Fundamentals of Accounting

Session - 1
Why Financial Accounting ?
• Students who take this course do not plan to
be accountants. If I’m not going to be an
accountant, why do I need to know
accounting?
Harold Geneen-Former Chairman of IT&T

• “To be good at your business, you have to know

the numbers”

• Success in any business comes back to the

numbers. You will rely on them to make
decisions, and managers will use them to
evaluate the performance. That is true whether
your job involves marketing, production,
management or IT.
a) Share prices of a company are affected by its
financial statement so a manager must know
accounting
b) Accountant will make the financial statement
but a manager should be good at interpreting
the numbers
c) To value firms(investment bankers),
understanding financial statement is must.
d) Manager has to evaluate financial health of a
business, analyze financial reports and make
critical decisions based on financial
statements.
e) Start up entrepreneurs should know
accounting so that they can manage
accounting and finance of their business.
 Accounting
Accounting is often called the language of
business. It is common language used to
communicate financial information in the
world of business.
It provides information which is useful in making
business and economic decision, for making
choices among alternative so that optimum
utilization of scarce resources takes place.
 Is accounting necessary?
Yes without any doubt !!

If an restaurant’s menu is Italian , a customer

should know Italian to be able to make sense of
the recipe.

In the same manner a decision maker who wish to

use accounting information should have a fair
understanding of accounting
Purpose of Accounting
Users of Accounting Information
• Investors
• Lenders
• Analysts and Advisors
• Suppliers and Trade
Externa Financiers
• Customers
l Users • Government and
Regulatory Authorities
Users of Accounting Information

• Managers
• CEO
• Trade Unions

Interna
l Users
 Accounting Concepts

• Business entity concept

• Money measurement concept
• Going concern concept
• Accounting period concept
• Accounting cost concept
• Duality aspect concept
• Realization concept
• Accrual concept
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• Matching concept
 Business entity concept
• This concept assumes that, for accounting purposes, the business
enterprise and its owners are two separate independent entities.
Thus, the business and personal transactions of its owner are
separate.

• For example, when the owner invests money in the business, it is

recorded as liability of the business to the owner. Similarly, when the
owner takes away from the business cash/goods for his/her personal
use, it is not treated as business expense.

• Thus, the accounting records are made in the books of accounts from
the point of view of the business unit and not the person owning the
business.
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• This concept is the very basis of accounting.

 Significance

• This concept helps in ascertaining the profit of the

business as only the business expenses and revenues
are recorded and all the private and personal
expenses are ignored.

• This concept restraints accountants from recording of

owner’s private/personal transactions.

• It also facilitates the recording and reporting of

business transactions from the business point of view.14
 Money measurement concept
• This concept assumes that all business transactions
must be in terms of money. Thus, as per the money
measurement concept, transactions which can be
expressed in terms of money are recorded in the
books of accounts.

• The transactions which cannot be expressed in

monetary terms are not recorded in the books of
accounts. For example, sincerity, loyalty, honesty of
employees are not recorded in books of accounts
because these cannot be measured in terms of
money although they do affect the profits and losses 15

of the business concern.

 Significance
• This concept guides accountants what to record and what
not to record.

• It helps in recording business transactions uniformly.

• If all the business transactions are expressed in monetary

terms, it will be easy to understand the accounts prepared
by the business enterprise.

• It facilitates comparison of business performance of two

different periods of the same firm or of the two different 16
firms for the same period.
 GOING CONCERN CONCEPT
• This concept states that a business firm will continue to
carry on its activities for an indefinite period of time.

• Simply stated, it means that every business entity has

continuity of life. Thus, it will not be dissolved in the near
future.

• It should be noted that “going concern concept” does not

imply permanent continuance of the enterprise. It rather
presumes that the enterprise will continue in operation
long enough to charge against income, cost, liabilities and
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to meet the contractual commitments.
 Significance

• This concept facilitates preparation of financial statements.

• On the basis of this concept, depreciation is charged on the

fixed asset.

• It is of great help to the investors, because, it assures them

that they will continue to get income on their investments.

• In the absence of this concept, the cost of a fixed asset will

be treated as an expense in the year of its purchase.

