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Financial Accounting

Introduction

The purpose of accounting is to provide the information that is needed for sound
economic decision making. The main purpose of financial accounting is to prepare
financial reports that provide information about a firm’s performance to external
parties such as investors, creditors, and tax authorities. Managerial accounting
contrasts with financial accounting in that managerial accounting is for internal
decision making and does not have to follow any rules issued by standard-setting
bodies. Financial accounting, on the other hand, is performed according to Generally
Accepted Accounting Principles (GAAP) guidelines.

In a manufacturing organisation, it provides information to management about the


cost of manufacturing a product, the cost of performing a job, the cost of sales
and the profit earned or loss incurred etc. Similarly, in a commercial organisation,
it provides information about the profit or loss and also the increase or decrease
in the assets and liabilities of the organisation. It also provides data for proper
budgetary control. In the case of government, accounting helps the various levels
of management, in the preparation of plans and exercise of proper financial
control. By providing data about the expenditure incurred on, various activities, it
helps budget planners to determine in advance, the taxes to be levied and also
the areas, where the cut in expenditure is possible. Again, it helps the
management in proper monitoring and implementation of plans, schemes. Thus,
accounting is an useful aid to management in performing its various managerial
functions effectively. Organized set of manual and computerized accounting
methods, procedures, and controls established to gather, record, classify,
analyze, summarize, interpret, and present accurate and
timely financial data for management decisions.

The accounting system of a company consist of following elements:

1. Journal

2. Ledger

3. Trial Balance

4. Profit and Loss A/c

5. Balance Sheet.
The elements are explained in detail in the following pages.

Eleven Key Accounting Concepts

Entity

Accounts are kept for entities and not the people who own or run the company.
Even in proprietorships and partnerships, the accounts for the business must be kept
separate from those of the owner(s).

Monetary

For an accounting record to be made it must be able to be expressed in monetary


terms. For this reason, financial statements show only a limited picture of the
business. Consider a situation where there is a labor strike pending or the business
owner’s health is failing; these situations have a huge impact on the operations and
financial security of the company but this information is not reflected in the financial
statements.

Going Concern

Accounting assumes that an entity will continue to operate indefinitely. This concept
implies that financial statements do not represent a company’s worth if its assets
were to be liquidated, but rather that the assets will be used in future operations.
This concept also allows businesses to spread (amortize) the cost of an asset over
its expected useful life.

Cost

An asset (something that is owned by the company) is entered into the accounting
records at the price paid to acquire it. Because the “worth” of an asset changes over
time it would be impossible to accurately record the market value for the assets of a
company. The cost concept does recognize that assets generally depreciate in
value and so accounting practice removes the depreciation amount from the original
cost, shows the value as a net amount, and records the difference as a cost of
operations (depreciation expense.)

Objectivity
The objectivity concept states that accounting will be recorded on the basis of
objective evidence (invoices, receipts, bank statement, etc…). This means that
accounting records will initiate from a source document and that the information
recorded is based on fact and not personal opinion.

Time Period

This concept defines a specific interval of time for which an entity’s reports are
prepared. This can be a fiscal year (Mar 1 – Feb 28), natural year (Jan 1 – Dec 31),
or any other meaningful period such as a quarter or a month.

Conservatism

This requires understating rather than overstating revenue (income) and expense
amounts that have a degree of uncertainty. The rule is to recognize revenue when it
is reasonably certain and recognize expenses as soon as they are reasonably
possible. The reasons for accounting in this manner are so that financial statements
do not overstate the company’s financial position. Accounting chooses to err on the
side of caution and protect investors from inflated or overly positive results.

Realization

Revenues are recognized when they are earned or realized. Realization is assumed
to occur when the seller receives cash or a claim to cash (receivable) in exchange
for goods or services. This concept is related to conservatism in that revenue
(income) is only recorded when it actually occurs and not at the point in time when a
contract is awarded.

