Financial Accounting Unit 1

Unit 1 Introduction to Financial Accounting

Structure:
1.1 Introduction
Objectives
1.2 Meaning of Book Keeping, Accounting and Accountancy
1.3 Distinction between Book Keeping and Accounting
1.4 Accounting Process
1.5 Objectives of Accounting
1.6 Various users of Accounting Information
1.7 Limitations of Accounting
1.8 Accounting Terminologies
1.9 Summary
1.10 Terminal Questions
1.11 Answers

1.1 Introduction
A business is started with a view to earn profits, to grow and to sustain in
the long run. Profits are earned through the transactions like purchases,
sale of goods and services, incurring various expenditures etc. As a
business person you would like to know in detail the various types and
amount of earnings as well as expenses also, the nature and value of
assets possessed during a particular period.
A systematic accounting procedure is the only way to ascertain the profits
earned or loss incurred from the business for a particular period. To make a
sound decision a business enterprise needs accounting information.
Government agencies, regulatory bodies, analysts and individuals need
accounting information at various points of time and at different levels.
Accounting is perhaps one of the oldest, structured management
information system. It has evolved in response to the social and economic
needs of society. Accounting as an information system is concerned with
identification, measurement and communication of economic information of
an organization to its users who may need the information for rational
decision making. The accounting system is a means to provide relevant and
reliable financial information to all the interested parties.

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In this unit you will learn the meaning of book keeping, accounting and
accountancy. You will also learn to distinguish between book keeping and
accountancy. The accounting process has 8 stages and each stage is
detailed in length. The objectives of accounting, briefs you the need for
accounting. There are various stakeholders and you will learn how these
stakeholders use the accounting information. You will learn the limitations of
accounting and finally the unit concludes with basic terminologies in
accountancy.
Objectives:
After studying this unit, you should be able to -
 Define book keeping, accounting and accountancy
 distinguish between book keeping and accounting
 describe the accounting process
 explain the objectives of accounting
 categorize various users of accounting information
 list the limitations of accounting

1.2 Meaning of Book Keeping, Accounting and Accountancy

Let us now understand the meaning of book keeping, accounting and
accountancy.
Meaning of Book keeping:
A business undertakes number of transactions. Can you estimate this
number? Every day business transactions may be around hundreds/
thousands. It depends upon the size of a business entity. Can a
businessman remember all these transactions in every respect? Not at all!
So it becomes necessary to record these business transactions in detail and
in a systematic manner. Recording of business transactions in a systematic
manner in the books of account is called Book keeping. Book keeping is
concerned with recording of financial data. This is defined as follows -

“The art of keeping a permanent record of business transactions is

Book keeping”

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Meaning of Accounting:
Accounting is an ancient art. In India, it existed in the times of Chandra
Gupta Maurya. Chanakya (Kautilya) speaks of accounting and auditing in
his famous work ARTHASHASTHRA.
However, accounting as we know today is of recent origin. Luca Pacioli, who
lived in Italy in the 15th Century is supposed to be the father of accounting.
He published his PRINCIPLES OF DOUBLE ENTRY SYSTEM in 1494. In
his book, he used the present day popular terms of accounting – Debit (Dr)
and Credit (Cr). He has discussed the details of memorandum, journal
ledger and specialised accounting procedures. He also stated that, “All
entries have to be double entries, i.e. if you make one creditor you must
make one debtor.”
We find a phenomenal growth of the subject especially after 1930s.
Accountancy like other subjects such as medicine, law, etc., has evolved in
response to the social and economic needs of society. As business and
society became more complex over the years, accounting developed new
techniques and concepts to meet the increasing needs for financial
information.
Many authorities have defined accounting and a study of these definitions
will help in understanding the meaning of accounting. Some of the
commonly accepted definitions are given here as stated by:
1. American Institute of Certified Public Accountants ( AICPA)

“The art of recording, classifying, summarising, analysing and

interpreting the business transactions systematically and
communicating business results to interested users is
accounting”

2. The American Accounting Association (AAA)

“Accounting is the process of identifying, measuring and

communicating economic information to permit informed
judgments and decisions by the users of the information”

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According to these definitions, Accounting means:

 Recording of transactions which can be expressed in terms of money.
The recording is made as soon as a transaction takes place and in an
orderly manner.
 Classifying of the recorded data by grouping the similar nature of
transactions.
 Summarising the information at the end of the financial period, generally,
a year.
 Interpreting of the summarised data for forming judgements and
formulating future policies.

