Unit 1 - Introduction to Accounting (Theory Only)

1.1 Meaning and Concept of Accounting:-

Accounting is a process of identifying financial transactions, measuring them in monetary terms, and
recording, classifying, summarizing, analyzing, interpreting them and communicating the results to the
users.

 Accounting- concept, meaning, as a source of information, objectives, advantages and

limitations, types of accounting information; users of accounting information and their needs.
Qualitative Characteristics of Accounting Information. Role of Accounting in Business.

 Basic Accounting Terms- Entity, Business Transaction, Capital, Drawings. Liabilities (Non
Current and Current). Assets (Non-Current, Current); Expenditure (Capital and Revenue),
Expense, Revenue, Income, Profit, Gain, Loss, Purchase, Sales, Goods, Stock, Debtor, Creditor,
Voucher, Discount (Trade discount and Cash Discount)

In 1941, The American Institute of Certified Public Accountants (AICPA) had defined accounting as the
art of recording, classifying, and summarising in a significant manner and in terms of money,
transactions and events which are, in part at least, of financial character, and interpreting the results
thereof‟. With greater economic development resulting in changing role of accounting, its scope,
became broader. In 1966, the American Accounting Association (AAA) defined accounting as „the
process of identifying, measuring and communicating economic information to permit informed
judgments and decisions by users of information‟.

What Is Accounting?

The practice of recording a business's monetary operations is known as accounting. These transactions
are collated, investigated, and submitted to oversight agencies, regulatory authorities, and tax-
collecting agencies as part of the financial process. Financial statements are used in accounting to
summarize a company's operations, financial situation, and cash flows.

How does Accounting work?

Accounting represents one of the most critical components of almost every business. Larger
organizations may have extensive finance sections with numerous employees, while a bookkeeper or
accountant may manage smaller enterprises individually.

The accounting information, which summarises a sizable organization's operations, financial situation,
and working capital during a specific period, are precise and compressed reports based on hundreds of
separate financial transactions. As a result, all professional accounting certifications result from lengthy
academic requirements, challenging tests, and at least some relevant real-world accounting
experience.

Types of Accounting

Accountants might need to keep track of transactions or deal with certain data sets in different ways
for different fields. This enables the division of accounting into several broad groups. Some major
types of accounting are as follows:

Financial Accounting
Financial accounting strongly emphasizes communicating information about a business to external
entities, including shareholders and creditors. The broad agreement between accountancy theory and
practice gives rise to GAAP (Generally Accepted Accounting Principles), which evolves to satisfy
decision-makers demands.

Financial accounting produces past-focused reports on a yearly or quarterly basis, typically regarding
the entire company. Also, the financial results are frequently released six to ten months after the end
of the accounting period.

The financial results of all transactions during an accounting cycle are comprehensively summarised in
the accounting records, financial information, and cash flows statement. Most businesses have their
financial accounts audited by a third-party CPA company once a year. Therefore, for one reason or
another, most organizations will have financial audits each year.

Management Accounting

Measurement, analysis, and reporting of data that might help managers accomplish organizational
goals are the main goals of management accounting. Internal accounting measures and reporting are
primarily concerned with cost-benefit analysis and are not required to follow widely accepted
accounting rules.

Management accounting reports typically incorporate financial and non-financial data, depending on
whether they focus on a particular product or division.

In managerial accounting, a report is created monthly or quarterly that a firm's management team
may use to decide how to operate the business.

Cost Accounting

Like management accountant helps businesses make decisions about administration, cost accounting
helps organizations make decisions about costing. Cost accounting considers every expenditure related
to the production of a thing. This information is used by analysts, supervisors, and business owners to
make cost projections for their goods. Money is seen as an economical ingredient in output in cost
accounting, but it is seen as a gauge of a firm's economic success in financial accounting.