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• A business is judged for its capacity to earn profits in future.
Going Concern Concept
 Accounting period concept
• All the transactions are recorded in the books of accounts on the
assumption that profits on these transactions are to be ascertained
for a specified period. This is known as accounting period concept.

• Thus, this concept requires that a balance sheet and profit and loss
account should be prepared at regular intervals.

• This is necessary for different purposes like, calculation of profit,

Financial position, Tax computation etc.

• Further, this concept assumes that, indefinite life of business is

divided into parts. These parts are known as Accounting Period. It
may be of one year, six months, three months, one month, etc. 20
 Significance

• It helps in predicting the future prospects of the business.

• It helps in calculating tax on business income calculated

for a particular time period.

• It also helps banks, financial institutions, creditors, etc to

assess and analyse the performance of business for a
particular period.

• It also helps the business firms to distribute their income

at regular intervals as dividends. 21
 Accounting cost concept
• Accounting cost concept states that all assets are
recorded in the books of accounts at their purchase
price, which includes cost of acquisition,
transportation and installation and not at its
market price.

• It means that fixed assets like building, plant and

machinery, furniture, etc are recorded in the books
of accounts at a price paid for them.

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• This cost is also known as historical cost.
 Significance

• This concept requires asset to be shown at the

price it has been acquired, which can be verified
from the supporting documents.

• It helps in calculating depreciation on fixed assets.

• The effect of cost concept is that if the business

entity does not pay anything for an asset, this
item will not be shown in the books of accounts. 23
 Duality aspect concept
• Dual aspect is the foundation or basic principle of accounting. It
provides the very basis of recording business transactions in the
books of accounts.

• This concept assumes that every transaction has a dual effect, i.e.
it affects two accounts in their respective opposite sides.

• Therefore, the transaction should be recorded at two places. It

means, both the aspects of the transaction must be recorded in
the books of accounts.

• For example, goods purchased for cash has two aspects which are
(i) Giving of cash (ii) Receiving of goods. These two aspects are to24
be recorded.
 Significance

• This concept helps accountant in detecting

error.

• It encourages the accountant to post each

entry in opposite sides of two affected
accounts.

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 Realization concept
• This concept states that revenue from any business transaction
should be included in the accounting records only when it is realised.

• For example: “A” places order with “B” for supply of certain goods
yet to be manufactured. On receipt of order, “B” purchase raw
materials, employs workers, produces the goods and delivers it to
“A”. “A” makes payment on receipt of goods. In this case the sale will
be presumed to have been made not at the time of receipt of order
for the goods but at the time when goods are delivered to “A”.

• The term realisation means creation of legal right to receive money.

Selling goods is realisation, receiving order is not.

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 Significance

• It helps in making the accounting information

more objective.

• It provides that the transactions should be

recorded only when goods are delivered to
the buyer.

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 Accrual concept
• The meaning of accrual is something that becomes due
especially an amount of money that is yet to be paid or
received at the end of the accounting period.

• It means that revenues are recognised when they become

receivable though cash is received or not received and the
expenses are recognised when they become payable though
cash is paid or not paid.

• Both transactions will be recorded in the accounting period to

which they relate. Therefore, the accrual concept makes a
distinction between the accrual receipt of cash and the right
to receive cash as regards revenue and actual payment of cash 28
and obligation to pay cash as regards expenses.
 Significance

• It helps in knowing actual expenses and actual

income during a particular time period.

• It helps in calculating the net profit of the

business.

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 Matching concept
• This is based on the Accounting Period Concept. The
paramount objective of running a business is to earn profit.

• In order to ascertain the profit made by the business during a

period, it is necessary that “revenues” of the period should be
matched with “expenses” of the period.

• The matching concept states that the expenses incurred to

earn the revenues must belong to the same accounting period.

• So once the revenue is realised, the next step is to allocate it

to the relevant accounting period. This can be done with the
help of accrual concept. 30
 Significance

• It guides how the expenses should be

matched with revenue for determining exact
profit or loss for a particular period.

• It is very helpful for the

investors/shareholders to know the exact
amount of profit or loss of the business.