Meaning of Accountancy:
Accountancy refers to a systematic knowledge of accounting. It explains
‘why to do’ and ‘how to do’ of various aspects of accounting. It tells us why
and how to prepare the books of accounts and how to summarize the
accounting information and communicate it to the interested parties.

Self Assessment Questions:

Fill in the blanks with suitable word/words:
1. Keeping systematic record of business transactions is known as
_______________.
2. Accounting is the process of identifying, measuring and communicating
economic information to permit _________________ and ________ by
the users of the information.
3. State true or false:
Accountancy explains ‘why and how to prepare the books of accounts
and how to summarize the accounting information and communicate it to
the interested parties’.

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1.3 Distinction between Book Keeping and Accounting

Let us now analyse the difference between book keeping and accounting.
Table 1.1: Differences between Book Keeping and Accounting
Basis of Difference Book Keeping Accounting
Nature It is concerned with It is concerned with summarizing
identifying financial the recorded transactions,
transactions; interpreting them and
measuring them in communicating the results.
monetary terms;
recording and
classifying them.
Objective It is to maintain It aims at ascertaining business
systematic records of income and financial position by
financial transactions. maintaining records of business
transactions.
Function It is to only record It is the recoding, classifying,
business summarizing, interpreting
transactions. business transactions and
So its scope is communicating the results. Thus
limited. its scope is quite wide.
Basis Vouchers and other Book keeping works as the
supporting basis for accounting information.
documents are
necessary as
evidence to record
the business
transactions.
Relation Book keeping is the Accounting begins where book
first step to keeping ends.
accounting.

1.4 Accounting Process

Accounting is the process of identifying the transactions and events,
measuring the transactions and events in terms of money, recording them in
a systematic manner in the books of accounts, classifying or grouping them
and finally summarizing the transactions in a manner useful to the users of
accounting information. Figure 1.1 illustrates Accounting Process.

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ACCOUNTING ENCOMPASSES

1. IDENTIFICATION 5. SUMMARISING

2. MEASURING 6. ANALYSING

3. RECORDING 7. INTERPRETING

4. CLASSIFYING 8. COMMUNICATING

Fig. 1.1: Accounting Process

Let’s now discuss these accounting processes one by one:

1) Identifying the transactions and events: This is the first step of
accounting process. It identifies the transaction of financial character
that is required to be recorded in the books of accounts. Transaction is
transfer of money or goods or services from one person or account to
another person or account. Events happen as a result of internal policies
or external needs. Events of non-financial character cannot be recorded
even though such events may have an impact on the operational results
of the firm.
2) Measuring: This denotes expressing the value of business transactions
and events in terms of money (in terms of Rupees in India).
3) Recording: It deals with recording of identifiable and measurable
transactions and events in a systematic manner in the books of original
entry that are in accordance with the principles of accountancy.
4) Classifying: It deals with periodic grouping of transactions of similar
nature that appear in the books of original entry into appropriate heads
by posting or transfer entries. For e.g.: All purchases of goods made for
cash or on credit on different dates are brought to purchase account.
5) Summarizing: It deals with summarizing or condensing transactions in
a manner useful to the users. This function involves the preparation of
financial statements such as income statement, balance sheet,
statement of changes in financial position and cash flow statement.

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6) Analysing: It deals with the establishment of relationship between the

various items or group of items taken from income statement or balance
sheet or both. Its purpose is to identify the financial strengths and
weaknesses of the enterprise. The above six process in the present day
scenario are generally performed using software packages.
7) Interpreting: It deals with explaining the significance of those data in a
manner that the end users of the financial statement can make a
meaningful judgment about the profitability and financial position of the
business. The accountants should interpret the statement in a manner
useful to the users, so as to enable the user to make reasoned decision
out of the alternative course of action. They should explain various
factors on what has happened, why it happened and what is likely to
happen under specific conditions.
8) Communicating: It deals with communicating the analysed and
interpreted data in the form of financial reports/statements to the users
of financial information e.g. Profit and Loss Account, Balance Sheet,
Cash Flow and Funds Flow Statement, Auditors Report etc.
Self Assessment Questions
4. State true or false: Identification of transactions, measurement,
recording, classification, summarizing and analysing are done using
software packages in the present day environment.
5. Choose the correct answer from among the choices given:
________________ deals with explaining the significance of those data
in a manner that the end users of the financial statement can make a
meaningful judgement about the profitability and financial position of the
business
(a) Interpreting (b) Summarizing (c) Analysing (d) Communicating
6. State true or false: Accountants need not explain various factors on what
has happened, why it happened, and what is likely to happen under
specific conditions.