1.2 Scope of Accounting

Scope of Accounting

The scope of accounting has been widening with the changes in the economy and societal demands. It
extends to business, trade, government, financial institutions, individuals and families and various
other avenues. The following points explain the scope of accounting in different areas:

Business organisations

Non-profit organisations

Government organisations

Professionals
Individuals

Business organisations

Accounting is widely applicable in the business sector. It is rightly called „Language of Business‟. The
main objective of every business is to earn profits. Financial transactions of a business concern are
recorded in the books of accounts to ascertain operating results and determine the financial position.

Non-profit organisations

Accounting also has scope in non-profit organisations. These organisations record their transactions
such as the donations received, subscription given by members and all the expenditures. To do so,
statements such as receipt and payment account, income and expenditure account and balance sheet
are prepared as per the rule of accounting.

Government organizations

The scope of accounting also exists in central and state-owned organizations. These organizations use
the system of accounting for various purposes such as determining the income, calculating expenditure
and proper running of the administration. Apart from that, interpretation and evaluation of accounting
data is required for performing national planning, pre- paring financial budget, determining national
progress or regress and so on.

Professionals

Professionals like engineers, doctors, lawyers and sportspeople also maintain their accounts to keep a
tab on their income and expenditure and determine their income tax liability.

Individuals

Individuals also perform financial transactions to earn their livelihood. They also do some form of
accounting to obtain financial information; thereby making personal economic decisions.

1.3 Advantages and Limitations of Accounting

Advantages of Accounting

 Accounting represents Financial Position: Accounting represents the financial position of a

particular or group of businesses. The financial performance of the company in the last year is
often useful to compare the performance of the other firms.

 Assistance to Manager: An account renders the essential data to the managers in the form of
a balance sheet and profit & loss account that benefits decision-making.

 Replaces Memory: Accounting in a systematic and timely manner records all the transactions
of an individual/firm. If one requires the information in the future, they can easily obtain the
information in books of accounting.

 Benefits in Comparison: The format of accounting for different businesses is the same, so
one can efficiently compare their business performance with the performance of other
organisations. One can also compare their performance with performance rendered last year.
 Benefits in Calculation of Tax Liabilities: The profit & loss account presents the current year
profit so that the individual/firm can effortlessly calculate the tax liability.

 Benefits in Decision-Making: Accounting assists in taking major decisions for the growth of
the organisation. Such decisions can include deciding the price of the product or checking over
the expenses of employees.

 Serves as an Evidence of Transaction: All the transactions are recorded and listed so that
one can utilise the account as evidence if something wrong occurred with the business.

 Maintenance of Records of a Business: All the financial transactions concerning the

respective year are recorded systematically in the books of accounts. It is not permissible for
management to commemorate each and every transaction for a long time due to their
complexities and size.

 Establishment of Financial Statements: Financial statements that include Profit and loss
account, Balance Sheet and Trading can be settled easily if there is a precise recording of
transactions is maintained. Precise recording of all the financial transactions is extremely crucial
for the preparation of the financial statements of the entity.

 Comparison of Results: It facilitates an easy comparison of the financial returns of one year
with another year. Also, the management can investigate the systematic recording of all the
financial transactions in accordance with the policies of the individual.

 Decision Making: Decision making becomes more straightforward for management if there is a
particular recording of all the financial transactions. Accounting information facilitates
management to make budgets and coordinate and plan the future activities of various
departments.

 Evidence in Legal Matters: The precise and systematic records of the financial transactions
function as evidence in the court of law.

 Provides Information to Related Parties: It executes the financial information of the

organisation prepared to stakeholders like customers, government, owners, creditors,
employees, etc., efficiently.

 Helps in Matters of Taxation: Various tax authorities like indirect taxes, income tax depends
on the accounts reported by the management for settlement matters related to taxation.

 Valuation of Business: For precise valuation of the accounting information of the entity‟s
business can be utilised. Thus, it assists in measuring the value of the entity by utilising the
accounting information in the case of the sale of the entity.

