Chapter 1 Introduction to Financial Accounting PDF

Introduction to Accounting The language of business is accounting. In financial accounting, the primary tasks include identifying and recording business transactions, and then summarizing them in terms of money. There are three primary financial statements that present the financial information: the...

Introduction to Accounting The language of business is accounting. In financial accounting, the primary tasks include identifying and recording business transactions, and then summarizing them in terms of money. There are three primary financial statements that present the financial information: the balance sheet, the profit and loss statement, and the cash flow statement. These statements serve the purpose of informing different stakeholders about the financial status of the organization, empowering them to make sound financial decisions. The American Accounting Association defines ‘Accounting as the process of identifying, measuring and communicating economic information, to permit informed judgments and decisions by a user of the information’. It should be emphasized that financial accounting exclusively deals with business events and transactions that can be measured in monetary units. Any other significant events, regardless of their importance, are not within the scope of financial accounting. Users of Financial Accounting Internal Users a. Management: Management uses financial accounting information to plan, control, and make strategic decisions to ensure the organization's growth and profitability. b. Employees: Employees use financial data to understand the company's performance and stability, which can influence job security, compensation, and career development opportunities. External Users a. Suppliers: Suppliers assess financial information to determine the creditworthiness of a company and decide on the terms of trade, ensuring timely payments and reliable business relationships. b. Credit Agencies: Credit agencies use financial reports to evaluate a company's creditworthiness and risk profile, which influences credit ratings and the terms under which they extend credit. c. Customers: Customers examine financial statements to gauge a company's stability and long-term viability, ensuring the reliability of products or services and continuity in supply chains. d. Government Agencies i. Tax Agencies: Tax agencies utilize financial accounting data to verify the accuracy of tax filings and ensure compliance with tax laws and regulations. ii. Regulatory Bodies: Regulatory bodies review financial information to ensure companies adhere to laws, regulations, and standards designed to protect the public interest and maintain market integrity. e. Trade Unions: Trade unions analyze financial reports to negotiate better wages and working conditions, ensuring fair treatment and benefits for their members based on the company's financial health. f. Researchers: Researchers use financial accounting data to conduct studies on market trends, economic conditions, and business practices, contributing to academic knowledge and industry insights. Types of Accounting Accounting can be divided into various categories, each with distinct purposes and serving different stakeholders. It may be categories under the following heads: 1. Financial Accounting: o Focuses on preparing financial statements for external users such as investors, creditors, and regulatory bodies. o Provides a historical perspective on a company's financial performance and position. 2. Managerial Accounting: o Designed for internal users such as management. o Involves budgeting, forecasting, and various financial analysis to aid in decision-making and business strategy. 3. Cost Accounting: o A subset of managerial accounting. o Focuses on recording, analyzing, and controlling costs associated with producing goods or services. 4. Tax Accounting: o Specializes in preparing tax returns and planning for future tax obligations. o Ensures compliance with tax laws and regulations. 5. Auditing: o Involves the independent examination of financial statements. o Ensures accuracy and compliance with accounting standards and regulations. 6. Forensic Accounting: o Combines accounting, auditing, and investigative skills. o Used to examine financial discrepancies, fraud, and legal matters. 7. Government Accounting: o Focuses on the financial operations of governmental entities. o Ensures accountability and transparency in the use of public funds. 8. Fund Accounting: o Used by non-profit organizations and government agencies. o Emphasizes accountability over profitability, tracking funds and ensuring they are used for their intended purposes. 9. International Accounting: o Deals with accounting practices and standards in a global context. o Addresses issues such as foreign exchange, international taxation, and cross- border transactions.  10. Environmental Accounting: o Also known as green accounting. o Focuses on accounting for environmental costs and integrating them into financial decision-making. Difference between Financial Accounting and Management Accounting Aspect Financial Accounting Management Accounting Purpose To provide financial To provide information for internal information to external management decision-making stakeholders Audience External stakeholders Internal stakeholders (managers, (investors, creditors, employees) regulators) Reporting Periodic (usually quarterly and As needed (can be daily, weekly, Frequency annually) monthly) Regulation Highly regulated (GAAP, Ind- Not regulated, flexible based on AS, IFRS) internal needs Focus Historical financial Future-oriented, includes budgets performance and forecasts Detail Level Summary-level information Detailed and specific information Type of Data Quantitative (financial data) Both quantitative