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 to
communicate and tell the affairs of the company to the outside
world 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 is
intended 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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• Communicating the results to persons, who may be
managers, investors, employees unions, government, tax
authorities and any other stake holders.
The above definition brings out the following attributes.
1. Financial Transactions.
It records only those transactions, which are of financial
character.
If a transaction has no financial character then it will not be
measured in terms of money and therefore will not be
recorded.
Recording
It is an art of recording business transactions in a
systematic manner.
Recording is done in the book called “journal”.
This book may be further subdivided into various
subsidiary books such as:
• Cashbook,
• Purchase daybook,
• Sales daybook etc.
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2. Classifying
Classifying refers to grouping of transactions or entries
of one nature at one place.
This is done by opening accounts in a book called
“ledger”
“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 includes
trading and profit and loss accounts and balance sheet.
4. Analysis and interpretations.
For the purpose of analysis, the accounting record must be in
such a way as to be able to bring out the significance of all
transactions and events individually and collectively.
Thus the analysis of financial statements will help the
management and other stakeholders to judge the performance
of business operations and for preparing for further course of
action.
Infact Financial Accounting is the original form of accounting.
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SCOPE AND OBJECTIVES OF FINANCIAL
ACCOUNTING
It provides:
[Link] to management:
In modern times in addition to financial results of
operations, financial accounting also performs certain
other significant functions, which helps the management
to perform their task in an efficient and systematic
manner, like:
(a) PLANNING
Management would like to know the sales, output,
expenses, etc. relating to the next year and also the
flow of cash.
Financial accounting will help in arriving at reasonable
estimates.
(b) DECISION MAKING
Management is faced at times with a number of
problems requiring decision.
For example: What should be the selling price of goods
produced? Should a concession be offered to a special
customer and how much etc.
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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 help
management in this regard.
For instance, management would be able to know
which department is overspending.
2. Replacement of memory.
No businessmen can remember everything about his
business.
It is necessary to record transactions in the books of
accounts promptly.
3. Comparative study.
A systematic record will enable a businessman to
compare one year’s 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 great
assistance 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 transactions
as good evidence.
6. Sale of business
In the case of sale or take over or mergers, the accounts
maintained 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 getting
the need based assistance.
To whom it is useful
Business information conveyed through financial
accounting is useful to different groups of persons
who have interest in the business like:
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1. Owners:
Owners need accounting information to know the
profitability and financial soundness of their
organization.
Accounting information enables them to take proper
decisions.
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Investors need accounting information to know how
safe is the company, growth potential etc for taking a
decision to invest further or to withdraw.
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Creditors need accounting information to know the
liquidity position and credit worthiness of the firm in
which they are going to extend credit.
4. Employees:
Employee’s union need accounting information to
know the profitability in order to demand more wages
and bonuses and other employee related benefits.
5. Government:
Government needs accounting information to assess
the indirect and direct taxes.
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[Link]:
Researchers are interested in interpreting the financial
statements 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 a
systematic manner and then interpreting the results
to serve various purposes depending on need of the
stakeholders.
Thus bookkeeping is part of accounting, concerned
only with original record of transactions.
While accounting is a generic term and
bookkeeping 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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LIMITATIONS OF ACCOUNTING
While the financial accounting has many
advantages, it has got certain limitations also.
Some of the limitations arise from the fundamental
principles, concepts and assumptions.
The limitations are as follows:
(i) Financial Accounting is not fully exact:
Although most of the transactions are recorded on actual
basis such as sale or purchase or receipt of cash.
Some estimates must be made such as useful life of an
asset, possible bad debts, value of closing stock to enable
the firm to arrive at profit or loss figure.
People have different views on estimates and therefore
the figure of profit differs.
Sometimes it is deliberately manipulated to suit certain
requirements.
Thus the profit figure cannot be treated as exact.
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(ii) Financial Accounting does not indicate what
the business will realize if sold:
The balance sheet should not be taken to show the
amount of cash which the firm may realize by sale of all its
assets.
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 is
appearing in the balance sheet.