Matching

To avoid overstatement of income in any one period, the matching principle requires
that revenues and related expenses be recorded in the same accounting period. If
you bill $20,000 of services in a month, in order to accurately represent the income
for the month you must report the expenses you incurred while generating that
income in the same month.

Consistency

Once an entity decides on one method of reporting (i.e. method of accounting for
inventory) it must use that same method for all subsequent events. This ensures
that differences in financial position between reporting periods are a result of
changed in the operations and not to changes in the way items are accounted for.

Materiality

Accounting practice only records events that are significant enough to justify the
usefulness of the information. Technically, each time a sheet of paper is used, the
asset “Office supplies” is decreased by an infinitesimal amount but that transaction is
not worth accounting for.
Journal

Journal is a book of accounts in which all day to day business transactions are
recorded in a chronological order i.e. in the order of their occurrence. Transactions
when recorded in a Journal are known as entries. It is the book in which transactions
are recorded for the first time. Journal is also known as ‘Book of Original Record’ or
‘Book of Primary Entry’.

Business transactions of financial nature are classified into various categories of


accounts such as assets, liabilities, capital, revenue and expenses. These are
debited or credited according to the rules of debit and credit, applicable to the
specific accounts. Every business transaction affects two accounts.

Applying the principle of double entry one account is debited and the other account
is credited. Every transaction can be recorded in journal. This process of recording
transactions in the journal is’ known as ‘Journalizing’.

In small business houses generally, one Journal Book is maintained in which all the
transactions are recorded. But in case of big business houses as the transactions
are quite large in number, therefore journal is divided into various types of books
called Special Journals in which transactions are recorded depending upon the
nature of transaction i.e. all credit sales in Sales Book, all cash transactions in Cash
Book and so on.

Format of Journal

Every page of Journal has the following format. It is a columnar book. Each column
is given a name written on its top.

Format of journal is given below:

Date Particulars L/F Debit Credit


Amount Amount

Classification Of Journal

Journal is a book in which transactions are recorded in chronological order/ date


wise, therefore it will be practically `difficult to record if the number of transactions is
large. To take the benefit of division of labor, journal should be divided into number
of journals. Journal can be classified into various special journals and Journal
proper. Special journals are also known as special purpose books. These journals
are explained below :

(i) Cash Journal/Cash Book

Cash Journal or Cash Book is meant for recording all cash transactions i.e., all cash-
receipts and all cash payments of the ‘business. This book he1ps us to know the
balance of Cash in hand at any point of time.

(ii) Purchases Journal

This journal is meant for recording all credit purchases of goods only as Cash
purchases of goods are recorded in the Cash Book. In this journal, purchases of
other things like machinery, typewriter, stationery, etc. are not recorded. Goods
means articles meant for trading or the articles in which the business deals.

(iii) Sales Journal

This journal is meant for recording all credit sales of goods made by the firm. Cash
Sales are recorded in the Cash Book and not in the Sales Book. Credit Sale of items
other than the goods dealt in like sale of old furniture, machinery, etc. are not
entered in the Sales Journal.

(iv) Purchase Returns Journal

Whenever, the goods are not as per the specifications, the buyer may return these
goods to the supplier. These returns are entered in a book known as Purchase
Returns Book. It is also known as Returns Outward Journal Book.

(v) Sale Returns Journal

Sometimes, when the goods are sold to the customer and they are not satisfied with
the goods, they may return these goods to the businessman. Such returns are
known as Sales Returns. Just like Purchase Returns, they are also recorded in a
separate Book which is known as Sales Returns or Returns Inward Journal/Book.

II. Journal Proper

This journal is meant for recording all such transactions for which no special journal
has been maintained in the business. Therefore, in this journal, all such transactions
are recorded which do not occur frequently and for these transactions no special
journal is required. For example, if Machinery is purchased on credit, it will be
recorded in the journal proper, because in the Cash Book, we will record only cash
purchases of machinery. Similarly, many other transactions, which do not find their
place in the special journals, will be recorded in the General Journal such as

(i) Outstanding expenses – Salaries outstanding, Rent outstanding, etc.


