associated with the items sold or service provided is transferred, where the amount can be estimated with reliability and when the amount is recoverable. Duality aspect Concept Each economic transaction in the business has two aspects & both transaction are accounted for in the financial statements. Timeliness concept Need for accounting information to be presented to the users in time to fulfil their decision making needs. Full Disclosure Concept All material information has to be disclosed in the financial statements either on the face of the financial statements or in the notes to the financial statements. Historical Cost Concept Accounting is concerned with past events and it requires consistency and comparability that is why it requires the accounting transactions to be recorded at their historical costs. In case where application of one accounting concept or principle leads to a conflict with another accounting concept or principle, accountants must consider what is best for the users of the financial information. An example of such a case would be the trade-off between relevance and reliability. Information is more relevant if it is disclosed timely. However, it may take more time to gather reliable information. Whether reliability of information may be compromised to ensure relevance of information is a matter of judgment that ought to be considered in the interest of the users of the financial information. Accounting System
  12. 12. The key is having an accounting system that adequately supports the critical areas of your company. Capture information at a level of detail that supports management decision-making. Define what five key metrics are critical to the organisational success and track them daily. Accounting systems capture information that can lead to more profit. The biggest mistakes are made when organizations don’t embrace the importance of timely and meaningful reporting to make informed decisions. It is the matter of greater importance to maintain accounting information in a way that gives management a clear picture of how different aspects of the company are doing. Accounting Information Accounting information can show trends that provide insight into efforts the company should focus on or de-emphasize, particularly if systems are aligned with your strategy or key growth areas. Today, companies are more focused on information that helps them better predict the future rather than understand the past, as has traditionally been the case. Reasons for failure of Accounting System Every organization has its own particular financial policies, processes and procedures, smaller organizations can be particularly challenged keeping up with “Businesses go through the exercise of keeping accounting information, but they don‟t give it sufficient review. It‟s always healthy to ask, „Where did this number come from & what does it say?” "In the past, man was first. In the future, the system will be first." -Frederick Winslow Taylor
  13. 13. industry best practices since they lack the resources of larger organizations. Here are some common pitfalls in accounting system that make the whole efforts on accounting as an ineffective system. Low Level of Technical Accounting Knowledge One area where we see companies struggling is technical accounting knowledge. Most organizations can handle basic transactions, but a smaller team is more likely to lack the in-house expertise to handle complicated accounting techniques. Some major areas where we routinely see a knowledge and technical know-how gap include revenue recognition, equity accounting and inventory accounting. Inadequate Cash Forecasting Tools Another area where many organizations routinely struggle is cash forecasting. Cash forecasting, or cash flow management, allows organizations to predict future levels of liquidity. Organizations may not have a consistent, steady level of revenues or expenses, so predicting future cash flows and making decisions without insight into future cash availability can be a challenge. Organizations should continually revisit and readjust their forecasts throughout the year; we recommend weekly for organizations where cash is tight and no more than monthly where cash shortfalls are not an issue. All forecasts are based on knowing the normal rhythm of the organization and anticipating when events should happen. This all starts with good budgeting and continually updating as new knowledge is gained. Not Instituting Proper Internal Controls A third issue that is regularly seen is a lack of internal controls. Adequate internal controls require segregation of duties, documentation of procedures and proper analysis of accounts and financial reports. A small team typically makes it hard for an organization to have the personnel required for proper segregation of duties, and a lean team usually lacks the bandwidth needed to accurately analyse accounts and reports. The most common problem with smaller organizations is when too much control resides in just one person and the same individual is tasked with preparing vendor cheques, getting signed those cheques, making deposits and reconciling the checking account. These duties must be segregated, even if that means having someone outside the accounting department performing them. Poorly Implemented or outdated Accounting Systems It starts with the chart of accounts and ends with financial reports. It is very difficult to get good quality financial statements in a meaningful format if the chart of accounts is not properly designed and structured to reflect the true operations of the
  14. 14. organization. However, even if the chart of accounts and financial reports are structured properly initially, most organizations change over time and the financial reporting needs to change with it. The primary reason for poorly structured or poorly implemented accounting systems is an inexperienced internal financial management team. The team may have not done it before and the organization may suffer for that lack of experience. Most organizations also need to periodically upgrade their systems, a piece of the process that often gets delayed in favour of other projects. Not upgrading an accounting system when an upgrade is needed can open up an organization to a variety of risks, including bugs, security issues and changes in regulatory rules. Not Fully Utilising an Accounting System Poor utilization of an accounting system is often related to lack of training. Accounting systems are designed to record every business transaction, and when used correctly, they can generate important strategic reports that help management make important decisions. However, when the accounting system is inadequately utilized, staff tend to use work-around. They will create manual processes to get the work done. The usual tipoff is that staff rely heavily on Excel spreadsheets rather than the system for reporting. Perhaps the chart of accounts isn’t correctly set up or users aren’t entering all the necessary information – it becomes more tedious or even impossible to generate reports with any meaningful information. Poor utilization of automated accounting systems typically leads to manually generated reports, yet another example of less-than-ideal internal controls. Too Many Systems – No Strategic Plan for Infrastructure As organizations grow they tend to make decisions to purchase new software based on the problem of the day rather than thinking about the whole infrastructure. We often see organizations employ multiple systems that do not speak to one another, which creates road blocks for good communication and reporting. When too many systems are used, the organization needs to bridge the gaps with manual processes. This causes errors and, of course, a lot of extra work. Often accounting managers that are caught in this trap are constantly falling behind. When information is requested, they have to do a lot of extra work. If an integrated systems infrastructure had been developed up-front, fewer manual processes would be necessary. Not Training Your Accounting Staff The roles of senior accountants, treasurers, and controllers have changed significantly in the past decade. With new business regulations and more complicated systems, accounting employees need a higher level of training just to stay up-to-date. Many organizations are not significantly investing in training for their
  15. 15. accounting and finance team. This ultimately hurts not only the employees, whose skills stagnate, but impacts the business itself. While the above list is by no means all-inclusive, these 7 sins are the most common problems that isoften seen. Overall, many of the problems that organizations continually encounter can be prevented with the right expertise and a proper distribution of resources. Not every finance and accounting team is going to have all the answers, but knowing when to get help is always a good first step. Accounting Setup The basic purpose of the accounting setup is to meet the organization's needs for accounting information as efficiently as possible and keeping it statutorily compliant in all possible manners along with supporting the management in keeping them well informed for their day to day decision making needs. It consists of Personnel, Procedures, Devices, and Records used by an organization. Therefore the basic functions of an efficient accounting setup includes: Collecting all transactional documents in house & externally Processing all such information & documents Interpreting & recording the effects of all business transactions Classifying records as prescribed by accounting procedures Dealing with all third parties to business in financial matters Keeping the organization statutorily compliant Projecting & preparing financial status of organization Keeping track & support rotation of cash flow cycle of the organization To develop accounting information, To communicate this information to decision makers etc. The design and capabilities of this setup varies widely from organization to organization according to The Company’s needs for accounting information, company's size, nature etc., the resources available for operation of the system, the management philosophy, Some information required by law e.g.: Income Tax, SEC etc. Accounting setup should always be cost-effective & result oriented. It is the only criterion for producing business information and measure the performance of the organisation. To develop an efficient accounting setup you need to consult with experts in management, information systems, and marketing and computer programmers with the supervision of a qualified accountants, depending upon your need and cost involved.