and qualitative data Standardization Standardized formats and Customized reports as per principles management requirements Time Orientation Past and present performance Future projections and planning Reports Examples Income statement, Balance Budget reports, Performance sheet, Cash flow statement reports, Cost analysis Legal Mandatory for publicly traded Not legally required, but essential Requirement companies for internal control Objective To ensure accuracy and To aid in strategic planning and compliance operational efficiency FUNCTIONS OF ACCOUNTING: (i) Recording. It records financial transaction and events in the books of original entry i.e., Journal Book. Journal Book is sub-divided into specialized books according to the number of transactions of particular category. These subsidiary books are: Cash Book, Purchase Book, Purchases Return Book, Sales Book, Sales Return book, Bills Receivable Book, Bills Payable Book. Cash Book to record cash and bank transactions. Cash book may be-: These are the types of Cash Single Column Cash Book has one column on each side to record cash receipts and Book and part of Journal. cash payments. Two Column Cash Book has two columns on each side to record cash and bank receipts and cash and bank payments. Further column can be added on each side if more than one bank account are maintained. Three Column Cash Book has three columns on each side to record cash and bank receipts and cash and bank payments. Third column is used for recording Cash Discount Allowed (on the Debit Side) and Cash Discount Received (on the Credit Side). Further column can be added on each side if more than one bank account are maintained. Other Specialized type of journal. Purchases Book to record credit purchases of goods dealt in or raw material used for production. Purchases Return Book to record return of purchases Sales Book to record credit sale of goods. Sales Return Book to record return of sales. Bills Receivable Book to record bills receivable received, and Bills Payable Book to record bills payable issued. (ii) Classifying. Classification means transactions or entries of one nature are grouped under one head of account. The transactions recorded in ‘Journal’ or the ‘Subsidiary Books’ are classified or posted to the ‘Ledger Account’. Ledger is the book that contains individual account heads under which all financial transactions of a similar nature are collected. For example, in Stationery Account, purchase of stationery is posted so that at the end of the period, expense on stationery is known. (iii) Summarizing. Summarizing is presenting the classified data in a form that is understandable and useful to users of accounting information. It means preparation of the financial statements i.e. Trial Balance, Trading and Profit and Loss Account, and Balance Sheet. Trading Account. Profit and Loss Account and Balance Sheet are collectively known as’ Final Accounts or Financial Statements’. (iv) Analysis and Interpretation. Analysis and interpretation of the financial data means analyzing and then interpreting the financial data to make a meaningful judgment of the profitability and financial position of the business. It helps in planning for the future in a better way. Communicating. Finally, the accounting function involves communicating the financial data to the users. Accounting Cycle Few Important Accounting Concept ACCOUNTING CONCEPTS: The accounting concepts are divided into two namely (1) Fundamental Accounting Concepts and (2) Other Accounting Concepts. Fundamental Accounting Concepts are Going Concern Concept, Accrual Concept and Consistency Concept. It is presumed that these fundamental accounting concepts have been followed in preparing the financial statements unless disclosed otherwise. (i) Going Concern Concept According to the Going Concern Concept it is assumed that business shall continue for an indefinite period and there is no intention to close the business or scale down it’s operations significantly. It is because of this concept that a distinction is made between a capital expenditure, i.e., expenditure that will render benefit for a long period and revenue expenditure, i.e. , one whose benefit will be exhausted quickly, say, within the year. On the basis of this concept, fixed assets are recorded at their original cost and depreciated in a systematic manner without reference to their market value. For example, a machine purchased is expected to last 10 years. The cost of the machinery is spread on a suitable basis over the next 10 years for ascertaining the profit or loss for each year. The total cost of the machine is not treated as an expense in the year of purchase itself. (ii) Accrual Concept According to the Accrual Concept a transaction is recorded at the time when it takes place and not when the settlement takes place. The concept is particularly important because it  recognises the assets, liabilities, revenues and expenses as and when transactions relating to it are entered into. Under this concept, revenue is regarded as earned at the time the goods or services are sold to a customer, i.e., the legal title is passed to the customer, who, in turn, has an obligation to pay for them. Similarly, expense is regarded as incurred when the goods or services are purchased and an obligation to pay for them has been assumed. It is immaterial whether cash has been received or not and paid or not. Let us take an example to understand the Accrual Concept. M/s. RSM & Co. purchases computers on 1st January, 2010 amounting to Rs. 5,00,000 to be paid on 15th April, 2010. Since the asset has been acquired by the enterprise and has in the process incurred a liability for the amount on 1st January, 2010, it must record the transaction in its books of account on 1st January, 2010. The transaction on recording shall reflect