 Replacement of Memory: Proper recording of accounting transactions substitutes the

requirement to remember transactions.
Disadvantages of Accounting

The accounting system has no disadvantages because of its systematic nature, but it has some
limitations. These are:

1. Possibility of Window Dressing:

Practices of manipulating the financial positions of the business, like mentioning debtors, and no
provisions are made for bad debts. This makes balance sheets lack fair and true information about
financial positions. This will have consequences as a fake bubble of information will create a hollow
foundation that further devastates the business in the long term.

2. Unbiased Accounting Information:

Income is the function of excess revenue over expenses in the books of accounts. This information
does not include the environmental cost, accidental injuries of employees, etc.

3. Mere Historical Records:

The records of books of accounts are of past transactions and do not contain any benefits which could
be ripened in the present or future. These only include historical details.

4. Bound to Periodicity:

The foundation of record keeping in the books of accounts of a business is bound to many principles of
accounting for recording transactions related to business. These are to be maintained throughout the
year and for years. If not done, the financial information or the accounting records may become
inconsistent and become worthless as they would not provide any valuable information about the
business's financial position, growth rate, e

5. Personal Estimates:

The use of estimations in the accounting system often prevents the exact interpretation of information.
Some examples are the estimation made for the useful life of an asset, the use of different methods of
calculation of depreciation of a good, etc. Since the decisions are based on the comprehension level of
accountants, they may lead to distinct observations.

6. Present Value of Business:

The cost concept is used in accounting to record assets. So original cost is recorded for the new asset,
and for old assets, book value is used as the basis for recording in the books of accounts. (The book
value is calculated by subtracting depreciation from the original cost). So, the present market value is
not considered. Thus, the effect of inflation and deflation is ignored. Ultimately, the financial position
shown by the balance sheet is not true.

7. Unrealistic Pieces of Information:

Although the financial statements are prepared strictly following the basic accounting principles and
conventions, still they can be incorrect and unrealistic. The going concern concept advocates for the
indefinite life of a business entity, and thus assets are recorded at cost or book value. Still, the market
value is lower, which is self-contradictory.
8. Record of Material Items Only:

The system only accounts for the significant materialistic item, and the insignificant unmaterialistic
items are ignored, which are important. An example is a goodwill.

9. Non-Monetary Transactions:

In the financial accounting branch of accounting, records of monetary transactions and non-monetary
transactions are not recorded. (Monetary transactions are transactions that can be measured in terms
of money, and non-monetary transactions are transactions that cannot be expressed in terms of
money). The insignificance of non-monetary transactions in the record books of account turns out to be
very important for business enterprises, such as the health of the working sales associates and
laborers, the day and night hard work of the authorities in managing the business, etc. Accounting
does not give a clear picture of information about all the events of a business.

10. No Estimation of Managerial Efficiency:

The accounting system does not give any information about the managerial works involved in a
business entity in terms of increased or decreased profit/loss margin. There is always scope for
adjustment or omitting of profit or income in expenses like advertisement expenses, expenses for
depreciation, the cost for research and development.

Limitations of Accounting

Nothing can be perfect in this world and the same statement applies to accounting also. There are
some misconceptions formed about the accounting like the fact that P&L A/c presents the true picture
of profit and loss taking place in the business, or that a balance sheet perfectly shows the financial
position of a company.

Whereas accounting is not yet a perfect science, art, or profession. It has so many limitations which
reduce its effectiveness in the business world. These limitations are as follows:

1. Measurability

It is among the biggest limitations of accounting. In accountancy, one cannot measure the value of
non-monetary terms, things, or events. In other words, if certain factors cannot be expressed in terms
of money then they cannot be included in accounting no matter how important it is for the company.
Some important but non-monetary qualities are management, loyalty, reputation, hard work,
employees' and customers' satisfaction, the firm's ability to develop new products, cordial
management-labor relationship, etc. are not mentioned in the company's balance sheet or income
statement. Hence, accounting focuses on the quantities only not on the qualities.

