UNIT 1 Introduction to Financial Accounting PDF

UNIT- 1 Introduction to Financial Accounting  Meaning, definition, Functions, objectives, advantages, limitations of Financial Accounting MEANING OF ACCOUNTING Accounting is the process of recording, classifying, summarizing, analyzing and interpreting the...

UNIT- 1 Introduction to Financial Accounting  Meaning, definition, Functions, objectives, advantages, limitations of Financial Accounting MEANING OF ACCOUNTING Accounting is the process of recording, classifying, summarizing, analyzing and interpreting the financial transactions of the business for the benefit of management and those parties who are interested in business such as shareholders, creditors, bankers, customers, employees and government. Thus, it is concerned with financial reporting and decision making aspects of the business. The American Institute of Certified Public Accountants Committee on Terminology proposed in 1941 that accounting may be defined as, “The art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof”. DEFINITION OF FINANCIAL ACCOUNTING The Accounting definition is given by the American Institute of Certified Public Accountants (‘AICPA’) clearly brings out the meaning of accounting. According to it, accounting is “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof”. As per Robert N. Anthony, “Accounting system is a means of collecting, summarizing, analyzing and reporting, in monetary terms, information about the business”. FUNCTIONS OF ACCOUNTING 1. Accounting helps in the maintenance of bookkeeping and record keeping. 2. Accounting helps collect and store financial information, transactions happening within the organization, and financial activities happening in the organization. 3. It helps track several financial information daily or monthly. 4. It helps create and document financial history from day to the latest period. 5. It helps in the formulation of comprehensive financial policy for the business. 6. It is also utilized in the preparation of budgets and financial projections. 7. It also helps to reconciliation information between two sources of financial systems. 8. The accounted information can be shared with the external stakeholders with the intent of business planning and growth. OBJECTIVES OF FINANCIAL ACCOUNTING According to principles of financial accounting, the main aim is to provide all internal and external stakeholders with an accurate view of profits and losses. This in-depth financial analysis allows organizations to protect stakeholders’ interests, meet legal requirements, and optimize resource allocation.  Here are a few objectives of financial accounting. 1. Compliance with statutory requirements 2. Recordkeeping 3. Determine profitability 4. Management decision-making 1. Compliance with statutory requirements Through the process of financial accounting, organizations comply with tax regulations, the Companies Act, and other statutory requirements of the country in which it conducts business. 2. Recordkeeping It creates a systematic process for recording financial transactions in the books of accounts. Organizations use these transactions to analyze and optimize their financial performance. 3. Determine profitability Organizations maintaining financial accounts can also easily measure net income for a period from assets, liabilities, and equities. While a simple way to calculate profit and loss is to subtract spending from revenues simply, profitability also considers other factors, such as pricing of goods and services, purchases, rent, salary, general expenses, depreciation, interest paid, and taxes. 4. Management decision-making a robust accounting process enables stockholders, shareholders, creditors, and other parties to gauge an organization’s financial stability. Moreover, it aids the management team in making analytical decisions for maximizing sales and profits. BENEFITS OF FINANCIAL ACCOUNTING FOR YOUR ORGANIZATION Financial accounting is important for tracking financial transactions and preparing financial statements. Here are a few reasons why organizations opt for it.  Consistent standards: Financial accounts make it easy for organizations to create financial statements that follow universally accepted standards.  Improved accountability: Financial statements improve an organization’s credibility among regulatory bodies, tax authorities, and lenders.  Efficient decision-making: Financial performance analysis enables enterprises to invest and allocate resources better.  Transparent financial reporting: Financial accounting also promotes transparency by setting rules that organizations must follow while disclosing financial performance.  A reliable source of information: The rules set by independent governing bodies ensure accurate reporting practices among organizations. LIMITATIONS OF FINANCIAL ACCOUNTING Financial accounting is concerned with the preparation of final accounts. The business has become so complex that mere final accounts are not sufficient in meeting financial needs. Financial accounting is like a post-mortem report. At the most it can reveal what has happened so far, but it cannot exercise any control over the past happenings. The limitations of financial accounting are as follows:- 1. It records only quantitative information.  2. It records only the historical cost. The impact of future uncertainties has no place in financial accounting. 