1.1 Introduction to Accounting
Accounting is a profession used to make financial and business decisions. Billions of dollars exchange hands every day, in millions of separate business transactions. These are recorded and reported on using a comprehensive set of guidelines, referred to as Generally Accepted Accounting Principles (GAAP).
Accounting: The bookkeeping methods involved in making a financial record of business transactions and in the preparation of statements concerning the assets, liabilities, and operating results of a business.
System: A group of interacting, interrelated, or interdependent elements forming a complex whole.
Accounting System: The people, procedures, and resources used to gather, record, classify, summarize and report the financial information of a business, government or other financial entity.
Double-entry bookkeeping: The practice of recording a business transaction in two equal parts, called debit and credit entries. Debit refers to the left column and credit refers to the right column, in an accounting journal.
Each transaction describes both:
- the object of the transaction – such as rent, telephone, or payroll expense; sales, fee or interest revenue.
- the source of payment – cash or credit.
Money eventually changes hands in almost all transactions, either at the time of the transaction, or perhaps at a future date in the case of items purchased on credit. (Adjusting and closing entries are an exception and not typical, and represent special entries made by accountants to prepare financial statements, and reset certain accounts at the end of a fiscal year.) Sometimes a transaction involves cash directly, at the time of the event, such as a cash sale at a grocery store. It is more common, and safer, to use a checking account for routine purchases. These are all considered part of the Cash account.
|Marble tablet: Account of Disbursements of the Athenian State c. 418-415 BC|
Many, and perhaps most, transactions in a business take place on a credit basis. Businesses usually purchase their supplies and merchandise on a 30-day account, known as a trade account, or Accounts Payable. Sales are typically made in a similar fashion, called Accounts Receivable.
1.2 A Brief History of Accounting
Accounting was born before writing or numbers existed, some 10,000 years ago, in the area known as Mesopotamia, later Persia, and today the countries of Iran and Iraq. This area contains the Tigris Euphrates river valley, a large fertile area 10,000 years ago with a large thriving population and active trading between towns and cities up and down the two rivers.
Writing and numbers would be not be invented for about another 5,000 years. And what happens next will directly lead to the invention of both writing and number systems.
At that time, merchants faced many of the same problems businesses face today. They had to ship their merchandise up and down the rivers, and that meant trusting a boatman with their goods. Unfortunately, not all boatmen were honest, and disagreements often arose about how much was shipped versus what was received at the other end.
It is hard for us today to imagine a world without writing and numbers. Try to imagine yourself in their position…. what would you do?
To deal with the problem, merchants came up with an ingenious plan. They made small clay tokens, in various shapes and with various markings, to indicate different products. One would mean a basket of grain, another would mean a pot of oil, etc. They had over 200 such tokens to indicate a large variety of common goods, including food, leather, clothing, utensils, tools, jewelry, etc.
|Bollae and tokens c. 3300 BC|
Before shipping their goods, a merchant would take one token for each item in the shipment, and encase the tokens in a ball of clay, called a “bollae” (pronounced “bowl-eye”) – meaning ball. The ball would be dried in the sun, given to the boatman, and then broken by the buyer on the other end of the transaction. The buyer would match the tokens with the items in the shipment, to verify that everything sent was accounted for.
This is the function of protection of assets, and is a major function of all modern accounting systems. It was important 10,000 years ago and is just as important now. Today we see merchants doing the same thing as their counterparts 10 millennia ago – today they get a bill of lading – a listing of the merchandise entrusted to a shipper.
The system of using bollae continued for almost 5,000 years, all before the invention of writing or numbers. One day, probably by accident, a wet clay bollae was rolled over a loose token, laying on the ground. The impression of the token was left in the wet clay. Merchants began pressing the tokens on the outside of the bollae, in addition to putting the tokens inside the ball.
Eventually they would press tokens into a flat piece of clay, leaving an impression for each item. Remember, they didn’t have numbers yet, so they would press a token into the clay for each individual item. Probably by accident one day the right token couldn’t be found, and someone used a stick or other object to make the right marks in the soft clay tablet. And writing was born….
New symbols were soon created representing multiple items, and suddenly both writing and number systems were invented. The last phase of this remarkable process took about 500 years, but once writing was invented, it caught on like wildfire, and was the most popular thing anyone had ever seen.
People were so much in love with writing they did it every chance they could. We have a huge amount of archaeological evidence to support this notion. Thousands of small clay tablets still survive today.