Activity 1:
Visit a Mall and a medical shop in your area. Find out how accounting
system is adopted by them and do a comparative analysis. Refer Tally 9
Simple accounting for guidance.

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1.5 Objectives for Accounting

The basic objective of accounting is to provide full, accurate and meaningful
financial information about the financial activities of a business to all those
who have a right and a need to have such information.
The main objectives of accounting include:
 Systematic recording of all business events or transactions and
subsequent posting to ledger, to finally prepare financial statements -
profit and loss account and balance sheet.
 Reporting the results to management, shareholders, creditors, bankers,
investors, stock brokers, stock exchanges, employees, government etc.
 Satisfying the statutory requirements, especially Registrar of Companies
(ROC), Securities Exchange Board of India (SEBI), tax authorities (sales
tax, excise, customs and income tax) and government in order to protect
the interest of general public.
 Protecting the properties of business by recording them on the date of
acquisition and showing their accounts in the balance sheet.
 Planning, controlling and decision making functions become easy where
books of accounts are maintained properly. This helps in internal control
by holding concerned persons responsible for any errors, lapses or
under performance.
 Accounting is a tool for effective planning. Current year’s financial
performance becomes the basis for future predictions and estimations.
Since it is a tool for planning, it also acts as a tool for controlling.
Preparation of budgets, cost analysis, tax planning, auditing are some of
the functions of accounting.

1.6 Various users of Accounting Information

Different categories of users need different kinds of information for making
decisions. These users can be divided into:
1. Internal Users
2. External Users.
1. Internal Users:
These are the persons who manage the business, i.e. management at
the top, middle, and lower levels. Their requirements of information are
different because they make different types of decisions. The top level is

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more concerned with planning, the middle level is concerned equally

with planning and control and the lower level is concerned more with
controlling operations. Information is supplied on different aspects, e.g.
cash resources, sales estimates, results of operations, financial position,
etc.
2. External Users:
All persons other than internal users come in the group of external
users. External users can be divided into two groups:
a. Those having direct interest
b. Those having indirect interest in a business organization.
The main sources of information for external users are annual reports of
business organizations. They not only state the financial position and
performance but also give the auditor’s report, director’s report and other
information. Investors and creditors are the external users having direct
interest. Tax authorities, regulatory agencies, customers, labour unions,
trade associations, stock exchanges, investors, etc., are indirectly interested
in the company’s financial strength, its ability to meet short-term and long-
term obligations, its future earning power, etc., for making various decisions.
Investors who are providers of risk capital would be interested to know the
financial health of the firm, Lenders would be interested to know whether the
firm will be able to service the loan, Security analyst, rating agencies and
other information specialists would be interested in assessing the
prospective returns of the firm. Managers need financial information for
planning and controlling operations, employees and Trade Unions would like
to know general operations, stability and profitability of the firm, customers
are interested to know the source of future purchase, after sale services and
finally Government and regulatory authorities are responsible to regulate
business activities and to collect tax.
The public- patronage
Self Assessment Questions
Fill in the blanks with appropriate word/words:
7. Interested users of accounting information are broadly classified into
___________ and ______________.
8. Expand SEBI ____________________________________________.

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Activity 2 :
Assume yourself as an owner of a mobile shop. List out all the revenues
you earn, the expenses you incur for a month. Also record the assets you
own and liabilities you owe to others to run the business. Refer format of
Profit and Loss account and Balance Sheet from any Financial
Accounting books.