3. It does not take into account price level changes. 4. It provides information about the whole concern. Product-wise, process-wise, department-wise or information of any other line of activity cannot be obtained separately from the financial accounting. 5. Cost figures are not known in advance. Therefore, it is not possible to fix the price in advance. It does not provide information to increase or reduce the selling price. 6. As there is no technique for comparing the actual performance with that of the budgeted targets, it is not possible to evaluate performance of the business. 7. It does not tell about the optimum or otherwise of the quantum of profit made and does not provide the ways and means to increase the profits. 8. In case of loss, whether loss can be reduced or converted into profit by means of cost control and cost reduction? Financial accounting does not answer this question. 9. It does not reveal which departments are performing well? Which ones are incurring losses and how much is the loss in each case? 10. It does not provide the cost of products manufactured  Difference Between Book-Keeping, Accounting, Accountancy Book-keeping Book-keeping is an art of recording in the books of accounts, the monetary aspect of commercial and financial transactions. It is a part of accounting. It is concerned with identifying, recording and classifying economic transactions and events. Accounting Accounting is a wider concept than book-keeping. It starts where book-keeping ends. It is concerned with summarizing the economic transactions, analysis, and interpretation of economic transactions and events and communicating the results of final users. Accountancy 'Accountancy' refers to the entire body of the theoretical knowledge of accounting. It is the theory part of accounting, whereas accounting relates to applying the knowledge of accountancy. Diagrammatically, the relationship can be viewed as: Title Bookkeeping Accounting Definition 1. Bookkeeping is mainly related to the 1. Accounting is the process of process of identifying, measuring, summarizing, interpreting, and recording, and classifying financial communicating financial transactions that transactions. were classified in the ledger account as a part of bookkeeping Stage 2. It is the beginning stage and acts as a 2. Accounting begins where bookkeeping base for accounting ends. Management 3. Management cannot make decisions 3. Management can make decisions based Decisions based on bookkeeping. on accounting. Objective 4. The objective of bookkeeping is to 4. The objective of accounting is to keep proper and systematic records of ascertain the financial position and further financial transactions. communicate the information to the relevant parties. Financial 5. Financial statements are not prepared 5. Financial statements are prepared on Statements during bookkeeping. the basis of records obtained through bookkeeping. Skill Level 6. Bookkeeping doesn’t require any 6. Accounting, on the other side, requires special skills as it is mechanical in nature. special skills due to its analytical and somewhat complex nature. Basis for Accounting Accountancy Comparison Meaning Accounting is a systematic process that Accountancy implies the systematic body involves measurement, recording, of knowledge that prescribes accounting classification, summarizing, presenting principles, conventions and techniques, and interpreting the financial information which are to be followed during the of an organization. accounting process. Explains Nature of work performed by the Profession pursued or opted by the accountants. accountants. Concerned with Practical part Both theoretical and practical part Relatedness It is an action based on the knowledge of It is a field of knowledge that indicates the accountancy. route to accounting. Scope Narrow Wide Tools Financial Statements Principles and Techniques   Users of Accounting Information Internal users of accounting information Internal users are individual who runs, manages, and operates the daily activities of the inside area of an organization. So who are the internal users of account information;  Owners and Stockholders.  Directors,  Managers,  Officers.  Internal Departments.  Employees  Internal Auditor. Managerial accounting identifies measures, analyzes, and communicates the financial information management needs to plan, control, and evaluate a company’s operations for internal users. ▸ iedunote.com/users-of-accounting-information External users of Accounting information External users are those individuals who take an interest in an organization’s account information but are not part of the organization’s administrative process. External users have a direct or indirect interest in accounting information. Financial accounting is the process of the preparation of financial reports of the enterprise for use by both internal and external parties. These reports are important to the external users of accounting information. Examples of external users of accounting information are;  Creditors.  Investors.  Government.  Trading partners.  Regulatory agencies.  International standardization agencies.  