A common example: a worker sent his boss a note saying he would be late for work that day because he had chores to do. He would hire a scribe to write the tablet (only a few people could read or write), and hire a child to carry the note to his boss. They sent notes like we use the phone today, and they loved it. They wrote for the sheer joy of it – the ability to communicate at a distance.
Written accounting records are some of the oldest writings that have survived until today, and they date back to circa 3300-3200 BC. These early records were simple single-entry listings of wages paid, temple assets, taxes and tributes to the king or Pharaoh. This simple system was used until the mid-1400s, and a period known as the Renaissance.
|Picture in the Tomb of Chnemhotep, pharaoh of Egypt c. 1950 BC|
The ancient Egyptian scribe (seated on the left) prepared his accounts on papyrus with a calamus. The accompanying text reads “Minute care is not only taken in the case of large amounts, but even the smallest quantities of corn or dates are conscientiously entered.” In ancient Egypt, the accountants were literally bean-counters. They also counted rice, beer, and everything else. Ancient Egyptians were paid in “kind” – they had not invented money yet so workers were paid with food, beer, clothing, etc. (Everyone drank beer back then, because it was more sanitary than the water. The alcohol content was very low, because they used a short brewing process.)
It is interesting to note that the Mediterranean and European nations had no concept of the number zero until the middle ages. They learned the concept of zero from Middle Eastern mathematicians, who also knew about the movements of the stars and planets, and had figured out the earth was round, and revolved around the sun in an orbit, etc. It took the Europeans another 500 years to figure that out, largely because those concepts were contrary to views held by the Roman Catholic church at the time. It’s also hard to do math using Roman numerals, so their math skills were limited until they started using Arabic numbers.
|c. 8500 BC||Merchants begin to use bollae and tokens to protect shipments|
|c. 3500 BC||Making marks onto wet clay replaces use of bolla, gives rise to writing and number systems|
|c. 3000 BC||Writing and number systems fully developed|
|c. Late 1400s||Luca Pacioli documents double entry accounting|
Luca Pacioli: Father of Modern Accounting
By the time Christopher Columbus was trying to sail west, a new form of accounting was in use by merchants in Venice . Luca Pacioli (pot-chee-O-lee) set down in writing for the first time a description of the double-entry system of accounting, which we still use today in much the same form. Although he didn’t actually invent the system he is called “the father of accounting” for his contributions and for documenting the system in his fifth book on mathematics Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion).
Written as a digest and guide to existing mathematical knowledge, bookkeeping was only one of five topics covered. The Summa’s 36 short chapters on bookkeeping, entitled De Computis et Scripturis (Of Reckonings and Writings) were added “in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business,” and to “give the trader without delay information as to his assets and liabilities” (All quotes from the translation by J.B. Geijsbeek, Ancient Double Entry Bookkeeping: Lucas Pacioli’s Treatise, 1914).
Luca Pacioli was a remarkable man. He was one of the best mathematicians of his time, and was a close friend of Leonardo DaVinci. They collaborated on many projects. Pacioli helped DaVinci lay out his painting, The Last Supper, with mathematical precision. And Leonardo illustrated Luca’s books on mathematics and accounting. History is full of instances of collaboration between these two great thinkers and Renaissance men.
Modern accounting follows the same principles set down by Luca Pacioli over 500 years ago. However, today it is a highly organized profession, with a complex set of rules for the fair disclosure and presentation of information in financial statements. Every day trillions of dollars in transactions are recorded by business, government and financial institutions world-wide. They all follow the same general set of rules.
In the United States, we follow Generally Accepted Accounting Principles (GAAP) as specified by the Financial Accounting Standards Board (FASB). We use the US Dollar for all financial statements and transactions. Other countries use similar accounting rules as the US, but there are differences from country to country. If you had a business in France, you would use the French equivalent to our GAAP.
GAAP developed over 500 years from the basic concepts Luca Pacioli set forth in the 1400s. There is a great deal of similarity in accounting practices around the world because they all have a common origin.
1.3 Definitions of Accounting
“Accounting is the art of recording, classifying and summarizing 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.”
“ The process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information.” – American Accounting Association (AAA)
“ A service activity whose function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions.” – American Institute of Certified Public Accountants (AICPA)
1.4 Need and Importance of Financial Accounting
- Financial Accounting is the very need of a business to provide the information which is useful for sound economic decision making process and owing to the diversification between ownership and management.
