Basic Concepts -I (Financial Accounting)

8/9/2019 Basic Concepts -I (Financial Accounting)

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Financial Accounting

What is Financial Accounting?

Financial Accounting is the language of business.

The purpose of any language is to communicate.

Therefore being a language, Financial Accounting is a tool tocommunicate and tell the affairs of the company to the outsideworld and also to the owners.

This is done through accounting statements.

Therefore the financial statements should be prepared in a manner,which is understood by all.

It should be prepared and presented in such a manner that what isintended to be conveyed should be clear and understandable.

It can be said that Financial Accounting is the science of:

Recording and Classifying business transactions and events, primarily of

financial character,

And

Art of making significant summaries, Analysis and interpretations of these transactions and

events and

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2. Classifying

Classifying refers to grouping of transactions or entriesof one nature at one place.

This is done by opening accounts in a book calledledger

Ledger contains all the accounts of the business.

3. Summarizing

Summarizing is the art of presenting the classified data,(ledger) in a manner, which is understandable, and user-friendly to the management and other stakeholders.

This involves preparation of final accounts , which includestrading and profit and loss accounts and balance sheet .

4. Analysis and interpretations.

For the purpose of analysis, the accounting record must be insuch a way as to be able to bring out the significance of alltransactions and events individually and collectively.

Thus the analysis of financial statements will help the

management and other stakeholders to judge the performanceof business operations and for preparing for further course of action.

Infact Financial Accounting is the original form of accounting.

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(c) CONTROLLING

Management would like to know whether:

(i) The work done is according to the plan, and

(ii) The cost incurred is reasonable.

Financial Accounting collects information to helpmanagement in this regard.

For instance, management would be able to knowwhich department is overspending.

2. Replacement of memory.

No businessmen can remember everything about hisbusiness.

It is necessary to record transactions in the books of accounts promptly.

3. Comparative study.

A systematic record will enable a businessman tocompare one years results with those of other years

and locate significant factors, which can be used for corrective action.

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4. Settlement of taxation liabilities.

If accounts are maintained properly, they will be of greatassistance when the firm is assessed to income tax and

sales tax, and service tax.

5. Evidence in court.

The courts often treat systematic record of transactionsas good evidence.

6. Sale of businessIn the case of sale or take over or mergers, the accountsmaintained by the firm will enable the ascertainment of the proper purchase price.

7. Assistance to an insolvent or sick industry

In case a firm is sick or declared insolvent, the proper accounting may help in sorting out the matter or gettingthe need based assistance.

To whom it is useful

Business information conveyed through financial

accounting is useful to different groups of personswho have interest in the business like:

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1. Owners:

Owners need accounting information to know theprofitability and financial soundness of their

organization.

Accounting information enables them to take proper decisions.

2.Investors:

Investors need accounting information to know howsafe is the company, growth potential etc for taking adecision to invest further or to withdraw.

3.Creditors:

Creditors need accounting information to know theliquidity position and credit worthiness of the firm inwhich they are going to extend credit.

4. Employees:

Employees union need accounting information toknow the profitability in order to demand more wagesand bonuses and other employee related benefits.

5. Government:

Government needs accounting information to assessthe indirect and direct taxes.

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6.Researchers:

Researchers are interested in interpreting the financialstatements of the business concerns for a given

objective.

BOOKKEEPING VS ACCOUNTING

Bookkeeping is maintaining the record of transactions, i.e. recording the transactions.

Accounting means classifying, summarizing in asystematic manner and then interpreting the resultsto serve various purposes depending on need of thestakeholders.

Thus bookkeeping is part of accounting, concernedonly with original record of transactions.

While accounting is a generic term andbookkeeping is an essential part of it.

Accounting begins where bookkeeping ends.

Bookkeeping provides the basis for accounting.

It is complementary to accounting process.

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(ii) Financial Accounting does not indicate whatthe business will realize if sold:

The balance sheet should not be taken to show theamount of cash which the firm may realize by sale of all itsassets.

This is because many assets are not meant to be sold:

They are meant for use and are shown at cost less

depreciation.The actual value may be much more than what isappearing in the balance sheet.

