Unit-1 Introduction to Financial Accounting

Meaning, definition, Financial accounting

Financial accounting is the process of recording, analyzing, and reporting a business's financial
transactions.
Financial accounting is a field or branch of accounting that works on the summary, analysis, and reporting
of financial transactions that take place in the business. In the financial amounting, an accountant
prepared the various financial statements for public use which shows the company's financial position.
This information is useful for many parties who have an interest in the business like stockholders,
supplies, banks, employees, business owners, Government agencies, etc. Financial accounting works by
using both local and international standards.

Objectives of Financial Accounting

Recording Transactions Systematically
The most important objective of financial accounting is too keeping a proper record of the financial
aspects of business transactions. These transactions are later used for the preparation of financial
statements, their analysis, and interpretation after classifying and summarizing them logically.
Ascertaining the Results of Recorded Transactions
Profit and loss account is useful for understanding the result of business operations for a certain period.
If the business expenses are more than the revenue generated by the business then the company is
running under loss. This analysis helps the management in investigating and taking required steps to
cover this loss. Other than the management, P&L Account helps the stakeholders also in taking rational
decisions. For example, if the business is not remunerative or profitable then the stakeholders will not
invest and search for another company which will provide a reasonable rate of return at their investment.
Ascertaining the Financial Position of Business
Financial statements are used to know what does the business owns and what does it owes, i.e., assets
and liabilities on a certain date. This helps in knowing the financial position of the business in the market.
For this purpose, the accountants prepare a financial position statement of assets and liabilities which is
known as the Balance Sheet.
Providing Information to the Users
There are various parties which are interested in the business and keep their eyes on the performance
of the business. Accounting as a 'language of business' communicates the financial results of the business
to various stakeholders, management, banks, and other parties by means of financial statements.
Financial accounting fulfills the objective of meeting the financial information to these parties so that
they can make a rational decision before investing their funds in the company or in any project.
Understanding the Liquidity and Solvency Position
The balance sheet is not only helpful in calculating the total assets and liabilities of the business but it
also determines the concerns ability to meet its liabilities in the short run which is known as liquidity
position and also in the long run which is known as solvency position as and when they fall due.
Basic Financial Statements
There are four basic financial statements used in financial accounting which include the following:
1. Income Statement
An income statement is a statement that shows the company's net income differing a certain period.
This net income is calculated by deducting total expenses from total revenue. Numerically, it can be
represented as follows:
Net Income = Total Revenue - Total Expenses
Sometimes, income statement is also referred to as the Profit and Loss Statement.
2. Balance Sheet
A balance sheet represents a company's assets (items which are owned by the company) and liabilities
(items which are owed to the company) along with the shareholders' equity as of a particular date,
generally prepared at the end of the financial year, i.e., 31 st March.
On a balance sheet, the combined balance of liabilities and equity is equal to the balance of assets.
Numerically,
Assets = Liabilities + Shareholders' Equity
Items to be Presented on Shareholders' Equity
o Stocks: Preferred and Common Stocks
o Retained Earnings: Amount of profit that is retained by the company for further growth and
development.
o Comprehensive Income: Profit and loss occurred in a company's investment during a specific
period.
3. Cash Flow Statement
The cash flow statement is a document that represents the complete detail related to the income and
debts off a company over a particular period. Add the name clears, the cash flow statement is related to
the inflow and outflow of cash only and it does not include depreciation and amortization costs like an
income statement.
Advantages and Disadvantages of Accounting Information
• Maintenance of Business Records: Records of all the transactions related to a business for a
particular period in the book of accounts.
• Preparation of Financial Statements: Financial statements like Profit and loss account, Cash
flow statement, and Balance Sheets are prepared with the recorded transactions.
• Comparison of Results: The financial statements facilitate the comparison of business results
of a year with the other one easily.
• Decision Making: Ultimately, it becomes easier for the decision making authorities to make a
decision or plan for future activities.
• Evidence in Legal Matters: Thus prepared records to become evidence in the court of law.
• Provides Information to Related Parties: Proper Accounting records make financial
information available for the owners, employees, customers, government etc.
• Helps in Taxation Matters: Accounting information helps the tax authorities for settlement of
taxation matters.
• Valuation of Business: Accounting information helps in measuring the value of the business in
case of sale of an entity.
 • Replacement of Memory: Recording of accounting information replaces the necessity to
memorize records.