- Being known as “The Language of business”, accounting is the basic need of a business organization to find out where it stands and how it performs.
- Accounting coach defines Financial accounting is a specialized branch of accounting that keeps track of a company’s financial transactions. Using standardized guidelines, the transactions are recorded, summarized, and presented in a financial report or financial statement such as an income statement or a balance sheet.
- It helps to ascertain the net results in terms of profit or loss (Income Statement) providing the information about financial position of the business (Balance Sheet) to the owners of a business relating to what the entity owns in the form of assets and what it owes in the form of liabilities at a particular point of time.
- Accounting information is valuable tool to the concerned managers to ensure whether or not the business entity is being directed in a way as wanted, While it’s a means to provide the information to the investors to find out the future prospects of business. It is also useful for the employees and customers in order to know the condition of the business entity.
- Accounting is of a great assistance to management for planning, controlling and decision making process. It is with the help of accounting information that the performance of an entity can be appraised, at the same , its methodical records make possible to eliminate the frauds and the thefts.
- Accounting is a must for every business. Exclusive of accounting leads to create chaos and discrepancies in business transactions.
- Companies rely on the financial reports being prepared by their accountants to be true and accurate that in turn can lead a business management to make sound business decisions.
1.5 Accounting an art or a science?
Accounting can be considered an art because it requires creative judgment and skills. In order to perform accounting functions well, discipline and training is required. Accounting can also be considered a science because it is a body of knowledge, but since the rules and principles are constantly changing and improving, it is not considered an exact science. The American Institute of Certified Public Accountants (AICPA) defines accounting as: “the art of recording, classifying, and summarizing 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”.
Accounting also as a profession. – an “accountant” takes facts and orders them into tables and manipulates them using well proven mathematical techniques. Therefore while a valid and honorable profession, the basic job of everyday accountancy does not require hypothesis and experimentation or imagination and creativity.
1.6 Users of Accounting Information
Accounting information consists of sets of financial statements which is useful for internal users (primary users) of an organisation as well as external users (secondary users).
Internal Users (Primary Users)
Following are some of the primary users of accounting system:
Management – Organization’s management requires accounting information for analyzing the performance and actual position of the business. Accounting information helps the management to arrive at an evaluated decision. It helps with cost determination, investment decisions, helps to identify warning signals in case of a down fall etc.
Owners/Partners – Owners are more concerned on the returns they get out of their investment in the organisation and this purpose if fulfilled through the accounting information. Not only do they want their capital safe they are also interested in knowing the profit earned or loss incurred by the business time to time.
Employees – Employees are interested to know the accounting details of their organisation so that they are aware about overall profitability of the company which has a direct impact on their remuneration and job security.
External Users (Secondary Users)
Following are some of the secondary users of accounting system:
Investors – Similar to owners, external investors are concerned about their ROI (Return on Investment) from the organisation. Since investors do not have a direct control over the business operations they use accounting information to find out how their money is being spent by the managers. It helps them in decision-making such as whether to increase, decrease or hold their investments.
Banks & NBFCs – They are a crucial part of any business environment since they advance both short & long-term loans to a business. Accounting information helps them in determining the credit worthiness of the organisation. Based on financial health of an organisation, the future terms and conditions of credit are assessed by the Banks and NBFCs.
Regulatory and Tax Authorities – Regulatory Authorities including the govt. agencies ensure that the accounting information is prepared based on the accounting principles, standards and rules & regulations governing the organisation. The primary objective is to protect the interest of the stakeholders of the organisation. Correct tax evaluation is also done by the authorities after analyzing the financial statements.
Customers – They are a complex group which include producers at every level of processing, wholesalers and retailers & the end users. Good financial health shows that customers at each level are comfortable with continuous inflow of stock from the business. Customers use the accounting information for assessing the financial position of its suppliers which is essential for maintaining stable source of supply in future.
Suppliers – Other businesses which supply goods to an organization on credit would also want to assess the repaying capacity of that organization before providing any form of credit. Accounting information play a crucial role in this case.
Public – General public would want to know the financial health of a business to get a fair idea of the firm’s niche & overall economy of the nation. It can help to analyze employment trends, general financial stability of a country etc.
1.7 Functions of Accounting
The following are the major functions of accounting:
(a) Keeping Systematic Records:
As a language of business, accounting is to report the results of most business events. Hence, its main function is to keep a systematic record of these events. This function embraces recording transactions in journal and subsidiary books like cashbook, sales book etc., posting them to ledger accounts and ultimately preparing the financial statements [final accounts].
