Accounting Discipline: Easy Conceptual Summary

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Accounting or Accountancy is a much dreaded discipline for those who do not understand. However it becomes easier once the conceptual bases becomes clear. This is not really a simple task, as there are a lot of variables involved in full blown accountancy. This essay will attempt to give a conceptual summary of the discipline, with a view to make the subject more understandable for those who do not know or know it only fleetingly.

Table of Contents

• Accounting is not Arithmetic
• Regulatory Framework
• Accounting and Double Entry System
• Final Accounts
• Presentation
• Accounting, Finance, Treasury, Control

Accounting is not Arithmetic

The basic misconception about accountancy is that it is mathematics, more specifically that it is like arithmetic. This is simply a gross misconception. It is true that for simple accounting, the only mathematics one needs to know is addition, subtraction, division, and multiplication. However, this is only half the truth.

Accounting can be understood as a huge data processing system that was developed at the time when electronic data processors had not come about. Accounting system can handle huge financial data in an organised and systemetic manner. It is therefore much more than mere arithmetic.

There are also other important elements of accounting discipline, without which the plain vanilla version of accounting wont be of much use. Accounting / Accountancy is about presentation. It is about making the figures speak for themselves. This involves the concepts of Disclosure and True and Fair. When we speak about accounting, it is not just made up figures – they are real and involves money. This money can be an individuals money and / or money collected from others as in case of shareholders or debentureholders or loans from banks. It can even be plans of the enterprise, to attract investment for its future expansion plans by floating bonds in the market.

Regulatory Framework

Accounting is not merely principle driven discipline, but is largely driven by legal requirements, various legislations and accounting standards.

The regulators can be (as in India) SEBI (Stock Exchange Board of India) for the Listed Companies (similar to SEC of USA), RBI (Reserve Bank of India) for the banks, IRDA (Insurance Regulatory and Development Authority) for the Insurance companies etc.

There are various issues at stake. For example, payment of taxes and duties to the government. These are governeed by legislations like the Income Tax Act, the Customs / Central Excise Act etc. Then there are tax regulations like the Central Sales Tax, State Sales Tax, Value Added Tax etc.

There are other issues like payment of salaries and wages to the employees. These involves compliance to various other legislations like Payment of Bonus Act, Employees Provident Fund Act etc.

And for the purpose of accounting, the mother of all Acts – the Companies Act. Every year the final accounts have to be got audited and filed by the business entity with the Registrar of Companies. All the company form of business entity (ie. Ltd. and UnLtd. variety of businees organisations), whether privately held or publicly held, are goverened by the Companies Act.

For other different forms of business entities there are different legislations or Acts requiring presentation of accounts eg. Cooperative Society, Partnership Firms etc.

So when we speak about accounting, we must keep in mind that it is not just arithmetic, but there are greater stakes involved and governed by requirements of law, that requires disclosure and presentation in an understandable format.

Accounting and Double Entry System

Usually, it is the double entry system (also known as mercantile system of accounting) that is usually referred to when we speak of accounting. There is also the Single Entry system (Cash basis) of accounting, that is followed by small businesses on which many of the laws do not apply. But cash basis of accounting is hardly accountancy, as verification / cross-checking is not possible.

The importance of verification particularly in case of double entry system is useful and necessary, because, we can keep track of the money (ie. trail the transaction from origin to culmination). eg. if a business in trading keeps cash basis of accounting, whatever it buys and sells, it will keep only the cash book, where only the cash transactions are recorded. There are various difficulties encountered in such system.

Consider the scenario – If a businessman has bought P quantity of goods A from X and Q quantity of goods A from Y. He has received A from X partly on cash and partly on credit. Similarly from Y. However, the prices in which he has bought them from the two are slightly different. Moreover from Y he receives discount, while from X he receives no discount.

In such a situation, if the basis of accounting is only cash ie. only cash received and cash paid is recorded, then such transactions becomes very difficult to keep trail of. It becomes equally difficult to make accounts from such records, unless the double entry system is followed.

It is to overcome difficulties like these that double entry system is the preferred system that is followed by businesses and prescribed by government. However many small individual businesses still continue with single entry. Double entry system makes for easier cross referencing and verification of transactions.

Final Accounts

Final Accounts relates to the ultimate outcome of all the accounting processes carried out by an entity throughout the accounting period (usually a year, but can be less eg. quarterly for reporting purposes).