2. No Future Assessment

Financial statements are the presentation of the company's financial position as of the date of
preparation. The users of these statements are more interested in getting information about the
company's future performance in the short and long run. However, it is not possible with accounting to
make any such estimates.
s we know, how dynamic the business environment is. It can change very quickly due to changes in
demand for the product, technology, customers' tastes and preferences, competitors' position, policies
adopted by the firm, market inflation or depression, etc. Auditors sometimes rectify the limitations of
accounting by disclosing the important events or changes that occur after the balance sheet date.

3. Historical Costs

The value in accounting is often measured by using the historical data or costs which ignores the
current factors or market conditions such as inflation, price changes, demand and supply effect, etc.
Because of this the accounting records and information get skew the relevance and reduce the
originality and reliability of the accounting data.

4. Accounting Policies

Accounting policies do not work on a global standard. For example, in India, accounting standards are
used, in USA GAAP and some international standards named IFRS are used, and so in other countries.
So if a company is operating its business in more than one country then it can be confusing to apply a
particular standard and even if the company does not choose a single standard then the results can
fluctuate.

This is because all accounting policies do not follow the same line of thinking which may cause
conflicts.

5. Influenced by Personal Judgments

An accountant can't determine the exact amount of an asset. That's sometimes estimation is required
in accounting also. But the problem is that these estimations are based on the personal judgment of
the accountant and also these are very subjective. In short, these estimates are a person's guess for
future events. Such estimates are made for the work related to the provision of doubtful debt, methods
of depreciation, etc.

6. Verifiability

There is no guarantee of the correctness of the financial statements even after having an audit of
them. The auditor can only assure that the statements are free from error as per his knowledge and
skills.

7. Errors and Frauds

Accounting is completed by human beings so there is always a possibility of having errors in it.
Sometimes, there is also a scope of manipulation of accounts to hide fraud. Since fraud is a deliberate
activity, it is very difficult to spot it. It is one of the most dreaded limitations of the accounting system.

8. Affected by Window Dressing

The practice of manipulating the accounts to disclose the company in a more favorable position than
the actual position by the means of its financial statements is known as window dressing. For example,
a company may not record the purchases made at the end of the year or the closing stock may be
overvalued. Hence, the true position of the company can't be concluded on the basis of such financial
statements.
9. Incomplete Information

Another limitation is that the accounting statements provide incomplete information regarding the
profit and loss of a business because logically, the actual profit and loss of a business can only be
calculated after the closed down of it.

10. Others

Some other drawbacks or limitations of accounting are as under:

o Installation cost is very high.

o Based on financial and cost records.

o Preference for intuitive decision making.

o So much complex and difficult to apply. Hence, can be done by experts only.

o Highly time and resources consuming process.

1.4 Accounting Concepts, Principles and Conventions

Accounting Convention

Accounting conventions refer to the principles and practices that guide preparing and presenting
financial statements, especially for recording specific business transactions that have not yet been fully
addressed by accounting standards. However, such rules or principles are legally binding. But they help
ensure that financial information is accurate, relevant, and reliable for investors, creditors, and other
stakeholders.

Accounting Concepts

Introduction

Various basic rules, assumptions, and conditions that define the parameters and constraints that
are used to operate accounting are known as accounting concepts. These concepts form the
fundamental basis for preparing financial statements. These principles or concepts are usually
called 'Generally Accepted Accounting Principles' (GAAP). These concepts are accepted and used
by accountants all over the world.