(b) Communicating the Results:
The second main function of accounting is to communicate the financial facts of the enterprise to the various interested parties like owners, investors, creditors, employees, government, and research scholars, etc.
The purpose of this function is to enable these parties to have better understanding of the business and take sound and realistic economic decisions.
(c) Meeting the Legal Requirements:
Accounting aims at fulfilling the legal requirements, especially of the tax authorities and regulators of the business. It discharges this function in accordance with certain fundamental truths and uniform enforcement of generally accepted accounting principles.
(d) Protecting the Properties of the Business:
Accounting helps protecting the property of the business.
(e) Planning and Controlling the Business Activities:
Accounting also helps planning future activities of an enterprise and controlling its day-to-day operations. This function is done mainly to promote maximum operational efficiency.
1.8 Branches of Accounting
1. Financial Accounting
Financial accounting involves recording and classifying business transactions, and preparing and presenting financial statements to be used by internal and external users.
In the preparation of financial statements, strict compliance with generally accepted accounting principles or GAAP is observed. Financial accounting is primarily concerned in processing historicaldata.
2. Managerial Accounting
Managerial or management accounting focuses on providing information for use by internal users, the management. This branch deals with the needs of the management rather than strict compliance with generally accepted accounting principles.
Managerial accounting involves financial analysis, budgeting and forecasting, cost analysis, evaluation of business decisions, and similar areas.
3. Cost Accounting
Sometimes considered as a subset of management accounting, cost accounting refers to the recording, presentation, and analysis of manufacturing costs. Cost accounting is very useful in manufacturing businesses since they have the most complicated costing process.
Cost accountants also analyze actual and standard costs to help managers determine future courses of action regarding the company’s operations.
External auditing refers to the examination of financial statements by an independent party with the purpose of expressing an opinion as to fairness of presentation and compliance with GAAP. Internal auditing focuses on evaluating the adequacy of a company’s internal control structure by testing segregation of duties, policies and procedures, degrees of authorization, and other controls implemented by management.
5. Tax Accounting
Tax accounting helps clients follow rules set by tax authorities. It includes tax planning and preparation of tax returns. It also involves determination of income tax and other taxes, tax advisory services such as ways to minimize taxes legally, evaluation of the consequences of tax decisions, and other tax-related matters.
6. Accounting Information Systems
Accounting information systems (AIS) involves the development, installation, implementation, and monitoring of accounting procedures and systems used in the accounting process. It includes the employment of business forms, accounting personnel direction, and software management.
7. Fiduciary Accounting
Fiduciary accounting involves handling of accounts managed by a person entrusted with the custody and management of property of or for the benefit of another person. Examples of fiduciary accounting include trust accounting, receivership, and estate accounting.
8. Forensic Accounting
Forensic accounting involves court and litigation cases, fraud investigation, claims and dispute resolution, and other areas that involve legal matters. This is one of the popular trends in accounting today.
1.9 Accounting equation
The equation that is the foundation of double entry accounting. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company’s shareholders. Thus, the accounting equation is: Assets = Liabilities + Shareholder Equity. The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity.
Assets = Liabilities + Shareholder Equity.
1.10 Types of Accounts
1. Real Accounts
All assets of a firm, which are tangible or intangible, fall under the category “Real Accounts“.
Tangible real accounts are related to things that can be touched and felt physically. A few examples of tangible real accounts are building, machinery, stock, land, etc.
Intangible real accounts are related to things that can’t be touched and felt physically. A few examples of such real accounts are goodwill, patents, trademarks, etc.
Golden rule for real accounts
|Debit what comes in|
|Credit what goes out|
2. Personal Accounts
These accounts are related to individuals, firms, companies, etc. A few examples of personal accounts include debtors, creditors, banks, outstanding/prepaid accounts, accounts of credit customers, accounts of goods suppliers, capital, drawings, etc.
Natural personal accounts: This type of personal accounts is the simplest to understand out of all and includes all god’s creations who have the ability to deal, who, in most cases, are people. E.g. Kumar’s A/C, Adam’s A/C, etc.
Artificial personal accounts: Personal accounts which are created artificially bylaw, such as corporate bodies and institutions, are called Artificial personal accounts. E.g. Pvt Ltd companies, LLCs, LLPs, clubs, schools, etc.