Journalists. Creditors and Investors are the most regular example of external users among many other external users. The external users of accounting are; Creditors: Creditors or lenders use accounting information to determine the borrower’s ability to repay the loan, the number of assets and liabilities of the borrower, evidence of income, economic position, etc., before he or she lends the money to the economic entity. Investors: Investors are the capital providers of a business. Before investing, an investor sees the financial report to figure out the business possibilities in the future. Financial information is important for an investor to ensure the investment is secure. Trading partners: Business needs business to do business; it is the truth. Associate trading companies look at the financial information and decide to trade with a particular economic entity. Government Regulatory Agencies: Financial information is vital for government regulatory agencies as it allows them to monitor the economy and market. Lawmakers and economic planners: Keeping a nation’s economic structure up-to-date with global changes is important. It is a job for lawmakers and economic planners.  Important Accounting Terminology 1 - Accounts Payable Accounts payable are short-term obligations to be paid by an organization. It arises from trading activities and other business-related expenses during the business, including parties from whom we have purchased goods or services and costs incurred for which money is yet to be paid, generally in the same financial year. 2 - Accounts Receivable Accounts Receivable form part of current assets and refer to amounts due from parties to whom we have sold goods or services or incurred expenses on their behalf for which money is yet to be realized. It may include debtors, bills receivable, etc., which can be converted into cash in the short term to ensure the organization’s liquidity. 3 - Balance Sheet A Balance Sheet is a reconciliation of assets (current and fixed) and liabilities (current and noncurrent), and capital invested in an organization. Stakeholders such as creditors, shareholders, and banks, which have granted loans to the organization and government, use the Balance Sheet to analyze the financial position, growth, and stability. 4 - Current Assets Current assets refer to an organization's realizable resources in the short term, generally during the same financial year. They include cash/bank balance and assets that can convert into cash, ranging from short-term loans and advances, sundry debtors, short-term investments, etc. 5 - Equity Equity is the amount invested in the business by its owners, in the form of capital in the case of sole proprietorship and partnerships, or shares (equity and preference) of varying denominations in companies (public or private). 6 - Expenses All the money outflow (present or future) incurred for procuring goods and services to affect sales in a business (direct expenses) and incidental to the business (indirect expenses) as well as ancillary to the running of an organization are referred to as expenses 7 - Fixed Assets Fixed assets are tangible resources that an organization uses for carrying out daily operations of a business, such as land, plant and equipment, furniture and fixtures, buildings, machinery, etc., which are not purchased to be sold in the short term. 8 - Ledger Ledger is the book of entry for recording transactions in such a way that we come to know the outstanding debit or credit balance of an account in our business for which we record the opening balance, transactions made in that account, and the closing balance to find out the exact position of that particular account. 9 - Income Statement The Income statement forms part of the financial statements and tells us the exact position of our gross and net profit at a particular cut-off date. It is done by recording all the direct incomes and closing stock on the credit side and all direct expenses and opening stock on the debit side to find the gross profit and all the indirect incomes and indirect expenses similarly to find out the net profit. 10 - Liabilities Liabilities are the present (short term) and future(long term) obligations of an organization which represents the debts due to be paid for goods and services procured for the business in the past and include sundry creditors, short term loans and advances, bills payable, etc. which come under short term liabilities and debentures, term loans from a bank, long term loans and advances, etc. which come under long term liabilities. 11 - Net Income The profit or loss arrived at after deducting all direct and indirect expenses from all the direct and indirect incomes equals to net income made by a business which is the earning done by the business at a cut-off date and is very useful in comparing the growth and financial position of an organization from previous years as well as for adopting measures for the betterment of the profitability levels of the business. 12 - Revenue The gross income earned by the organization from carrying out core business activities without deduction of any expenses is termed as revenue earned by the organization, which also indicates the sale and other incomes in total. 13 - Credit Wherever an account is credited, it reduces the balance of an account in the case of real accounts, creates an obligation to pay an individual in the case of personal accounts, and increases the income side if a nominal account is credited. 