that the enterprise owns assets (computers) worth Rs. 5,00,000 and also owes an equal amount of money to the supplier. Similarly, if M/s. RSM & Co. makes a sale of goods to M/s. VS & Co. on 27th February, 2010 for Rs. 15,000 on credit of two months, the sale must be recorded on 27th February, 2010 although the amount will be received on 27th April, 2010. The transaction is recorded because the revenue has been earned, although the amount has not been received. M/s. VS & Co. should also record the purchase in its books of accounts on 27th February, 2010 because goods have been purchased although the amount has not been paid. (iii) Consistency Concept According to the Consistency Concept, accounting practices once selected and adopted, should be applied consistently year after year. The concept helps in better understanding of accounting information and makes it comparable with the previous years. Consistency eliminates personal bias and is particularly important when alternative accounting practices are equally acceptable. For example, two methods of charging depreciation, Written-down Value Method and Straight-Line Method, are equally acceptable. The method once chosen and applied should be applied consistently year after year. It however, does not mean that accounting practice once adopted can not be changed. It can be changed if it is at variance with law or accounting standard. Whenever change is made, its effect on accounts must be disclosed. The rationale of the consistency concept can be better understood with the following example: A company purchases a fixed asset for Rs. 10,00,000 and charges depreciation @ 20% on the Straight Line Method. At the end of the second year, the book value of the asset will be: Rs. Cost of the Fixed Asset 10,00,000 Less: Depreciation @ 20% for year 1 (20% of Rs. 10,00,000) 2,00,000 8,00,000 Less: Depreciation @ 20% for year 2 (20% of Rs. 10,00,000) 2,00,000 6,00,000 Now, if the method is changed to the Written Down Value Method in the second year, the book value of the asset at the end of the 2nd year will be:  Rs. Cost of the Fixed Asset 10,00,000 Less: Depreciation @ 20% for year 1 (20% of Rs. 10,00,000) 2,00,000 8,00,000 Less: Depreciation @ 20% for year 2 (20% of Rs. 8,00,000) 1,60,000 6,40,000 The effect of change will be that the depreciation in year 2 will be less by Rs. 40,000 and its effect on profit will be that it will be more by Rs. 40,000 and also asset will be more by Rs. 40,000 in the Balance Sheet. Other Accounting Concepts (i) Money Measurement Concept According to the Money Measurement Concept, transactions and events that can be measured in money terms are only recorded in the books of accounts. In other words, money is the common denominator in recording and reporting the transactions. This concept makes accounting information more meaningful and useful for analysis of financial statements. However, the concept suffers from two major limitations: (i) Transactions and events that cannot be measured in money terms are not recorded, howsoever important they may be to the enterprise. (ii) Money is considered as having static value as the transactions are recorded at the value on the transaction date and the subsequent changes in the money value are ignored. (ii) Dual Aspect Concept According to the Dual Aspect Concept, every transaction has two aspects, a debit and a credit of equal amount. In other words, every transaction has a two- fold effect. Simply stated, for every debit there is a credit of equal amount and vice versa. The expression can be shown in the form of an equation as follows: Capital (Equities) = Cash (Assets) Rs. 1,00,000 = Rs 1,00,000. The term ‘assets’ denotes the resources owned by a business whereas the term ‘equities’ denotes the claims against the assets. Equities are of two types i.e., “owners’ equity” and “outsiders’ equity”. Owners’ equity (or capital) is the claim of owners against the assets while outsiders’ equity (or liabilities) is the claim of outsiders such as creditors, debenture-holders against the assets of the business. Since all assets of the business are claimed by someone (either owners or outsiders), the total of assets is equal to total of liabilities. Therefore, the  relationship between assets, liabilities and capital can be expressed in the form of accounting equation as follows: Assets = Equities or Assets = Capital + Liabilities or Capital = Assets – Liabilities The term ‘accounting equation’ also denotes the relationship of equities to assets. In fact, this equation says, “for every debit, there is an equivalent credit”. It be noted that the system of book keeping is based on this concept. It is the core of accountancy. (iii) Accounting Period or Periodicity Concept According to the Accounting Period or Periodicity Concept the life of an enterprise is broken into smaller intervals (usually a year) so that its performance is measured at regular intervals. It enables the users of accounting information to take timely decisions that may be required according to the current business situation. Also the Government can assess the tax liability of the enterprise for the year. (iv) Matching Concept According to the Matching Concept, cost incurred to earn the revenue should be recognised as expense in the period when revenue is recognised as earned. Under this concept the expenses for an accounting period are matched against related revenues. Since the accounts are usually prepared on accrual basis, the expenses incurred in an accounting period are matched with the revenues recognised in that period. The Matching Concept operates as follows: When an item of revenue is recognised as income, i.e., is entered in the Profit and Loss Account, all related expenses incurred (whether paid or not) should also be recognised as expense, i.e., should be set down on the