Disadvantages of Accounting
• Records in Terms of Money: Since the transactions that are measurable in terms of money can
only be recorded, non-financial transactions are not given effect in the book of accounts.
• Records Based on Estimates: Certain data are based on estimates and of the accuracy of
records may not be possible.
• Records may be Biased: Since the accountant’s influence affects the accounting information, it
may be biased.
• Records at the Original Cost: The balance sheet may not disclose the exact financial status of
the company due to the difference between the original cost and replacement cost due to the
various aspects.
• Manipulation of Accounts: The accountant may manipulate the profits of the business.
• Money as a Measurement Unit Changes in Value: Since the value of money keeps changing,
the accounting information will not show the true economic position of the company.
Limitations of Financial Statements:
The limitations of financial statements are such aspects that a user must be well aware of, before
depending upon them to an enormous amount. Knowledge of these aspects can result in a devaluation
of invested capital in a trading concern or actions taken to analyse further.
The following are the limitations of financial statements:
• Dependence on historical costs: Transactions are documented at their cost. This is interest
when analysing the balance sheet, where the values of assets and liabilities might vary over
time. A few items, such as marketable securities, are modified to equal the changes in their
market values; however, other items, namely – fixed assets, don’t change. Hence, the balance
sheet might be ambiguous if a large chunk of the amount depicted is grounded on historical
costs.
• Biased: Financial statements are the results of the documented facts, accounting notions and
conventions utilised and personal decisions made in distinct scenarios by the accountants.
Therefore, bias may be noticed in the outcomes, and the financial position shown in financial
statements may not be practical.
• Significant data missing: Balance sheet does not reveal the data that is associated with loss
of markets and end of agreements, which have an important aspect on the business.
• Aggregate Information: Financial statements depict average data but not explained data.
Therefore, they may not assist users in making decisions.
• Assets may not realise: Accounting is performed on the ground of a few definite conventions.
Some of the assets might not realise the declared values if the liquidation is enforced on the
enterprise. Assets shown in the balance sheet reflect slightly at an unexpired cost.
• They are only interim reports: Statement of Profit and Loss reveals the P/L for a defined
period. It does not furnish an idea about the earning capability over time correspondingly, the
financial position reflected in the balance sheet is appropriate at that point of time, the likely
change on a future date is not shown.
What is the Difference Between Bookkeeping and Accounting
In financial parlance, the terms bookkeeping and accounting are almost used interchangeably. However,
these concepts are different. While bookkeeping is all about recording of financial transactions,
accounting deals with the interpretation, analysis, classification, reporting and summarization of the
financial data of a business.
What is Bookkeeping?
Bookkeeping is the process of systematic recording and classification of financial transactions of an
organisation.
Bookkeeping is said to be the basis of accounting, whereas accounting forms a part of the broader scope
in finance.
The most important focus of bookkeeping is to maintain an accurate record of all the monetary
transactions of a business. Companies use this information to take major investment decisions.
The bookkeeper maintains bookkeeping records. Accurate bookkeeping is critical for business as it gives
a piece of reliable information on the performance of a company.
Bookkeeping process consists of the following steps:
1. Identifying a financial transaction
2. Recording a financial transaction
3. Preparing a ledger account
4. Preparing trial balance
What is Accounting?
Accounting is the systematic process of recording, measuring and communicating information about the
financial transaction taking place in a business. Accounting helps in determining the financial position of
a firm and present the same to stakeholders.
It helps a business in the short and long term decision making and also conveys the credibility of a
company to the market.
It is also known as the language of business.
The purpose of accounting is to provide a clear view of financial statements to its users, which includes
investors, creditors, employees, and government.
Let us look at the most important points of difference between bookkeeping and accounting in the
following table:
 Bookkeeping Accounting
Definition
Bookkeeping deals with identifying and Accounting refers to the process of summarising,
recording financial transactions only interpreting and communicating the financial data of an
organisation.
Decision making
Data provided by bookkeeping is not Management can take important decisions based on the
sufficient for decision making data obtained from accounting
Preparation of Financial Statement
Not done in the case of bookkeeping Financial statements are a part of the accounting process
Analysis
No analysis is required in the Accounting analyses the data and creates insights for the
bookkeeping business
Persons Involved
The person concerned with The person concerned with accounting is known as an
bookkeeping is known as a bookkeeper accountant
Determining Financial Position
Bookkeeping does not show the Accounting helps in showing a clear picture of the
financial position of a business financial position of a business
Level of Learning
No high-level learning required High-level learning required for understanding and
analysing accounting concepts
This article will help the students of Commerce in developing an understanding of the differences between
bookkeeping and accounting. Stay tuned to BYJU’S for more such interesting concepts.
