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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
• 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.
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 userfriendly 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.
SCOPE AND OBJECTIVES OF FINANCIAL ACCOUNTING It provides: 1.Assistance 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.
(c) CONTROLLING Management would like to know whether: (i) (ii) The work done is according to the plan, and 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.
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:
1. Owners: Owners need accounting information to know the profitability and financial soundness of their organization. Accounting information enables them to take proper decisions. 2.Investors: Investors need accounting information to know how safe is the company, growth potential etc for taking a decision to invest further or to withdraw. 3.Creditors: 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.
6.Researchers: 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.
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.
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.
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.
2.Liability: 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 3.Asset “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”
Example of revenues is receipts from the sale of goods, rent income etc. 5.Expense: 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. 6.Income: “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
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”.
The term “sale” includes: “cash sales” and “credit sales”. 9.Stock: 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.
10.Debtors: 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. 11.Creditors: 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. 12.Losses: Loss really means something against which the firm receives no benefit. Expenses lead to revenue but losses do not, such as theft etc.
13. Proprietor: A person who invests in business and bears all the risks connected with the business is called proprietor. 14.Drawings: 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:
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: 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 its assets and has its obligations.
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.
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
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.
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.
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.
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. 6.The 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.
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.
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.
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
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.
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
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.