1.7 Limitations of Accounting

Accounting suffers from various limitations. They are as follows:
1) Accounting information is expressed in terms of money: Non-
monetary events or transactions are completely omitted.
2) Fixed assets are recorded in the accounting records at the original
cost: Actual amount spent on the assets like building, machinery, plus
all incidental charges is recorded. In this way the effect of rise in prices
is not taken into consideration. As a result the Balance Sheet does not
represent the true financial position of the business.
3) Accounting information is sometimes based on estimates:
Estimates are often inaccurate. For example, it is not possible to predict
the actual life of an asset for the purpose of depreciation.
4) Accounting information cannot be used as the only test of
managerial performance on the basis of mere profits : Profit for a
period of one year can readily be manipulated by omitting certain
expenses such as advertisement, research and development,
depreciation etc. i.e. window dressing is possible.
5) Accounting information is not neutral or unbiased: Accountants
ascertain income as excess of revenue over expenses. But they
consider selected revenue and expenses for calculating profit of the
concern. They also do not include cost of items such as water, noise or
air pollution i.e. social cost, they may use different methods of valuation
of stock or depreciations.

1.8 Accounting Terminologies

Here, some important basic terms of accounting are given with detailed
explanation. This may help to understand the various accounting concepts
in the coming chapters.
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1. Business Entity: It is an economic unit that performs economic

activities. For accounting, it is assumed that business has separate
existence and its entity is different from that of its owner(s).
2. Sole trader: A single individual carrying on business with or without the
help of his kith and kin is called sole trader.
3. Partnership: It is a relationship between partners to contribute capital
to start business, agree to distribute profits and losses in an agreed
proportion and the business being carried on by all or anyone acting for
all. Partnership firm refers to business where as the partnership refers
to relationship caused by the agreement.
4. Joint Stock Company: It is an organization, for which the capital is
contributed by shareholders to carry on business and it is registered
under Companies Act and it has a legal entity, having perpetual
existence and a common seal.
5. Capital: Funds brought in to start business, by the owner/s. In the case
of a company, capital is collected by issue of shares. Capital used to
purchase fixed assets is called fixed capital and the capital used for
day to day affairs of business is known as working capital. From
business point of view, Capital is a liability.
6. Equity: Equity is the residual interest in the asset of the enterprise after
deducting all its liabilities. The equity of a company is called
shareholders’ equity. Its components include share capital, share
premium and retained earnings.
7. Share: A share in a company is one of the units into which the total
capital of the company is divided.
8. Assets: Assets are resources legally owned by the enterprise as a
result of past events and from which future economic benefits are
expected to flow to the enterprise. Eg: Land and buildings, plant and
machinery, furniture and fixtures, cash in hand and at bank, debtors
and stock etc., are regarded as assets, Assets may be fixed, current,
liquid or fictitious.
9. Fixed Assets: Fixed assets are those which are held for use in the
production or supply of goods and services. E.g.: plant and machinery,
which is used fairly for long period.

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10. Current Assets: Current assets are those which are held or receivable
within a year or within the operating cycle of the business. They are
intended to be converted into cash within a short period of time. E.g.:
Stock in trade, debtors, bills receivable, cash at bank etc.
11. Liquid Assets: Liquid Assets are those which can be easily converted
into cash and for instance, cash in hand, cash at bank, marketable
investments etc.
12. Fictitious Assets: Fictitious Assets are in the form of such expenses
which could not be written off during the period of their incidence. For
example, promotional expenses of a company which could not be
treated as expenditure in the year of incidence are shown as fictitious
asset.
13. Inventory: Inventory refers to goods held by a business for sale in the
ordinary course of business or for consumption in the production of
goods or service for sale. It includes stock of raw materials, stock of
work in – progress and stock of finished goods.
14. Debtor: A debtor is a person who owes money to the business. A
debtor may be of 4 types as mentioned below:-
 Trade debtor is a person who owes money to the business for the
goods supplied to him on credit.
 A loan debtor is a person who owes money to the business for
the loan advanced to him.
 Debtor for asset sold is a debtor who owes money to the
business for any asset sold to him on credit.
 A debtor for service rendered is a debtor who owes money to
the business for the service rendered to him on credit.
15. Liability: It is a financial obligation of an enterprise arising from the
past event, the settlement of which is expected to result in an outflow
of resources embodying economic benefit. Eg. Loans payable,
salaries payable, term loans.
16. Drawings: It refers to cash, goods or any other asset withdrawn by
the proprietor from his business, for his personal or domestic use. In
short, the amount the owner withdraws from his business for living
and personal expenses.