Users of accounting information, important accounting terminology, principles of accounting
– concepts and conventions.
Main objectives of financial accounting:
1. Maintenance of records: To record financial transactions and events of the organisations in the
books of account in a systematic manner and interpret and summarise the results thereof to the
users of the financial information.
2. Ascertainment of profits or loss: For this purpose, an income statement or the trading and profit
and loss accounts are prepared.
3. Determination of financial position: Every businessman needs to know the financial status of the
organisation. For this purpose, a statement consisting of assets, liabilities, and the shareholder’s
capital is prepared, called a balance sheet statement.
4. Facilitates management: The management requires financial information for decision making and
better control, budgeting, and forecasting. Accounting helps to provide such financial information,
based on which the management can effectively take any decision.
5. Provides accounting information to users: Providing accounting information to users and
interested parties, they analyse such information as per their necessities.
Basics of Accounting
Let us learn some of the basics terminologies in accounting below.
• Assets: These are the possessed resources which are owned by a particular company or
individual. Some examples of assets are land, inventory, cash, buildings, supplies, etc.
• Liabilities: These are debts or financial obligations a company has during their business
operations. They are settled with time with transfer of money services or goods. Some examples
of liabilities are deferred revenues, earned premiums, mortgages, etc.
• Expenses: These are costs of different processes and operations which companies incur while
generating revenue. Some of the expenses are wages of employees, suppliers payment, leases,
etc.
• Revenue: Revenue is money which a business earns from its products and services.
• Equity: It is the amount of money which a company needs to return to its shareholders when all
its assets are liquidated after the company pays off its debts.
• Contra entry
A contra entry is a bookkeeping transaction that involves both a debit and credit to two related
accounts, such as cash and bank accounts. Contra entries are used to offset each other, and they
don't impact the financial position of the company. Here are some examples of contra entries:
Cash withdrawal from bank
When a company withdraws cash from its bank account for office expenses, the contra entry would
be:
Bank account: Debit Rs 1000
Cash account: Credit Rs 1000
Cash deposit into bank
When a company deposits cash into its bank account, the contra entry would be:
Bank account: Debit the amount deposited
Cash account: Credit the amount deposited
Debtor
What is a Debtor?
A firm or person that owes money is referred to as a debtor. If the debt is in the form of a loan from
a financial institution, the debtor is referred to as the borrower, and if the debt is in the form of
securities like bonds, the debtor is referred to as the issuer. Legally, a person who voluntarily files a
petition for bankruptcy is also regarded as a debtor.
Example of a Debtor
Consider Sally, who wants a mortgage loan to purchase a house. To finance a property, she
collaborates with a bank. She finally gets a $250,000 loan.
Sally is now in debt to the bank and owes them $250,000. Her bank is the creditor. Mortgages employ
the property (in this case, Sally's home) as security for the loan.
Liabilities in Accounting
Meaning
Liability refers to the sum of money that the firm owes to the outsiders or the amount that the firm
has to pay to the shareholders, investors, creditors, workers and employees, and many other parties.
The company can settle these liabilities over time through cash, goods, or services. Some examples
of liabilities are accounts payable, mortgage, bonds, warranties, deferred revenues, accrued
expenses, etc. All the liabilities are presented on the left side of the balance sheet. Sometimes,
liability can also mean a legal or regulatory risk or obligation.
What is Loan?
A loan is a financial instrument used by persons and businesses to borrow money from authorized
institutions, such as banks. The loan could also be a certain amount of money lent by one person to
another with a consideration that the person receiving the loan will repay that amount in the future.
Many times, the issuer giving the loan charges some interest on the principal amount, and the person
receiving the loan must pay the interest along with the principal amount.
Income
The first and most important factor which largely affects the lender's decision is the borrower's
income.
In the case in which the loan amount is big, it is very important for the lender to check whether the
income of the borrower is enough to repay the loan and the borrower will not face any difficulty in
the repayment of the loan.
If the loan is a home loan, in such a case, the stable employment of the borrower plays a deciding
role in the grant of the loan by the lender.