(iii) Financial Accounting does not tell the wholestory:

It is known that in the books of accounts only suchtransactions and events are recorded as can beinterpreted in terms of money.

There are, however, many other important factors, whichthough not recorded in the books of accounts, may makeor mar the firm such as:

Relations with the employees, Caliber of management, Brand of the product, Integrity of management etc.

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Unless such factors are also kept in mind it is difficult toassess the future of the firm.(iv) Accounting statements may be drawn up

wrongly:

Due to different method being employed, say for valuingclosing stock, it is possible to arrive at different figure of profit and loss and to give totally different financial picture.

Off course auditing gives measure of checks but still onemust be cautious and also go through the footnotes and

also comments by the auditors carefully.ACCOUNTING TERMINOLOGY

1. Capital:

Capital means the amount (in terms of money or assetshaving money value), which the proprietor/ owner/shareholders/ partners have invested in theorganization/business.

For the business, capital is a liability towards the owner.

It is also known as owners equity and also net worth.

Owners equity means owners claim against the assets.

It is always equal to:

Capital = Assets Liabilities.

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2.Liability:

Liabilities mean the amount, which the firm owes tooutsiders, excepting the proprietors.

Thus claim of those who are not owners are calledLiabilities .

Liabilities=Assets Capital3.Asset

Assets are things of value owned.

It can be said that assets are anything, which willenable the firm to get cash or a benefit in future.

Building, debtors, stock of goods are some of the exampleof assets.

4. Revenue:

Revenue means the amount, which, as a result of

operations is added to the capital.

Revenue is an inflow of assets which results in anincrease in the owners equity

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The income is Rs.21, 000 Rs. 15,000 =Rs.6, 000.

Income is known as profit.Income or Profit = Revenue Expense.

7. Purchases: The term purchase is used only for purchase of goods.

Goods are those things which are purchased for resale or producing finished products which are also meant for sale.

Goods purchased for cash is called cash purchases.

Goods purchased on credit are calledcredit purchases

The term purchases includes both

Cash purchases as well as

Credit purchases.

8. Sale:

This term is used for sale of goods only.

When goods are sold for cash, it is called cash sales.

When goods are sold but payment is not receivedimmediately, it is called credit sale .

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The term sale includes:

cash sales and credit sales.

9.Stock:

The term stock includes goods lying unsold on aparticular date. To ascertain the value of the closing stock, it isnecessary to make a complete list of all the items in the

godown together with quantities.The stock is valued on the basis of:

Cost or market price

which ever is less.

The stock may be opening or closing stock.

The opening stock means:

Goods lying unsold in the beginning of the accountingyear.

Whereas the term

Closing stock includes:

Goods lying unsold at the end of the accounting period.

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10.Debtors:

A person who owes money to the firm mostly onaccount of credit sale of goods is called debtor.

For example, when goods are sold to a person on creditthat person does not pay immediately but he pays in

future.He is called a debtor because he owes some money tothe firm.

11.Creditors: A person to whom the firm owes some money is called acreditor.

It is mostly on account of credit purchases by the firm,where the money is not paid immediately by the firm butat a future date.

12.Losses:

Loss really means something against which the firmreceives no benefit.

Expenses lead to revenue but losses do not, such astheft etc.

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13. Proprietor:

A person who invests in business and bears all the risksconnected with the business is called proprietor .

14.Drawings:

It is the amount of money or the value of goods, whichthe proprietor takes for his domestic or personal use.

15. Transaction:

Transaction means any exchange of goods or servicesfor cash or on credit, big or small like purchasing amachine or a pencil.

Strictly, transactions are only with the outsiders.

However, there are some events like wear and tear of machinery, which also must be recorded like other transactions.

Thus, a transaction is a business event involvingtransfer of money or moneys worth. 16. Entry:

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The record made in the books of accounts in respect of a transaction or an event is called an entry.

ACCOUNTING CONCEPTS AND CONVENTIONS.

A renowned accountant once observed that:

accounting was born without notice and reared inneglect.

Accounting was first practiced and then theorized.

Certain ground rules were initially set for financialaccounting; these rules arose out of conventions.

Therefore these are called accounting concepts or conventions and are very much useful in understandingaccounting.