Final Accounts comprises Balance Sheet, Income Statement (also known as Profit and Loss statement), Cash Flow statemtnt, Notes to Accounts regarding the Accounting Policies followed, and various Schedules to the B/s P/L, Cash Flow statement that have been used for such calculation or make the accounts more clear to understand or give a greater disclosure of the accounts. An example of schedule is the depreciation schedule. There can be many other schedules, depending on the nature of business and the regulatory requirement.

Presentation

It is in the context of Final Accounts that the concept of presentation becomes utmost important. What is presentation? It means putting the various different items of accounts in a particular format. Presentaiton makes for clarity and comparability. This means that the accounts for an entity can be compared within a range of period, as well as, it can be compared with similar entities. Such analysis is useful to understand the performance of the business by the stakeholders (Govt, Investors, Banks, Employees etc). Better presentation improves understanding of the financial results of the business organisations.

Presentaiton of final accounts are usually governed by the Accounting Standards that are prescribed by the national accounting bodies. The following of such Accounting Standards are usually mandatory. There are also the IAS (Internationsl Accounting Standards), that are now called the IFRS (International Financial Reporting Standards) that is prescribed by the IASC (International Accounting Standards Committee, estd. 1973, HQ at London), now rechristened as IASB (International Accounting Standards Board).

The national level accounting bodies usually adopt the IFRS standards to the local requirements, so that the local national standards are compatible to the international standards. In India the Accounting Standards are prescribed by the Institute of Chartered Accountants of India.

Presentation means both format as well as judgement or estimate. The Accounting Standards prescribe and guides as to which situation is to be presented in what ways, and if such a situation is to be presented at all, or if only disclosure is enough.

A simple example of presentation is that of Provisions. Provision is basically on the Liability side of the B/S. However Provision for Bad Debt is to be shown as a deductible item from the Debtors on the Asset side of the B/S. This is to make for a clarity of presentation to the users of the financial information.

A more complicated example: An accounting entry is a consequence of a financial transaction. However there may be situation where there is no transaction, yet there might be possibility of inflow / outflow of money. For example, a patent case that is being fought by the company in a court of law.

Given the nature of the case, the Company feels that it has no hope of winning the case and may have to give compensation. In such cases the company may estimate the value, if that can be estimated. Such contingent loss ie. loss that is dependant on happening of a certain event ie. the judgement by the Justice of the court. Such contingent loss that has been estimated is not to be treated as loss in the Income Statement, but the estimated value is to be disclosed as Notes to the Accounts.

This would seem quite in contrast to the situation of Provision for Bad Debt. The provision for bad debt is also a sort of contingency (as bad debt may or may not happen), and that is treated as an expense in the P/L statement of the particular year of estimation itself (though, adjustable in later periods with bad debt actually incurred); while contingent loss is not to be recongnised till that contingent event leading to loss actually happens. Also this treatment of contingent losses might seem to be an exception to the principle of conservativeness that is usually followed in Accounting.

But then, Accountancy, unlike mathematics, is not a principle driven discipline; accountancy is driven by experience and various legal requirements. In the example that I have mentioned, a possible reason for such treatment may be the Taxation angle, as businesses would be tempted to declare contingent losses to save paying taxes, and earn interest on such savings (time value of money). Consequently, a contingent loss is considered a rare event, while a situation of bad debt and providing for that is a usual and recognised business practice.

Accounting, Finance, Treasury, Control

Often we come across these terms and the difference is hardly appreciated. To put it simply, while Accounting relates to recording of financial transaction and presentation of the financial information, and is tactical in nature, Finance is a strategic function for an organisation. Finance deals with future planning, raising of capital, etc. Usually the functions of the Finance are dealt with more specialised area called the Treasury function that is more related to management of funds and the money that is with the organisation. These relate to cash management, credit management, banking relations, portfolio management etc.

Control is a more regulatory related function (and consequently more related to Accountancy) and deals with Financial and Cost Accounting, Taxation, Internal Audit, Budgeting etc. For an organisation these functions usually overlap depending on the size and the nature of the business. Also, some functions like eg. the Treasury function predominates in the Banking and the investment sectors, while the control function predominates in the manufacturing companies.

© Anup Mukherjee

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