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 Accounting conventions

• To make the accounting information useful to various

interested parties, the basic assumptions and concepts
discussed earlier have been modified. These are called as
convention, they are as under:

• Cost Benefit
• Materiality
• Consistency
• Prudence
• Full Disclosure 32
 Cost Benefit conventions

• This convention states that the cost of

applying a principle should not be more than
the benefit derived from it.

• If the cost is more than the benefit then that

principle should be modified.

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 Materiality conventions

• The materiality convention requires all

relatively relevant information should be
disclosed in the financial statements.

• Unimportant and immaterial information are

either left out or merged with other items.

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 Consistency conventions
• The aim of consistency principle is to preserve the comparability
of financial statements. The rules, practices, concepts and
principles used in accounting should be continuously observed
and applied year after year.

• Comparisons of financial results of the business among different

accounting period can be significant and meaningful only when
consistent practices were followed in ascertaining them.

• For example, depreciation of assets can be provided under

different methods, whichever method is followed, it should be
followed regularly.
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 Prudence (Conservatism) conventions

• Prudence principle takes into consideration all

prospective losses but leaves all prospective
profits. The essence of this principle is
“anticipate no profit and provide for all
possible losses”.

• For example, while valuing stock in trade,

market price or cost price whichever is less is
considered. 36
 Full Disclosure

• According to this convention accounting

reports should disclose fully and fairly the
information they represent.

• They should be honestly prepared and

sufficiently disclose information which is of
material interest to proprietors, present and
potential investors and creditors.
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 Few Terminology
• Revenue/Sales
• Expenses
• Net Income and Net Loss
• Assets (Fixed Assets and Current Assets)
• Liability
• Equity
• Capital
• Drawings
• Accounts Receivable(Debtor) and Accounts Payable
(Creditor)
 Accounting Equation
• It shows the relationship between the
economic resources of a business and the
claims against those resources.

Economic Resources = Claims

Assets = Liabilities + Equity
 Assets
• What you Own
 Liabilities
• What you Owe
 Equity
• What is Left over
Analyze the effect of business transactions
March 1. Suresh began business with cash Rs.50,000
March 2. Took a loan from Manish Rs.20,000
March 3. Bought for cash a computer Rs.58,000
March 4. Bought computer supplies on credit Rs.6,000
March 19. Received payment for software sales Rs.12,000
March 21. Paid creditors for supplies Rs. 2,000
March 29. Paid salaries Rs.4,000 and office rent Rs.12,000
March 30. Sold software on credit Rs.8,000
March 31. Withdrew cash for personal use Rs. 3,500
• Assets= Liabilities + Equity
• Equity = Capital + Revenue-Expenses-Drawings
- Dividends
• Assets= Liabilities + Capital + Revenue-
Expenses-Drawings - Dividends
 Quiz 1
Identify the concept
Assets are normally shown at cost price in the
balance sheet, and the cost is the basis for all
subsequent accounting for the asset.
 2. Which accounting assumption does the
comment below refer to?
Everything is recorded in terms of money. Items
which cannot be recorded in terms of money are
ignored and not included. It follows that the
financial statements only give a partial picture of
the state of a business.
 3. Which accounting concept does the
comment below refer to?
Profit is the difference between revenue and
expenses not cash received and paid. Expenses
are matched to revenues, for example if rent has
been set as a percentage of sales (a turnover
rent), then the rent is accrued in the accounts is
the same period as the sales and not when the
rent is actually paid.
 4. Which accounting concept does the
comment below refer to?
There are two sides to accounting, one
represented by the assets and the other
represented by the liabilities against them.
 5. Which accounting assumption does the
comment below refer to?

Accounting assumes the business will continue.

 6. Which accounting assumption does the
comment below refer to?
For accounting purposes the business is treated
as a separate entity from the owner. The
accounting records show transactions of the
business not the owner
 7. Which accounting concept does the
comment below refer to?
• Profit is earned (realized) at the time the
goods or services are passed to the customer
and the customer incurs liability for them.
 8. Which concept is violated
• Xylon’s CEO purchased a yacht for personal use and
charged it to the company expenses.
 9. Which concept is violated
• Inventory with a cost Rs. 186400 is reported in
Balance Sheet at its market value of Rs.
235600