Objectives of Accounting Concepts

Accounting concepts are helpful in making the accounting information meaningful to various parties,
i.e., internal and external. Its various objectives are as follows:

o Accounting concepts bring uniformity and consistency in preparing and maintaining financial
statements.

o These concepts act as the underlying principles which assist the accountants in
the preparation and maintenance of business records.

o One of the most important aims of accounting concepts is to bring a common understanding of
rules that are to be accepted and followed by all types of businesses which is further beneficial
in facilitating integral and comparable financial information.
Various Accounting Concepts

Some of the generally accepted accounting concepts are given below:

1. Going Concern Concept

Going concerned is an accounting term that is used in the context of a company that is financially
stable, can pay its dues on time, and continue the business for the foreseeable future. In the financial
reports of such companies, certain assets and expenses may be deferred

n other words, a going concern is expected to have the following things working in its favor:

o The trade is able of running everyday operations and has capital and crude materials to do so.

o Trade can pay off the obligation during the bookkeeping period.

o There ought to be requested within the showcase for the items or administrations advertised by
the company.

o There should be no changes within the law overseeing the commerce.

2. Consistency Concept

Consistency means that once accounting procedures have been chosen, they must be applied
consistently in the future. For similar scenarios, the same tactics and techniques must be employed. It
suggests that a company must not change its accounting policy unless there are compelling reasons to
do so.

The consistency concept is important for determining company patterns that span multiple accounting
periods. The financial statements will not be comparable across accounting periods if the company
continuously changes accounting procedures.

3. Accrual Concept

Under this concept of accounting, the transactions are recorded in the books as they occur even if they
are paid for a particular good or service that has not been received. This is a more appropriate method
to assess the financial health of the company. This method is based on the matching
principle, according to which revenues and expenses should be recorded in the same period.

4. Business Entity Concept

This concept states that a business should be treated separately from its owners, managers,
creditors, and others. This means there must a separate set of books for the business and all the
transactions must be recorded from the business' point of view only.

5. Money Measurement Concept

As per this concept, the company should record only those items in the books which can be expressed
in terms of money. An event can never be recorded in accounting unless its effect can be calculated
in monetary terms with accuracy. For example, quarrels between the production manager and sales
manager, strikes of the workers, etc. can't be recorded in the books.
To make the accounting records simple, relevant, homogenous, and understandable it is necessary to
express them in a common unit of measurement and with the help of money, this problem can be
solved as it helps in adding and dealing with various things of diverse nature.

6. Accounting Period Concept

Every businessperson starts, the business with intends to continue indefinitely for a long period.
Because of this, the true results of business operations can only be calculated at the time of the wind
up of the company. But calculating the profit after such a long period will be of no means for all the
parties. The users of financial statements need the results frequently. Thus, the entire life of the
company is divided into time intervals generally, twelve months or a financial year. Apart from this, a
company that is listed on the exchange is bound to publish a report of profitability and financial
position quarterly.

7. Cost Concept or Historical Cost Concept

The cost concept is one of the most important concepts in Economics. It is a payment made to acquire
any goods or services. In simple terms, the cost concept is a financial valuation of resources, risks,
materials, time, and utilities consumed to purchase the goods and services. From the point of view
of an economist, the cost of manufacturing or producing something is the concept of opportunity
cost. The cost concept has various types:

o Outlay costs and Opportunity costs

o Accounting costs and Economic costs

o Direct/Traceable costs and Indirect/Untraceable costs

o Incremental costs and Sunk costs

o Private costs and social costs

o Fixed costs and Variable costs

8. Matching Concept

To determine the net profit correctly, this concept is highly useful. As per this concept, all costs which
apply to the revenue of a particular financial year should be charged against that revenue to figure out
the net profit from the business operations. For this purpose, both revenue and costs should be
recognized. Some points should be considered at the time of matching the costs with the revenue
which include the following:

o The closing stock should be carried over to the next year as opening stock.

o Income receivable and income in advance should be added and deducted respectively from
the revenues.

9. Dual Aspect Concept

As per this concept, every business transaction has a dual aspect. To put it another way, every
business transaction has an impact on at least two accounts. If one account is debited, the other
will receive a credit. The 'Double Entry System' is a method of documenting transactions twice. The
two sides of the balance sheet are always equal because of this principle, and the following accounting
equation is always proven:

Assets = Liabilities + Capital

Or

Capital = Assets - Liabilities

Numerically, if a transaction affects one side of the equation then it will also affect the other side of the
equation or can cause an increase in one account and then decrease the other account of the same
side so that the balance gets automatically equal.