Credit Score
The second most important factor which should be considered before lending the loan amount to the
borrower is the borrower's credit score.
A credit score is a numerical representation that reflects the creditworthiness of a person. The credit
score depends upon past borrowing and repayment of the loan by the person.
If the person applying for the loan has a good credit score, then it becomes a plus factor for the
borrower to get a loan. The credit score is affected by past missed payments on the loan, and even
bankruptcy can lower the credit score.
What Are Bills Payable?
Bills payable refers to the short-term borrowing of banks from other banks, where the lender is often
the country's central bank. Banks will borrow money from the central bank or other banks in order
to maintain reserve requirements and adequate liquidity
Payment
In accounting, payment is the transfer of money, goods, or services from one party to another, or to
meet a legal obligation:
• Parties
The party that makes the payment is called the payer, and the party that receives the payment is
called the payee.
• Methods
Payments can be made in many ways, including cash, checks, debit or credit cards, wire transfers,
or cryptocurrencies.
• Terms
Payments are usually made after all parties agree to the terms, but they can also be made before or
during the provision of goods or services. Payment terms can include discounts for early payment.
• Invoices
In trade, payments are often accompanied by a bill or invoice. Invoices can include terms of payment,
such as the due date, payment method, and any discounts
Voucher - meaning, preparation and presentation.
What is Accounting Voucher?
Vouchers are prepared to support the accounting entries made in the books of accounts to provide
correctness to the transactions. Initially, every transaction finds a place in the source documents and
then using source documents, every transaction is recorded in the form of vouchers. For every
business firm or party involved, there are vouchers in the name of every firm with their specific
name. Also, different vouchers are created for every transaction as well. Every voucher indicates the
accounts that are required to be credited or debited. Vouchers are usually sanctioned by the accounts
payable department to authorize the payments. For every voucher, there is a certain serial number
written on it and its related source document is tied up to the particular voucher. The main reason
to assign a serial number to every voucher is to make it easy for the auditors to file and vouch them.
Like source documents, vouchers add to the documentary evidence of business transactions.
What are Source Documents?
Source documents are the documents that are authentic, original, and the very first record, which
incorporates the important details of the business transactions. This document contains important
information like the name of the party, the date on which the transaction happened, the amount of
the transaction, and the nature of the transaction. Source documents become the base to record the
transaction in the books of accounts. There’s always a unique number associated with every source
document to differentiate it from others. These documents serve the purpose of providing authentic
evidence for every transaction. Source documents are also important for auditors and accountants
because these records help them in auditing accounts and making tax assessments. These are the
written proofs as per the accounting principle of verifiable objective, as it says that every transaction
must have sufficient proof to support the transaction. Also, it can serve as legal evidence if any
dispute arises.
But to make the entries and to form financial statements further, transactions need to be recorded
in a more systematic manner and this is the step where ‘vouchers’ comes into existence.
A Voucher is an internal document used for supporting the entries in accounting books. It is treated
as a redeemable transaction bond, has monetary value and is useful for specific purposes. There are
different types of accounting vouchers for any business, which are as follows:
• Cash Voucher – These vouchers get prepared by a firm solely for cash transactions like receipts
and payments. It can be a Debit Voucher that a firm prepares only for cash payments to suppliers
or vendors to purchase raw materials and semi-finished goods for production, purchase of assets
or payments of expenses. It can also be a Credit Voucher that a firm prepares only for cash
 receipts from customers or vendors to sell goods to the customer, sale of assets or receipt of
income.
• Non-Cash Voucher – These vouchers are also known as transfer vouchers, and they get
prepared for credit transactions only. Examples of such transactions are credit purchase or sale
of goods, purchase or sale of fixed assets on credit, etc.
The preparation of vouchers depends on how a transaction gets recorded in the account books. Based
on the complexity of a transaction, the vouchers can be classified as follows:
• Transaction Voucher – It is a voucher prepared by the firm when one account gets debited and
another account gets credited for a transaction.
• Compound Voucher – It is a voucher prepared by the firm for two types of transactions. The
first type is where more than one account gets debited, but only one account gets credited for a
transaction. And the second type is where more than one account gets credited, but only one
account gets debited for a transaction.
• Complex Voucher – It is a voucher prepared by a firm when multiple accounts are debited and
credited for a transaction.