(ii) Prepaid expenses – Prepaid Rent, Salaries paid in advance

(iii) Income received in advance – Rent received in advance, interest received in


advance, etc.

(iv) Accrued Incomes – Commission yet to be received, interest yet to be received.

(v) Interest on Capital

(vi) Depreciation

(vii) Credit Purchase and Credit Sale of fixed Assets – Machinery, Furniture.

(viii) Bad debts.

(ix) Goods taken by the proprietor for personal use.


Ledger

While journal lists transactions in chronological order, its format does not facilitate
the tracking of individual account balances. The ledger is used for this purpose.

The journal ledger is a collection of T- accounts to which debit and credit


transactions are transferred. The action of recording a debit or credit in the ledger is
referred to as Posting. The posting of a journal entry to the ledger accounts is purely
a mechanical process using information already in the journal entry and requiring no
additional analysis.

Format of Ledger

A ledger has 2 sides – Debit and Credit. Each side of the ledger account is sub
divided into 4 columns – Date, Particulars, Journal Folio and Amount. Both sides of
the account look similar and the account looks symmetrical about the center. It looks
as follows:

Date Particualrs J/F Amount Date Particualrs J/F Amount

Because the general ledger is organized by account, it allows one to view the activity
and balance of any account at a glance.
Trial Balance

At first the transactions are entered in the Journal and Special Purpose Books like
Cash Book, Purchases Book, Sales Book, etc. From these books items are posted in
the ledger in their respective accounts. Finally, at the end of the accounting year
these accounts are balanced. To check the accuracy of posting in the ledger a
statement is prepared with two columns i.e. debit column and credit column which
contain debit balances of accounts and credit balances of accounts respectively.
Total of the two columns are if equal, it means the ledger posting is arithmetically
correct. This statement is called Trial Balance.

Trial Balance may be defined as a statement which contains balances of all ledger
accounts on a particular date. Trial Balance consists of a debit column with all debit
balances of accounts and credit column with all credit balances of accounts. The
totals of these columns if tally it is presumed that ledger has been maintained
correctly. However, Trial Balance proves only the arithmetical accuracy of posting in
the ledger.

Format of Trial Balance:

Particulars Debit Particulars Credit


Amount Amount
Profit And Loss Account

The purpose of the profit and loss account is to:

• Show whether a business has made a PROFIT or LOSS over a financial year.
• Describe how the profit or loss arose – e.g. categorising costs between “cost
of sales” andoperating costs.

A profit and loss account starts with the TRADING ACCOUNT and then takes into
account all the other expenses associated with the business. It has three parts.

1) The Trading Account.

This records the money in (revenue) and out (costs) of the business as a result of
the business’ ‘trading’ ie buying and selling. This might be buying raw materials and
selling finished goods; it might be buying goods wholesale and selling them retail.
The figure at the end of this section is the Gross Profit.

2) The Profit and Loss Account proper

This starts with the Gross Profit and adds to it any further costs and revenues,
including overheads. These further costs and revenues are from any other activities
not directly related to trading. An example is income received from investments.

3) The Appropriation Account.

This shows how the profit is ‘appropriated’ or divided between the three uses
mentioned above.

Uses of the Profit and Loss Account.

1) The main use is to monitor and measure profit, as discussed above. This
assumes that the information recording is accurate. Significant problems can arise if
the information is inaccurate, either through incompetence or deliberate fraud.

2) Once the profit(loss) has been accurately calculated, this can then be used for
comparison ie judging how well the business is doing compared to itself in the past,
compared to the managers’ plans and compared to other businesses.
3) There are ways to ‘fix’ accounts. Internal accounts are rarely ‘fixed’, because there
is little point in the managers fooling themselves (unless fraud is going on) but public
accounts are routinely ‘fixed’ to create a good impression out to the outside world. If
you understand accounts, you can usually (not always) spot these ‘fixes’ and take
them out to get a true picture.
Balance Sheet
A balance sheet, also known as a "statement of financial position", reveals a
company's assets, liabilities and owners' equity (net worth). The balance sheet,
together with the income statement and cash flow statement, make up the
cornerstone of any company's financial statements.