10. Materiality Concept

According to this concept, the financial statements must show all the items that leave an important
economic effect on the business. It gives the consent to disregard the other concepts in the event that
the uncovered things are immaterial for the company's commerce and the endeavors included in
recording them are not profitable.

Accounting Principles

Meaning

Accounting principles refer to various rules and guidelines that a company is bound to follow while
preparing and reporting financial data. These principles aim to make the financial
statements complete, consistent, and comparable. This makes things easier for the insiders as well
outsiders who have an interest in the business. The financial performance helps the creditors in
deciding whether to give the loans to the company and helps the investors in deciding whether they
should invest in the company or not. They also mitigate accounting fraud by increasing
transparency and allowing red flags to be identified.

Characteristics of Accounting Principles

o These principles are the set of rules and guidelines which are prepared to bring uniformity
and easy availability and understanding of the accounting information.

o These principles are derived from experience and reasons. They are not tested in the laboratory
unlike principles of science and hence are not universally applicable, i.e., their use can vary in a
different business environments.

o Accounting principles are not static, meaning they can change over time to reflect changes in
corporate practices, government legislation, and the demands of accounting information users.

o There are three criteria that decide the general acceptance of the accounting principles. They
include:

o Relevance
These principles are relevant because they provide useful information to accounting
users.

o Objectivity
Any principle is called objective if there are not any personal biases or judgments of the
 person who is furnishing information. On this basis, accounting principles are objective.
Also, these principles are variable.

o Feasibility
Accounting principles are feasible as they can be applied without any cost or undue
complexity.

Need for Accounting Principles

Accounting information must be reliable and comparable so that a meaningful conclusion can be
derived from it by internal and external users. The information is required to be comparable in order to
compare the performance of the firm with other firms as well as with the previous year's performance
of the firm. This can be possible only if the accounting information is based on some particular set of
rules which are known as policies, principles, and conventions. These rules are usually known as
GAAP and they bring uniformity and consistency to the accounting process. These principles also help
in enhancing the utility to various users.

Generally Accepted Accounting Principles (GAAP)

GAAP is a set of commonly accepted accounting principles, standards, and procedures that are formed
by the Financial Accounting Standards Board (FASB). These principles are accepted by
accountants all over the world as general guidelines for preparing accounting statements. FASB has
developed these principles over a period from usage, reason, common experiences, historical
precedents, individual statements, professional bodies, and regulation of government agencies.

These principles aim to bring clarity, consistency, and comparability to accounting information. GAAP is
based on ten principles which are given below:

1. Principle of Regularity

2. Principle of Consistency

3. Principle of Sincerity

4. Principle of Permanence of Methods

5. Principle of Non-Compensation

6. Principle of Prudence

7. Principle of Continuity

8. Principle of Periodicity

9. Principle of Materiality

10. Principle of Utmost Good Faith

Various Accounting Principles

Accounting Principles

Accounting principles are known by different terms such as assumptions, conventions, concepts,
doctrines, postulates, etc. There are mainly two categories in which these principles can be divided.
They include:

1. Accounting Concepts or Assumptions

To make the accounting language more meaningful, a set of accounting concepts is made by various
accountants which are used to prepare the financial statements. These concepts provide a foundation
for the accounting process and help in knowing how the transaction should be recorded and reported.
Some of the basic accounting concepts as per the Accounting Standard (AS-1) issued by the Institute
of Chartered Accountants of India are as follows:

Going Concern Assumption

It is presumed that the business is a going concern, i.e., it continues to exist for an estimated period.
This presumption is necessary because all the business transactions are recorded in the books on this
basis. As per his concept, fixed assets are recorded at their original cost, and depreciation is charged
on these assets without reference to their market value. Because of the going concern, exterior parties
enter into long-term contracts with the enterprise.

