Accounting is the systematic process of recording, organizing, and analyzing business transactions. It evolved over 5,000 years as a way to record economic activities and facilitate trade. There are different forms of accounting based on the intended users, including financial accounting for external reporting, management accounting for internal decision making, tax accounting for tax compliance, and other specialized types. Maintaining accurate accounting records and systems is important for the effective operation and management of a business.

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.