expenses side. If an expense is incurred against which the revenue will be earned in the next period, the amount is carried to the next period (and shown in the balance sheet as an asset) and then next year be treated as an expense. It will become clear from the following examples: a) At the end of the year, some of the goods purchased remain unsold. Then, the cost of unsold goods should be carried forward to the next year and set out against the sales of the next year. The value of unsold stock being deducted from the total costs makes sales and costs of goods sold comparable. b) Machinery purchased will last 10 years. Then, only one-tenth of the cost should be treated as expense and remaining should be carried forward to the balance sheet. c) Insurance paid is partly for the next year. The part relating to the next year should be shown as expense in the next year and not this year.  If an amount of revenue is received during the year but be against it service is to rendered or goods are to be sold in the next year, the amount received must be treated as revenue in the next year after the services have been rendered or the goods have been sold. This year it will be shown as a liability. (v) Realisation Concept According to the Realisation Concept, revenue is considered to have been realised when a transaction has been entered into and the obligation to receive the amount has been established. It is to be noted that recognising revenue and receipt of an amount are two separate aspects. Example: An enterprise sells goods in February 2010 and receives the amount in April 2010. Revenue of this sale should be recognised in February 2010, i.e., when the goods are sold. It is so because the legal obligation has been established (upon sale) in February 2010. Another Example: Suppose, an enterprise has received an advance in February 2010 for the sale to be made in May 2010, revenue shall be recognised in May 2010, upon sale having been made because the legal obligation to receive the amount has been established in May 2010. But there are certain exceptions to this rule. First, in the case of long-term contracts, revenue is recognised before completion of the contract. Second, when the cash basis of accounting is followed, revenue is recognised when cash is received in cash. Third, in case of sale of goods under hire-purchase system, revenue is recognised in proportion to the amount becoming due. (vi) Business Entity Concept According to the Business Entity Concept, business is considered to be separate from its owners. Business transactions, therefore, are recorded in the books of accounts from the business point of view and not owners. Owners being separate from the business are considered creditors of the business to the extent of their capital. Their account with the business is credited with the capital introduced and profit earned during the year, etc., and debited by the drawing made. For example, when the proprietor introduces his capital, the cash account or bank account is debited and the capital account is credited. The amount in the credit of the capital is a liability of the enterprise towards the proprietor. (vii) Materiality Concept The Materiality Concept refers to the relative importance of an item or an event. According to the American Accounting Association, “an item should be regarded as material if there is a reason to believe that knowledge of it would influence the decision of an informed investor.” Thus, whether an item is material or not shall depend on its nature and/or amount and thus, means is a matter of exercising judgment. An item material for one enterprise may not be material for another enterprise. For example, amount spent on repairs of building say Rs. 2,50,000 is material for an enterprise having a turnover of say Rs. 15,00,000 but it is not material for an enterprise having a turnover of say Rs. 15 crores. On the other hand, closure of a production plant, even temporary, say because of an environmental problem is material. In keeping with the principle of materiality material items are disclosed whereas items that are not material, are either left out or merged with other items. (viii) Conservatism or Prudence Concept The Prudence Concept is many a times described using the phrase “Do not anticipate a profit, but provide for all possible losses.” In other words, it takes into consideration all prospective losses but not the prospective profits. The application of this concept ensures that the financial statements present a realistic picture of the state of affairs of the enterprise and do  not paint a better picture than what actually is. For example, closing stock is valued at lower of cost or market price or making the provision for doubtful debts and discount on debtors in anticipation of actual bad debts and discount. The concept of conservatism needs to be applied with more caution and care so that the results reported are not distorted (ix) Concept of Full Disclosure The Concept of Full Disclosure holds that “there should be complete and understandable reporting on the financial statements of all significant information relating to the economic affairs of the entity.” Apart from legal requirements, good accounting practice requires all material and significant information to be disclosed. Whether information should be disclosed or not always depends on the materiality of the information. Such information is normally disclosed by way of notes to the annual accounts. For example, along with the assets, its mode of valuation should also be disclosed. Likewise, revenues and expenses should be grouped and disclosed. (x) Historical Cost Concept According to the Historical Cost Concept, an asset is recorded in the books of account at the price paid to acquire it and cost is the basis for all subsequent accounting of the