Consistency Concept

As per this Concept, the accounting principles and methods should remain consistent from year to
year. This is because if a company applies different accounting principles in two accounting periods
then it will be difficult for the company to compare the profits of the current year with the preceding
year.

Matching Concept

The matching principle states that there must be a comparison made between the income and
corresponding expenditure for a particular financial year so that the company can figure out the actual
profit that occurred during that period.

Accrual Accounting Concept

According to this principle, both revenue and expenditure must be recorded in the actual incurred
instead of at the time when the cash or cash equivalent is received or spent. Irrespective of the
successive cash flow, income and expenditure are significant.

Accounting Period Principle

This principle states that the accounting process of the company will be completed within a certain
period. This period is usually a financial year or a calendar year. Thus, every transaction that takes
place within that particular period of accounting must be included or can say recorded in the financial
statement of the company.
Other Accounting Principles

The list of some other important accounting principles is given below:

Cost Principle or Historical Cost Concept

Economic Entity Principle

Monetary Unit Principle

Reliability Principle

Revenue Recognition Principle

Time Period Principle

Dual Aspect Concept

Business Entity Concept

2. Accounting Conventions

These are the customs or generally accepted practices that accountants follow after reaching a general
agreement or consensus. The following are types of accounting conventions:

Convention of Full Disclosure

According to this norm, all relevant information pertaining to the company's financial concerns must be
fully revealed. In other words, the information that is of material relevance to the users of the financial
statements should be disclosed. These users can be proprietors, present and potential creditors,
investors, and others. According to the Companies Act, the contents of the Balance Sheet and Profit &
Loss Account are to be disclosed.

Convention of Materiality

This convention states that the company should not disclose such items which have an insignificant
effect or are irrelevant. This is an exception to the general rule of full disclosure. These useless
elements are either left out or integrated with other relevant items to remove unneeded burdens from
the accounting statement.

Convention of Conservatism or Prudence

As per this convention, the company should record all anticipated losses in the books of accounts but it
should ignore all the unrealized gains. In short, it is the policy of playing safe. The company should
make provision for all known liabilities or losses to recover them even if the amount is not known.
1.5 Accounting Policies

Accounting Policies Definition

Accounting policies, methods, processes, or procedures are the specific steps taken by a business to
create its financial statements while adhering to certain policies. They provide guidance on how
transactions should be recorded, how assets and liabilities should be valued, and how income and
expenses should be recognized. Accounting policies are generally set out or created in a company's
accounting manual or policy handbook.

Role of Accounting Policies

Role in Financial Reporting

The preparation of financial statements in conformity with generally accepted accounting principles
(GAAP) or other pertinent accounting standards is one of the main purposes of accounting policies. By
establishing consistent principles, practices, and procedures, accounting policies help ensure that
financial information is accurate, reliable, and comparable across companies and over time.

Accounting policies also help companies comply with regulatory requirements, such as the Securities
and Exchange Commission's (SEC) rules on financial reporting. Companies must disclose their
accounting policies in their financial statements, which are subject to review and audit by external
auditors to ensure compliance with applicable accounting standards.

Role in Decision-Making

Accounting policies also play a critical role in decision-making. By providing users of financial
statements with a clear understanding of how financial information has been prepared, accounting
policies enable them to make informed decisions about investing, lending, or other financial activities.
Creditors can use financial statements to determine a company's creditworthiness and default risk,
while investors can analyze a company's financial condition and future growth potential.

Different Types of Accounting Policies

In this section, we will discuss the different types of accounting policies that companies may adopt.
They are:

Revenue Recognition Policy

A revenue recognition policy is one of the most critical accounting policies, which defines when a
company should recognize revenue from its sales of goods or services. Revenue recognition policies
may vary based on the nature of the business, the types of products or services sold, and the terms of
the contracts with customers.