(iii) Financial Accounting does not tell the whole
story:
It is known that in the books of accounts only such
transactions and events are recorded as can be
interpreted in terms of money.
There are, however, many other important factors, which
though not recorded in the books of accounts, may make
or 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 to
assess the future of the firm.
(iv) Accounting statements may be drawn up
wrongly:
Due to different method being employed, say for valuing
closing 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 one
must 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 assets
having money value), which the proprietor/ owner/
shareholders/ partners have invested in the
organization/business.
For the business, capital is a liability towards the owner.
It is also known as owner’s equity and also net worth.
Owner’s equity means owner’s claim against the assets.
It is always equal to:
Capital = Assets – Liabilities.
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Liabilities mean the amount, which the firm owes to
outsiders, excepting the proprietors.
Thus claim of those who are not owners are called
“Liabilities”.
Liabilities=Assets –Capital
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“Assets are things of value owned”.
It can be said that “assets” are anything, which will
enable the firm to get cash or a benefit in future.
Building, debtors, stock of goods are some of the example
of 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 an
increase in the owner’s equity”
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Example of revenues is receipts from the sale of goods,
rent income etc.
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Expense is the amount spent in order to produce and sell
goods and services, which produce the revenue
“Expenses” are the use of things or services for the
purpose of generating revenues”.
Examples are: payment of salaries, wages, rent etc.
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“Revenue” is different from “Income”
When goods are sold, the receipt is called “revenue”.
The cost of goods sold is called “expense”.
The difference between “revenue” and “expense” is
called income.
For example, the goods costing Rs. 15,000 are sold for
Rs. 21,000.
The “revenue” is Rs.21, 000,
The “expense” is Rs 15,000 and
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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 called
“credit 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 received
immediately, it is called “credit sale”.
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The term “sale” includes:
“cash sales” and “credit sales”.
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The term “stock” includes goods lying unsold on a
particular date.
To ascertain the value of the closing stock, it is
necessary 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 accounting
year.
Whereas the term
“Closing stock” includes:
Goods lying unsold at the end of the accounting period.
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A person who owes money to the firm mostly on
account of credit sale of goods is called debtor.
For example, when goods are sold to a person on credit
that person does not pay immediately but he pays in
future.
He is called a debtor because he owes some money to
the firm.
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A person to whom the firm owes some money is called a
creditor.
It is mostly on account of credit purchases by the firm,
where the money is not paid immediately by the firm but
at a future date.
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Loss really means something against which the firm
receives no benefit.
Expenses lead to revenue but losses do not, such as
theft etc.
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13. Proprietor:
A person who invests in business and bears all the risks
connected with the business is called proprietor.
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It is the amount of money or the value of goods, which
the proprietor takes for his domestic or personal use.
15. Transaction:
Transaction means any exchange of goods or services
for cash or on credit, big or small like purchasing a
machine 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 involving
transfer of money or money’s 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 in
neglect’.
Accounting was first practiced and then theorized.
Certain ground rules were initially set for financial
accounting; these rules arose out of conventions.
Therefore these are called accounting concepts or
conventions and are very much useful in understanding
accounting.
These are:
[Link] entity concept:
Under this concept a business is an artificial entity
distinct from its proprietor.
A business entity is an economic unit, which owns its
assets and has its obligations.
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The owner(s) may have personal bank accounts, real
estate and other assets, but these will not be considered
as 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 sole
proprietor is considered fully responsible for the welfare
of the entity and, in the eyes of the law the proprietor
and business are not considered to have separate
existence.
For accounting purposes, however they are separate
entities and an accountant will record transactions
between the owner and the firm:
For instance, when capital is provided by the owner, the
record will show that the firm has received so much
money and is owing it to proprietor.
In case the proprietor withdraws the money from
business 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 one
owner 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, entirely
divorced from its owners (called equity shareholders).
A sole proprietorship business normally comes to an
end with the expiry of owner,
A partnership firm may cease to operate or, at least,
there will be reconstruction of the agreement on the
expiry of an owner (called partner).