Difference between Voucher and Source Documents
Voucher Source Documents
1. Vouchers denote the evidence of the 1. Source document refers to the
transaction. document recording transactions in the
correct manner.
2. Vouchers are supported by the source 2. Source document provides the base
documents. to prepare the vouchers.
3. Vouchers contain information on what account is to 3. Source document only collects the
be debited or credited. details of the business transactions.
4. The main purpose of preparing vouchers is not to 4. The main purpose of preparing the
record transactions and rather to verify transactions. source documents is to record business
transactions.
5. Common Examples of Vouchers are: debit note, 5. Common examples of source
credit note, letter of credit, etc. documents are cash memos, invoices
or bills, cash receipts, etc.
Types of Vouchers
Vouchers can be prepared in two forms:
A. Cash Vouchers
B. Non-Cash Vouchers
A. Cash Voucher
Cash Vouchers basically refer to vouchers that incorporate all the cash transactions that are cash
receipts and payments. Under the category of Cash vouchers, there can be two types of vouchers;
Debit Vouchers and Credit Vouchers.
1. Debit Vouchers:
Debit Vouchers are prepared to record transactions related to the cash payments like:
• Cash payments to buy goods
• Cash payments to buy fixed assets & investments
• Cash payments to Creditors
• Cash payments regarding expenses (rent, salaries, etc.)
• Securing cash in the banks
Details included in the Debit Voucher:
1. Date on which transaction is recorded
2. Serial no. of Voucher
3. Name of the account debited
4. Amount involved in the debit transaction
5. Description of the transaction along with required information.
6. Serial Number of the Source document attached to the Voucher
2. Credit Vouchers:
Credit Vouchers are prepared to record the transactions relating to the cash receipts like:
• Cash receipts from selling goods
• Cash receipts from selling out fixed assets & investments
• Cash receipts from debtors
• Cash receipt related to income (interest income etc.)
• Withdrawal of cash from the banks.
Details included in the Credit Voucher:
1. Date on which transaction is recorded
2. Serial no. of Voucher
3. Name of the account credited
4. Amount involved in the credit transaction
5. Description of the transaction along with required information
6. Serial Number of the Source document attached to the Voucher
B. Non-Cash Vouchers
Non-cash vouchers are also known as Transfer Vouchers. These vouchers basically incorporate all
the non-cash transactions. Following are the details scribbled in the Non-cash voucher.
Details included in the Non-cash voucher:
• Buying or Selling goods on credit
• Buying or Selling out fixed assets & investments
• Goods sold on credit
• Returns of goods bought
• For writing off bad debts
• To provide depreciation
Details included in the Non-Cash Voucher:
1. Date on which Voucher is prepared
2. Serial no. of Voucher
3. Name of the account debited or credited in regard to credit transactions
4. Amount involved in the credit transactions
5. Description of the credit transaction along with required information
6. Serial number of Source document attached to the particular voucher
Illustration:
There is a business named M/s Shikha Enterprises (59/3 Model Town, New Delhi, 110006). On April
14, 2022, this business purchased 5 wooden chairs at the unit price of ₹500 each and 10 plastic
chairs at the unit price of ₹300 each on credit from The Furniture Hub. Prepare a voucher for this
particular transaction:
Solution:
Format of Voucher

Advantages:
• Accuracy: Accounting vouchers help ensure the accuracy of financial records, as they provide a
detailed record of each transaction.
• Organization: Accounting vouchers help organize financial records by providing a structured
format for recording transactions.
• Audit trail: Accounting vouchers provide an audit trail that can be used to track transactions and
identify errors or fraud.
• Accountability: Accounting vouchers help ensure accountability by documenting who authorized
and carried out each transaction.
• Compliance: Accounting vouchers help businesses comply with tax and regulatory requirements
by providing detailed records of financial transactions
Disadvantages:
• Time-consuming: Creating and managing accounting vouchers can be time-consuming,
especially for businesses with a large volume of transactions.
• Paperwork: Accounting vouchers can result in a significant amount of paperwork, which can be
difficult to manage and store.
• Complexity: Accounting vouchers can be complex, especially for businesses with multiple
accounts or subsidiaries, leading to potential errors and confusion.
• Cost: Accounting vouchers may require additional resources and software, leading to additional
costs for businesses.
• Vulnerability: Accounting vouchers are vulnerable to loss, theft, or damage, which can impact
the accuracy and completeness of financial records.