These are:

1.The entity concept:

Under this concept a business is an artificial entity

distinct from its proprietor.

A business entity is an economic unit, which owns itsassets and has its obligations.

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The owner(s) may have personal bank accounts, realestate and other assets, but these will not be consideredas assets of the business.

A business entity may be in the form of:

A sole proprietorship concern,

A partnership entity, or

A corporate entity.

In the case of a proprietorship business, the soleproprietor is considered fully responsible for the welfareof the entity and, in the eyes of the law the proprietor and business are not considered to have separateexistence.

For accounting purposes, however they are separateentities and an accountant will record transactionsbetween the owner and the firm:

For instance, when capital is provided by the owner, therecord will show that the firm has received so much

money and is owing it to proprietor.

In case the proprietor withdraws the money frombusiness for his personal use, it will be charged to him.

An account is kept for the owners like other persons.

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A partnership form of business has more than oneowner who have

agreed to share profits of a business carried on by all or any one of them acting for all.

A corporate entity is a separate legal entity, entirelydivorced from its owners (called equity shareholders).

A sole proprietorship business normally comes to anend with the expiry of owner,

A partnership firm may cease to operate or, at least,there will be reconstruction of the agreement on theexpiry of an owner (called partner).

But a corporate entity is not disturbed at all on the expiryof any equity shareholder.

2. Money Measurement concept

This implies that only those transactions andevents are recorded in accounting, which can beexpressed in monetary terms.

In other words, an event, howsoever important maybe to the business, will not be recorded unless its

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monetary effect can be measured with a fair degreeof accuracy.

For example the death of Dhiru Bhai Ambani cannot

be recorded in the books of accounts, as themonetary effect cannot be measured with a fair degree of accuracy.

Although it had great effect on the fortunes of various Reliance group companies.

This has been one of the serious limitations of accounting since, probably; one of the mostimportant assets of an undertaking is the quality andcaliber of its management, which cannot berecorded.

The basic measurement in accounting is money andit is assumed that the monetary unit i.e. rupee isstable unit in value.

Although this assumption is not valid as moneyvalue changes over a period of time, the purchasingpower of money changes quite often due to inflationand changes in global markets.

3. The Going concern concept

The going concern means that the firm will last for a longtime.

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This implies that the business will exist for an infinite timeand transactions are recorded from this point of view.

This necessitates distinction between expenditure that will

render benefit for a long period and that whose benefit willbe exhausted quickly, say within a year.

Of course if it is certain that the business will exist only for a limited time, the accounting record will keep theexpected life in view.

The financial statement of a business is prepared on theassumption that it is a continuing enterprise.

On the basis of this assumption fixed assets are recordedat their original cost and are depreciated in a systematicmanner without reference to their market value.

An example of this would be purchase of machinery,which would last, say for next 10 years.

The cost of machinery would be spread on a suitablebasis over the next 10 years for ascertaining the profit andloss of each year.

The full cost of machine would not be treated as an

expense in the year of its purchase.

In the absence of this concept no outside parties wouldenter into long term contracts with the company for supplying funds and goods.

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A firm is said to be a going concern when there is neither the intention nor the necessity to wind up its operations.

4. The cost concept:

Assets such as land, buildings, plant and machinery etc.and obligations such as loans, public deposits should berecorded at historical cost (i.e., cost at the time of acquisition)

For example: Land purchased by a business entity five

years back at a cost of Rs. 20 lacs should be shown, asper cost concept, at the same amount even today whenthe current price of land have increased five fold.

The greatest limitation of this concept is that it distorts thetrue worth of an asset by sticking to its original cost.

5. The periodicity concept:

The activities of a going concern are continuous flows.

In order to judge the performance of a business entity,one cannot wait for eternity to see the business coming toa halt.

Therefore the best way to judge a business is to have aperiodic performance appraisal.

Such a period to measure business performance iscalled an accounting period.

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The results of operations of an entity are measuredperiodically i.e., in each accounting period.

As per Companies Act, 1956 different business entities

may follow different accounting periods depending onconvenience.

An entity may follow calendar year as an accountingperiod another may follow the financial year.

But the Income Tax Act, 1961 has now made it

compulsory for all companies to follow financial year as anaccounting period for reporting to Income tax authorities.