Representative personal accounts: Accounts which represent a certain person or a group directly or indirectly. E.g. Let’s say that wages are paid in advance toan employee – a wage prepaid account will be opened in the books of accounts. This wages prepaid account is a representative personal account indirectly linked to the person.
Golden rule for personal accounts
|Debit the receiver|
|Credit the giver|
3. Nominal Accounts
Accounts which are related to expenses, losses, incomes or gains are called Nominal accounts. The dictionary meaning of the word “nominal” is “existing in name only” and the meaning remains absolutely true in accounting sense too, because nominal accounts do not really exist in physical form, but behind every nominal account money is involved. E.g. Purchase A/C, Salary A/C, Sales A/C, Commission received A/C, etc.
The final result of all nominal accounts is either profit or loss which is then transferred to the capital account.
Golden rule for nominal accounts
|Debit all expenses & losses|
|Credit all incomes & gains|
1.11 Accounting Principles
- Business entity concept: A business and its owner should be treated separately as far as their financial transactions are concerned.
- Money measurement concept: Only business transactions that can be expressed in terms of money are recorded in accounting, though records of other types of transactions may be kept separately.
- Dual aspect concept: For every credit, a corresponding debit is made. The recording of a transaction is complete only with this dual aspect.
- Going concern concept: In accounting, a business is expected to continue for a fairly long time and carry out its commitments and obligations. This assumes that the business will not be forced to stop functioning and liquidate its assets at “fire-sale” prices.
- Cost concept: The fixed assets of a business are recorded on the basis of their original cost in the first year of accounting. Subsequently, these assets are recorded minus depreciation. No rise or fall in market price is taken into account. The concept applies only to fixed assets.
- Accounting year concept: Each business chooses a specific time period to complete a cycle of the accounting process—for example, monthly, quarterly, or annually—as per a fiscal or a calendar year.
- Matching concept: This principle dictates that for every entry of revenue recorded in a given accounting period, an equal expense entry has to be recorded for correctly calculating profit or loss in a given period.
- Realisation concept: According to this concept, profit is recognised only when it is earned. An advance or fee paid is not considered a profit until the goods or services have been delivered to the buyer.
There are four main conventions in practice in accounting: conservatism; consistency; full disclosure; and materiality.
- Conservatism is the convention by which, when two values of a transaction are available, the lower-value transaction is recorded. By this convention, profit should never be overestimated, and there should always be a provision for losses.
- Consistency prescribes the use of the same accounting principles from one period of an accounting cycle to the next, so that the same standards are applied to calculate profit and loss.
- Materiality means that all material facts should be recorded in accounting. Accountants should record important data and leave out insignificant information.
- Full disclosure entails the revelation of all information, both favourable and detrimental to a business enterprise, and which are of material value to creditors and debtors.
1.12 Double Entry System
Double entry is the fundamental concept underlying present-day bookkeeping and accounting. Double-entry accounting is based on the fact that every financial transaction has equal and opposite effects in at least two different accounts. It is used to satisfy the equation Assets = Liabilities + Equity, in which each entry is recorded to maintain the relationship.
Double entry system is acknowledged as the best method of accounting in the modern world. Following are the main advantages of double entry system:
- Under this method both the aspects of each and every transaction are recorded. So it is possible to keep complete account.
- Since both the aspects of a transaction are recorded, for each debit there must be a corresponding credit of an equal amount. Therefore, total debits must be equal to total credits. In fact, it is possible to verify the arithmetical accuracy of the books of accounts by ascertaining whether the two sides become equal or not through a process known as trial balance.
- Under this system profit and loss account can be prepared easily by taking together all the accounts relating to income or revenue and expenses or losses and thereby the result of the business can be ascertained.
- A balance sheet can be prepared by taking together all the accounts relating to assets and liabilities and thereby the financial position of the business can be assessed.
- Under this system mistakes and deflections can be detected – this exerts a moral pressure on the accountant and his staff.
- Under this system necessary statistics are easily available so that the management can take appropriate decision and run the business efficiently.
- All the necessary details about a transaction can be obtained quickly and easily.
- The total amount owed by debtors and the total amount owed to creditors can be ascertained easily.
- Sale, purchase of goods, stock, revenue, expenses and profit or loss of different years can be compared and the success or failure of the business measured. Thereafter the causes of failure can be found out and necessary remedial measures taken to ensure success of the business.