Inventory Valuation Policy

The inventory valuation policy defines how a company values its inventory, such as using the FIFO
(first-in, first-out) or LIFO (last-in, first-out) method. Both the value of inventory on the balance sheet
and the cost of goods sold are impacted by this policy.
Foreign currency translation policy defines how a company translates its foreign currency transactions
and balances into its reporting currency. This policy impacts the amount of foreign exchange gain or
loss recorded in the income statement and the carrying value of assets and liabilities on the balance
sheet denominated in foreign currencies.

Capitalization Policy

Capitalization policy defines how a company determines whether to capitalize or expense costs related
to the acquisition, development, or improvement of assets. This policy has an impact on the asset's
carrying value on the balance sheet as well as the timing and quantity of expenses recorded in the
income statement

1.6 Terms used in accounting: - Capital, Drawings, Sundry Debtors, Sundry Creditors,
Assets, Liabilities, Contra Entry, Bills Receivable, Bills Payable, Suspense Account

Capital:-

The capital means the assets and cash in a business. Capital may either be cash, machinery, receivable
accounts, property, or houses. Capital may also reflect the capital gained in a business or the assets of
the owner in a company.

Capital is very important in running any business. When a person starts a business, the money he
invests in that enterprise is considered capital. Suppose a businessman does not have his own money
and starts the firm with a loan from a bank or a person. In this case, the amount contributed by the
individual is also referred to as capital. A loan from others is a loan for the businessman, but it is
considered capital when money is invested in a business.

Drawings

Drawings are the sum of money or items taken out of a business by the proprietor for personal use. It
lowers the company's capital.

Sundry Debtors, Sundry Creditors

A person who receives goods or services from a business in credit or does not make the payment
immediately and is liable to pay the business in the future is called a Sundry Debtor.

People who provide goods or services on credit are known as sundry creditors. They are also the
companies or customers that a firm owes money to as a result of the credit facilities obtained in the
products or services used to develop the business. Such businesses, customers, persons and
organizations are called “Sundry Creditors” in accounting.

Assets/Resources

All of a company's resources with monetary value are referred to as an asset. These resources enable
the company to make a profit and retain its worth in the future. These are essential for running a
business and are held by business owners. There are two types of this.

a) Non-current assets

Fixed assets are assets that a company/firm uses for a long period of more than one year. For
example, land, a building, a plant, machinery, furniture, a vehicle, etc.
b) Short-term assets

This is the asset that is used within a year or is immediately converted to cash. For instance, cash and
its equivalents, inventories, etc.

c) Intangible assets

These are the resources with worth but no substance, such as copyrights, trademarks and intellectual
property

Liabilities

Liabilities are legal responsibilities or debts owed to another individual or business. The amount a
company pays to others is known as its liability. In other terms, liabilities are future economic gains
sacrificed by one entity to another as a result of past events or transactions.

Liabilities are classified into two types: -

a) Long-term obligations

The liabilities are typically due after one year. Long-term loans from financial institutions and corporate
bonds.

b) Short-term commitment

These must be paid within a year. For example, accounts payable, overdrafts, etc.

Contra entry

Contra entry refers to transactions involving cash and bank account. In other words, any entry which
affects both cash and bank accounts is called a contra entry. Contra in Latin means the opposite. It is
more popularly known as contra voucher

Bills Receivable, Bills Payable, Suspense Account

A bill receivable is a document that your customer formally agrees to pay at some future date (the
maturity date). The bill receivable document effectively replaces, for the related amount, the open debt
exchanged for the bill. Bills receivable are often remitted for collection and used to secure short term
funding.

Bills payable are physical records of the amount owing for any products or services that a company
buys on credit.

A suspense account is an account where you record unclassified transactions. The account
temporarily holds entries while you decide how you will classify them. A suspense account can also
hold information about discrepancies as you gather more data.