asset. Asset is recorded at the cost at the time of its purchase but is systematically reduced in value by charging depreciation. The market value of an asset may change with the passage of time, but for accounting purposes it continues to be shown in the books of accounts at its book value (i.e., cost at which it was purchased minus depreciation provided up-to-date). (xi) Objective Evidence Concept Objectivity means reliability, trustworthiness and verifiability, which means that there is some evidence for ascertaining the correctness of the information reported. The Objective Evidence Concept holds that accounting should be free from personal bias. Measurements that are based on verifiable evidence are regarded as objective. It means all accounting transactions should be evidenced and supported by business documents. These supporting documents are cash memo, invoices, sales bills, etc., and provide the basis for accounting and audit. Five Elements of Financial Statements The five elements of financial statements are: 1. Assets: Assets are resources that an entity controls as a result of previous events and are expected to generate future economic benefits for the entity. Some examples are cash, inventory, property, and equipment. 2. Liabilities: The entity has existing liabilities from previous events, which will require the use of resources that hold economic value for their settlement. Some examples are loans, accounts payable, and mortgages. 3. Equity: The remaining value of the entity's assets after subtracting its liabilities. This refers to the ownership stake in the assets and consists of components like common stock, retained profits, and extra funds invested. 4. Income: Economic benefits during the accounting period can be seen through inflows or enhancements of assets, or decreases of liabilities, resulting in increased equity,  excluding contributions from equity participants. Examples include the sales revenue, the income generated from interest, and the profits obtained from selling assets. 5. Expenses: Equity decreases during the accounting period due to asset depletions, liability incurrences, or other factors that result in economic benefits declining, except for distributions to equity participants. Some examples of expenses include the cost of goods sold, salaries, and rent. These elements are fundamental components of financial statements, providing a structured representation of the financial position and performance of an entity. Relation of Accounting with other Disciplines in real life scenario Accounting interacts with various other disciplines in real-life scenarios, creating a comprehensive framework for business operations and decision-making. Here are some key relationships: 1. Accounting and Finance: o Relationship: Accounting provides the necessary financial information and data that finance professionals use to make investment decisions, manage assets, and plan for future financial strategies. o Scenario: A company’s accounting department prepares financial statements that the finance department analyzes to create budgets, forecast cash flows, and plan capital expenditures. 2. Accounting and Economics: o Relationship: Economics provides the broader context in which businesses operate, while accounting provides the detailed data on individual business performance. o Scenario: An economist may use accounting data to understand the financial health of a company and its impact on the broader economy. Conversely, accounting practices may be influenced by economic policies and market conditions. 3. Accounting and Information Technology: o Relationship: Information technology supports the automation and streamlining of accounting processes, enabling efficient data management and reporting. o Scenario: Implementation of an ERP (Enterprise Resource Planning) system that integrates various functions including accounting, allowing real-time financial reporting and data analysis. 4. Accounting and Law: o Relationship: Accounting must comply with various legal requirements and regulations. Legal knowledge is essential for understanding and applying tax laws, corporate laws, and regulatory standards. o Scenario: An accountant ensures that the company’s financial practices comply with tax laws and financial regulations, thereby avoiding legal penalties and fines. 5. Accounting and Management: o Relationship: Management relies on accounting to provide accurate and timely information for decision-making, performance evaluation, and strategic planning.  oScenario: Managers use financial reports prepared by accountants to assess the profitability of different departments, control costs, and make informed strategic decisions. 6. Accounting and Marketing: o Relationship: Accounting helps in budgeting and controlling marketing expenses, and in evaluating the financial impact of marketing strategies. o Scenario: A marketing campaign’s success is measured not only by sales metrics but also by its return on investment (ROI), which accounting helps to calculate. 7. Accounting and Human Resources (HR): o Relationship: Accounting works with HR to manage payroll, employee benefits, and compliance with labor laws. o Scenario: The HR department collaborates with accounting to ensure accurate payroll processing, benefits administration, and financial planning for hiring and training programs. 8. Accounting and Operations: o Relationship: Operations depend on accounting for cost control, inventory management, and efficiency analysis. o Scenario: Manufacturing units use cost accounting to determine the cost of production, which aids in pricing decisions and cost management. In real-life scenarios, the interplay between accounting and these disciplines helps organizations to operate efficiently, make informed decisions, and achieve their strategic objectives.