But a corporate entity is not disturbed at all on the expiry
of any equity shareholder.
2. Money Measurement concept
This implies that only those transactions and
events are recorded in accounting, which can be
expressed in monetary terms.
In other words, an event, howsoever important may
be to the business, will not be recorded unless its
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monetary effect can be measured with a fair degree
of accuracy.
For example the death of Dhiru Bhai Ambani cannot
be recorded in the books of accounts, as the
monetary 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 most
important assets of an undertaking is the quality and
caliber of its management, which cannot be
recorded.
The basic measurement in accounting is money and
it is assumed that the monetary unit i.e. rupee is
stable unit in value.
Although this assumption is not valid as money
value changes over a period of time, the purchasing
power of money changes quite often due to inflation
and changes in global markets.
3. The Going concern concept
The going concern means that the firm will last for a long
time.
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This implies that the business will exist for an infinite time
and 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 will
be 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 the
expected life in view.
The financial statement of a business is prepared on the
assumption that it is a continuing enterprise.
On the basis of this assumption fixed assets are recorded
at their original cost and are depreciated in a systematic
manner 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 suitable
basis over the next 10 years for ascertaining the profit and
loss 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 would
enter 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 be
recorded 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, as
per cost concept, at the same amount even today when
the current price of land have increased five fold.
The greatest limitation of this concept is that it distorts the
true 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 to
a halt.
Therefore the best way to judge a business is to have a
periodic performance appraisal.
Such a period to measure business performance is
called an accounting period.
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The results of operations of an entity are measured
periodically i.e., in each accounting period.
As per Companies Act, 1956 different business entities
may follow different accounting periods depending on
convenience.
An entity may follow calendar year as an accounting
period 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 an
accounting period for reporting to Income tax authorities.
[Link] Accrual Concept:
It suggests that income and expenses should be
recognized as and when they are earned and incurred,
irrespective of fact whether the money is received or paid
in connection thereof.
The Companies Act, 1956 has prescribed that this
concept has to be followed for practically all-accounting
purposes.
The alternative to accrual concept is cash basis of
accounting as per which the entry will be made only when
the cash is received.
As per Act, wherever it is not possible to follow the accrual
concept, the cash basis may be followed and the fact
must 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 be
recognized 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 Rs
20 lacs and not Rs 15 lacs.
7. Matching Concept:
The inherent concept involved in accrual accounting is
called 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 the
financial results of a business.
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In accrual basis of accounting, revenue is recognized
when the sale is complete or services are rendered rather
than when the cash is received.
Similarly the expenses are recognized not when cash is
paid but when assets or services have been used to
generate 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 will
be earned in the next period.
The amount should be carried down to the next period
and
(the amount is shown in the balance sheet as an asset)
and the same will be treated as an expense in the next
period.
To illustrate the point we take the following example:
(a) at the end of the year, some of the goods purchased
remain unsold.
Then the cost of the goods concerned should be carried
to the next year and set off against the sales of the next
year.
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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 trading
account) 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 the
balance 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 required
under 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 be
accounted for but not the anticipated gains.
9. The Realization Concept
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The realization concept tells that to recognize revenue, it
has 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 the
seller of goods has transferred to the buyer the title of
the goods for a price and no uncertainty exists regarding
the consideration that will be derived from the sale of
goods.
DOUBLE ENTRY ACCOUNTING
Accounting starts with recording and ends in
presenting financial information in a manner which
facilitates
“informed judgments and decisions by users”
The recording of transactions and events follow a
definite 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 that
it affects two sides- debit and credit- equally.
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The Accounting Trail
The sequence of activities in an accounting process can
be shown as below:
Transaction/event
Preparation of vouchers
Recording in the primary
books
Posting in the secondary
books
Preparation of Trial balance
Preparation and presentation of financial
statements
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 business
entity negotiates a wage settlement with the employees
union, 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 materials
from its supplier, it is an external event and it involves
exchange of value instantly.
Thus, all external events do not involve immediate
exchange of value.
The external events that involve transfer of value
between the entities are called transactions.
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