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17. Debt: The amount due from a debtor to the business is called a
“Debt”, generally debt may be of three types :
 Good debt refers to fully recoverable debt.
 Bad debt refers to debt, which is not recoverable (irrecoverable).
 Doubtful debt refers to debt whose recovery is doubtful.
18. Current liability is that obligation which has to be satisfied within a
year. For example, payment to be made sundry creditors for the goods
supplied by them on credit; bills payable accepted by the businessman;
overdraft raised by the businessman in a bank etc.
19. Creditors: A creditor is a person to whom the business owes money.
A creditor also may be of 4 types.
 Trade creditor is a person to whom the business owes money for
goods purchased from him on credit.
 Loan creditor is a person to whom the business owes money for
the loan borrowed from him.
 Creditor for asset purchased is a creditor to whom the business
owes money for any asset purchased from him on credit.
 Expenses creditor refers to a creditor to whom the business owes
money for any service received from him on credit. For e.g.:
salaries unpaid, commission unpaid etc.
20. Income: The difference between revenue and expense is called
income. For example, goods costing Rs.25000 are sold for Rs.35000,
the cost of goods sold, i.e. Rs.25000 is an expense and the sale of
goods i.e. Rs.35000 is revenue. The difference, i.e. Rs.10000 is
income. In other words, we can state that Income = Revenue -
Expense.
21. Gain: Usually this term is used for profit of an irregular nature, for
example, capital gain.
22. Expenses: Costs incurred by a business in the process of earning
revenue are called expenses. In general, expenses are measured by
the cost of assets consumed or services used during the accounting
period. The common items of expenses are: Depreciation, Rent,
Wages, Salaries, Interest, Cost of Heating, Light and water and
Telephone, etc.

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23. Loss: It means something against which the firm receives no benefit. It
is a fact that expenses lead to revenue but losses do not, such as theft.
24. Transaction: It is an event which involves exchange of some value
between two or more entities. It can be purchase of stationery, receipt
of money, payment to a supplier, incurring expenses, etc. It can be a
cash transaction or a credit transaction. Credit transaction is one where
there is a promise to pay/receive cash at a future date.
25. Goods: Goods refer to merchandise, commodities, products, articles or
things in which a trader deals. It is the commodities or things meant for
resale. Goods account is divided into six heads viz: purchase account,
sales account, purchase return account, sales return account, opening
stock account and closing stock account. Let us get the meaning of
each one.
26. Purchase: Goods purchased by a business are called purchase.
Goods purchased may be Cash Purchases or Credit Purchases. Thus,
Purchase of goods is the sum of cash purchases and credit purchases.
27. Sales: Sales are total revenues from goods or services provided to
customers. Sales may be in cash or in credit.
28. Purchase Return or Return Outward: Goods returned by the
business to its suppliers out of the purchases already made from them
are called purchase return.
29. Sales Return or Return Outward: Goods returned to a business by its
customers out of the sales already made to them are called Sales
Return.
30. Opening Stock: Unsold goods lying in a business at the beginning of a
year, are called opening stock.
31. Closing Stock: Unsold goods lying in a business at the end of a year,
are called closing stock.
32. Bills Payable: It is a bill of exchange stating an obligation to pay a
certain sum of money at a specified date. In case of purchase of raw
materials on credit the supplier or the creditor draws bills of exchange
on the business entity. When the entity accepts the bill it becomes bills
payable for the entity. The same bill for the supplier is termed as bills
receivable.

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33. Bills Receivable: It is a bill of exchange containing an acceptance

from the drawee (or Payee) a certain sum of money at a specified date.
On sale of goods on credit the entity draws a bill of exchange on the
customer. When the customer or debtor accepts the bill it becomes bills
receivable for the firm. Bills receivables can be discounted with banks
or discount houses.
34. Voucher: It refers to any written document in support of a financial
transaction.
35. Journal: A journal is a daily record of business transactions. It is a
book of original, prime or first entry in which all the business
transactions are first entered in the specified manner in the order of
dates. A preliminary record where business transaction is first entered
into the accounting system.
36. Narration: It is a brief explanation to a journal entry, given below the
journal entry, with in brackets. It gives the explanation for the particular
journal entry.
37. Posting: Posting is the process of entering in the ledger the
information already recorded in the journal or in any of the subsidiary
books. In other words process of transferring balances from
bookkeeping records called journals to a "final" bookkeeping record
called the general ledger.
38. Ledger: A ledger is an account book in which all the accounts are
maintained. It is the books of final entry as well as principal book of
accounts.
39. Carried Forward: The term carried forward or its abbreviation [c/f] is
used at the foot of a page to indicate that the total amount at the foot of
that page has been carried forward to the head of the next page.
40. Brought Forward: The term brought forward or its abbreviation [b/f] is
used at the head of page to indicate that the total amount at the head
of that page has been brought forward from the foot of the previous
page.
41. Carried Down: The term carried down or its abbreviation c/d is written
in a ledger account at the time of its closing to indicate that the balance
in that account has been carried down to the next period.