If you are a shareholder of a company, it is important that you understand how the
balance sheet is structured, how to analyse it and how to read it.

How the balance sheet works

The balance sheet is divided into two parts that, based on the following equation,
must equal (or balance out) each other. The main formula behind balance sheets is:

assets = liabilities + shareholders' equity

This means that assets, or the means used to operate the company, are balanced by
a company's financial obligations along with the equity investment brought into the
company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and
equity are two sources that support these assets. Owners' equity, referred to as
shareholders' equity in a publicly traded company, is the amount of money initially
invested into the company plus any retained earnings, and it represents a source of
funding for the business.

It is important to note, that a balance sheet is a snapshot of the company's financial


position at a single point in time.

Assets
Current assets have a life span of one year or less, meaning they can be converted
easily into cash. Such assets classes are: cash and cash equivalents, accounts
receivable and inventory. Cash, the most fundamental of current assets, also
includes non-restricted bank accounts and checks.

Cash equivalents are very safe assets that can be are readily converted into cash
such as US Treasuries. Accounts receivable consists of the short-term obligations
owed to the company by its clients. Companies often sell products or services to
customers on credit, which then are held in this account until they are paid off by the
clients.

Lastly, inventory represents the raw materials, work-in-progress goods and the
company's finished goods. Depending on the company, the exact makeup of the
inventory account will differ. For example, a manufacturing firm will carry a large
amount of raw materials, while a retail firm caries none. The makeup of a retailers
inventory typically consists of goods purchased from manufacturers and wholesalers.
Non-current assets, are those assets that are not turned into cash easily, expected
to be turned into cash within a year and/or have a life-span of over a year. They can
refer to tangible assets such as machinery, computers, buildings and land.

Non-current assets also can be intangible assets, such as goodwill, patents or


copyright. While these assets are not physical in nature, they are often the resources
that can make or break a company - the value of a brand name, for instance, should
not be underestimated.

Depreciation is calculated and deducted from most of these assets, which represents
the economic cost of the asset over its useful life.

Liabilities

On the other side of the balance sheet are the liabilities. These are the financial
obligations a company owes to outside parties. Like assets, they can be both current
and long-term. Long-term liabilities are debts and other non-debt financial
obligations, which are due after a period of at least one year from the date of the
balance sheet.

Current liabilities are the company's liabilities which will come due, or must be paid,
within one year. This is comprised of both shorter term borrowings, such as accounts
payables, along with the current portion of longer term borrowing, such as the latest
interest payment on a 10-year loan.

Shareholders' equity

Shareholders' equity is the initial amount of money invested into a business. If, at the
end of the fiscal year, a company decides to reinvest its net earnings into the
company (after taxes), these retained earnings will be transferred from the income
statement onto the balance sheet into the shareholder's equity account.

This account represents a company's total net worth. In order for the balance sheet
to balance, total assets on one side have to equal total liabilities plus shareholders'
equity on the other.
Accounting System of Marathawada Textiles

Marathawada textiles is located in Nanded. They are into wholesale business of


shirting and suiting. They supply to almost all the retailers in the district. It follows
various accounting concepts and conventions. It follows the convention of going
concern, entity concept, monetary concept, cost concept, matching concept,
realisation concept, consistency concept and materiality concept.

It follows the April – March accounting period i.e. its accounting period starts from 1st
April and ends on 31st March every year.

The books of accounts maintained by the company are:

1. Purchase journal

2. Purchase Return Journal

3. Sales Journal

4. Sales return Journal

5. Cash Book

6. Journal Proper

7. Ledger

8. Trial Balance

9. Profit and loss account

10. Balance Sheet.