6.The Accrual Concept:

It suggests that income and expenses should berecognized as and when they are earned and incurred,irrespective of fact whether the money is received or paidin connection thereof.

The Companies Act, 1956 has prescribed that thisconcept has to be followed for practically all-accountingpurposes.

The alternative to accrual concept is cash basis of

accounting as per which the entry will be made only whenthe cash is received.

As per Act, wherever it is not possible to follow the accrualconcept, the cash basis may be followed and the factmust be reported as a footnote to the balance sheet.

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Example of accrual concept is:

(i) Rent paid for fifteen months in advance on 1st

January 2005.

The business follows calendar year as accounting year.

In this case rent for first twelve months should berecognized as an expense for the year 2005.

(ii) Credit sales for the year 2005 were Rs.20 lacs.Cash collected from customers during the year was Rs 15 lacs.

Therefore the sales for 2005 should be considered as Rs20 lacs and not Rs 15 lacs.

7. Matching Concept:

The inherent concept involved in accrual accounting iscalled matching concept.

The revenue earned in an accounting year is offset(matched) with all the expenses incurred during the same

period to generate that revenue.

The matching concept is very much vital to measure thefinancial results of a business.

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In accrual basis of accounting, revenue is recognizedwhen the sale is complete or services are rendered rather than when the cash is received.

Similarly the expenses are recognized not when cash ispaid but when assets or services have been used togenerate revenue.

For example:

(i) When an item of revenue is entered in the profit and

loss account, all the expenses incurred (whether paid for in cash or not) should be taken in the expense side.

If an amount is spent but against which the revenue willbe earned in the next period.

The amount should be carried down to the next periodand

(the amount is shown in the balance sheet as an asset)and the same will be treated as an expense in the nextperiod.

To illustrate the point we take the following example:

(a) at the end of the year, some of the goods purchasedremain unsold.

Then the cost of the goods concerned should be carriedto the next year and set off against the sales of the nextyear.

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The valuation of the stock and deducting it from the

total costs (or being put in the credit side of the tradingaccount) makes sales and costs comparable.

(b) machinery purchased will last say for ten years .

Then only one tenth of the cost will be treated as expense

for the year and remaining amount should be shown in thebalance sheet as an asset.

8. Concept of Prudence

It states that anticipate no profits but provide for all possible losses.

Prudence means the caution in the exercise of the judgments needed in making the estimates requiredunder conditions of uncertainty, such that:

Assets and income are not, overstated and liabilities or expenses are not understated.

The principle is that: Expected losses should beaccounted for but not the anticipated gains.

9. The Realization Concept

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The realization concept tells that to recognize revenue, ithas to be realized.

Realization principle does not demand that the revenue

has to be received in cash.

The revenue from sales should be recognized when theseller of goods has transferred to the buyer the title of the goods for a price and no uncertainty exists regardingthe consideration that will be derived from the sale of goods.

DOUBLE ENTRY ACCOUNTING

Accounting starts with recording and ends inpresenting financial information in a manner whichfacilitates

informed judgments and decisions by users

The recording of transactions and events follow adefinite rule.

Each transaction and /or events has two aspects or sides- debit and credit.

Every debit has an equal and opposite credit.

This is the crux of double entry concept.

Each transaction should be recorded in such a way thatit affects two sides- debit and credit- equally.

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The Accounting Trail

The sequence of activities in an accounting process canbe shown as below:

Transaction/event

Preparation of vouchers

Recording in the primarybooks

Posting in the secondarybooks

Preparation of Trial balance

Preparation and presentation of financialstatements

Transactions and Events

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An event is happening of consequence to an entity.

An event may be an internal happening or an external

incident.

For example, when the management of a businessentity negotiates a wage settlement with the employeesunion, it is an internal event.

On the other hand, when the same management

recruits a fresh MBA, it is an external event.However, this does not involve transfer or exchange of any value instantly.

Again if the same business purchases raw materialsfrom its supplier, it is an external event and it involvesexchange of value instantly.

Thus, all external events do not involve immediateexchange of value.

The external events that involve transfer of valuebetween the entities are called transactions.

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Basic Concepts -I (Financial Accounting)

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