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42. Brought Down: The term brought down or its abbreviation b/d is
written in a ledger account at the time of its opening to indicate that the
opening balance in that account has been brought down from the
previous period.
43. Trial Balance: A worksheet listing of all the accounts appearing in the
general ledger with the amount of the debit or credit balance of each,
used to make sure the books are "in balance" total debits and credits
are equal.
44. Balance Sheet: It is the financial statement, which shows the amount
and nature of business assets, liabilities, and owner's equity as of a
specific point in time. It is also known as a Statement of Financial
Position or a Statement of Financial Condition.
Self Assessment Question:
9. Write against the following statements the terms for which these are
made in reference to accounting information
1) ______________ is a common language used to communicate
financial information.
2) Managing Director, Functional Managers, shareholders, etc., using
the accounting information are _______________
3) Ability of the firm to meet all its short term or current obligations as
and when they fall due ________________

1.9 Summary
Let’s recapitulate the important concepts discussed in the unit
 Accounting is the art of recording, classifying and summarizing in terms
of money transactions and events of a financial nature and interpreting
the results thereof.
 It is the process of collecting, recording, summarizing and
communicating financial information. It is an information system which
generates information for decision making by the interested parties.
 Recording of business transactions in a systematic manner in the books
of accounts is called book keeping.
 Accounting consists of economic events which are identified, measured,
recorded and communicated.

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 Accounting in modern times is treated as an information system which

has transaction, accounting process, decision- useful financial
information as the necessary ingredients.
 Important accounting terms are : Business entity, transactions,
purchases, sales, debtors, creditors, etc.

1.10 Terminal Questions

1. Define book keeping, accounting and accountancy.
2. Distinguish between book-keeping and accounting.
3. Explain the accounting process.
4. What are the objectives of accounting?
5. Explain how accounting information is beneficial to various users.
6. List out the limitations of accounting.

1.11 Answers
Self Assessment Questions
1. Book keeping
2. Informed Judgments, decisions.
3. True
4. True
5. (a) Interpreting
6. False
7. Internal and External
8. Securities Exchange Board of India
9. (1) Accounting (2) Users (3) Liquidity
Terminal Questions
1. Book keeping is defined as “The art of keeping a permanent record
of business transactions is book keeping”. Refer section 1.2 for
further details.
2. Basis of difference depends on – nature, objective, function, basis
and relations. Refer section 1.3 for further details.
3. Accounting is the process of identifying the transactions and events,
measuring the transactions and events in terms of money, recording
them in a systematic manner in the books of accounts, classifying or
grouping them and finally summarizing the transactions in a manner

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useful to the users of accounting information. Refer section 1.4 for

further details.
4. It helps in systematic recording of all business events or transactions
It measures the financial performance of the enterprise through
preparation of profit and loss account, financial position statement
(balance sheet) and cash flow statement. Refer Unit 1.5 for further
details.
5. These users of accounting information can be divided into external
and internal. Refer Unit 1.6 for further details.
6. The limitations are:
1. Accounting information is expressed in terms of Money. Non-
monetary events or transactions are completely omitted.
2. Fixed assets are recorded in the accounting records at the
original cost.
3. Accounting information is sometimes based on estimates.
Refer section 1.7 for further details.

References:
 Lal Jawahar (2008), Accounting for Managers, 4th Edition, Himalaya
Publications.
 Ramachandra N. (2008), Financial Accounting, 2nd Edition, The
McGraw Hill Companies.
 Tulsian P. C (2010), Financial Accounting, Fifth Impression Pearson
Education.

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