Despite so may advantages of the system, double entry system has some disadvantages which are as follows:
- Under this method each transaction is recorded in books in two stages (journal and ledger) and two sides (debit and credit). This results in increase of number and size of books of account and creation of complications.
- It involves time, labor and money. So it is not possible for small concerns to keep accounts under this system.
- It requires expert knowledge to keep accounts under this system.
- As the system is complex, there is greater possibility of committing errors and mistakes.
1.13 Introduction to Accounting Standards
We know that Generally Accepted Accounting Principles (GAAP) aims at bringing uniformity and comparability in the financial statements. It can be seen that at many places, GAAP permits a variety of alternative accounting treatments for the same item. For example, different methods for valuation of stock give different results in financial statements.
Such practices sometimes can misguide intended users in taking decision relating to their field. Keeping in view the problems faced by many users of accounting, a need for the development of common accounting standards was aroused.
For this purpose, the Institute of Chartered Accountants of India (ICAI), which is also a member of International Accounting Standards Committee (IASC), had constituted Accounting Standard Board (ASB) in the year 1977. ASB identified the areas in which uniformity in accounting was required. After detailed research and discussions, it prepared and submitted a draft to the ICAI. After proper examination, ICAI finalized them and notified for its use in financial statements.
Meaning of Accounting Standards:
Accounting standards are the written statements consisting of rules and guidelines, issued by the accounting institutions, for the preparation of uniform and consistent financial statements and also for other disclosures affecting the different users of accounting information.
Accounting standards lay down the terms and conditions of accounting policies and practices by way of codes, guidelines and adjustments for making the interpretation of the items appearing in the financial statements easy and even their treatment in the books of account.
Nature of Accounting Standards:
On the basis of forgoing discussion we can say that accounting standards are guide, dictator, service provider and harmonizer in the field of accounting process.
(i) Serve as a guide to the accountants:
Accounting standards serve the accountants as a guide in the accounting process. They provide basis on which accounts are prepared. For example, they provide the method of valuation of inventories.
(ii) Act as a dictator:
Accounting standards act as a dictator in the field of accounting. Like a dictator, in some areas accountants have no choice of their own but to opt for practices other than those stated in the accounting standards. For example, Cash Flow Statement should be prepared in the format prescribed by accounting standard.
(iii) Serve as a service provider:
Accounting standards comprise the scope of accounting by defining certain terms, presenting the accounting issues, specifying standards, explaining numerous disclosures and implementation date. Thus, accounting standards are descriptive in nature and serve as a service provider.
(iv) Act as a harmonizer:
Accounting standards are not biased and bring uniformity in accounting methods. They remove the effect of diverse accounting practices and policies. On many occasions, accounting standards develop and provide solutions to specific accounting issues. It is thus clear that whenever there is any conflict on accounting issues, accounting standards act as harmonizer and facilitate solutions for accountants.
Objectives of Accounting Standards:
In earlier days, accounting was just used for recording business transactions of financial nature. Its main emphasis now lies on providing accounting information in the process of decision making.
(i) For bringing uniformity in accounting methods:
Accounting standards are required to bring uniformity in accounting methods by proposing standard treatments to the accounting issue. For example, AS-6(Revised) states the methods for depreciation accounting.
(ii) For improving the reliability of the financial statements:
Accounting is a language of business. There are many users of the information provided by accountants who take various decisions relating to their field just on the basis of information contained in financial statements. In this connection, it is necessary that the financial statements should show true and fair view of the business concern. Accounting standards when used give a sense of faith and reliability to various users.
They also help the potential users of the information contained in the financial statements by disclosure norms which make it easy even for a layman to interpret the data. Accounting standards provide a concrete theory base to the process of accounting. They provide uniformity in accounting which makes the financial statements of different business units, for different years comparable and again facilitate decision making.
(iii) Simplify the accounting information:
Accounting standards prevent the users from reaching any misleading conclusions and make the financial data simpler for everyone. For example, AS-3 (Revised) clearly classifies the flows of cash in terms of ‘operating activities’, ‘investing activities’ and ‘financing activities’.
(iv) Prevents frauds and manipulations:
Accounting standards prevent manipulation of data by the management and others. By codifying the accounting methods, frauds and manipulations can be minimized.
(v) Helps auditors:
Accounting standards lay down the terms and conditions for accounting policies and practices by way of codes, guidelines and adjustments for making and interpreting the items appearing in the financial statements. Thus, these terms, policies and guidelines etc. become the basis for auditing the books of accounts.