14 - Debit Wherever an account is debited, it increases the balance of an account in the case of real accounts, creating an obligation to receive money from an individual in the case of personal accounts and increasing the expenses side if a nominal account is debited. 15 - Audit An audit is an examination of books of accounts prepared by an organization to validate the entries recorded and ensure the accuracy and correctness of the financial statements along with finding out any discrepancies in the books, including frauds, if any, hidden by the employees of the organization.  Accounting Concepts, Principles, and Conventions Accounting Concepts Meaning: In India, there are several rules which need to be followed while walking or driving on the road as it enables the smooth flow of traffic. Similarly, there are accounting rules that an accountant should follow while recording business transactions or recording accounts. They may be termed as accounting concepts. Hence, it can be said that: “The term accounting concepts refer to basic rules, assumptions, and principles which act as a primary standard for recording business transactions and maintaining books of accounts”. 1. Business Entity Concept This concept assumes that the organization and business owners are two independent entities. Hence, the business translation and personal transaction of its owner are different. For example, when the business owner invests his money in the business, it is recorded as a 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 a business expense. Thus, the accounting transactions are recorded in the books of accounts from the organization's point of view and not the person owning the business. 2. Accrual Concept The term accrual means something is due, especially an amount of money that is yet to be paid or received at the end of the accounting period. It implies that revenue is realized at the time of sale through cash or not whereas expenses are recognized when they become payable whether cash is paid or not. Therefore, both the transactions are recorded in the accounting period in which they relate. In the accounting system, the accrual concept tells that the business revenue is realized at the time goods and services are sold irrespective of the fact when cash is received for the same. For example, On March 5, 2021, the firm sold goods for Rs 55000, and the payment was not received until April 5, 2021, the amount was due and payable to the firm on the date goods and services were sold i.e. March 5, 2021. It must be included in the revenue for the year ending March 31, 2021. Similarly, expenses are recognized at the time services are provided, irrespective of the fact that cash paid for these services are made. For example, if the firm received goods costing Rs.20000 on March 9, 2021, but the payment is made on April 7, 2021, the accrual concept requires that expenses must be recorded for the year ending March 31, 2021, although no payment has been made until this date though the service has been received and the person to whom the payment should have been made is represented as a creditor of business firm. 3. Accounting Cost Concept The accounting cost concept states all the business assets should be written down in the book of accounts at the price assets are purchased, including the cost of acquisition, and installation. The assets are not recorded at their market price. It implies that the fixed assets like plant and machinery, building, furniture, etc. are recorded at their purchase price. For example, a machine was purchased by ABC Limited for Rs.10, 00,000, for manufacturing bottles. An amount of Rs.2,000 was spent on transporting the machine to the factory site. Also, Rs.2000 was additionally spent on its installation. Hence, the total amount at which the machine will be recorded in the books of accounts would be the total of all these items i.e. Rs.10, 040, 00. This cost is also termed as historical cost. 4. Dual Aspect The dual aspect is the basic principle of accounting. It provides the basis for recording business transactions in the books of accounts. This concept assumes that every transaction recorded in the books of accountants is based on dual concepts. This implies that the transaction that is recorded affects two accounts on their respective opposite sides. Hence, the transaction should be recorded at dual places. It implies that both aspects of the transaction should be recorded in the books of account. For example, goods purchased in exchange for cash have two aspects such as paying cash and receiving goods. Therefore, both the aspects should be registered in the books of accounts. The duality of the transaction is commonly expressed in the terms of the following equation given below: Assets = Liabilities + Capital The dual concept implies that every transaction has a similar effect on assets and liabilities in such a way that the value of total assets is always equal to the value of total liabilities. 5. Going Concepts  The Going concept in accounting states that business activities will be carried by any firm for an unlimited duration this simply means that every business has continuity of life. Hence, it will not be dissolved shortly. This is an important assumption of accounting as it provides a base for representing the asset value in the balance sheet. For example, the plant and machinery was purchased by a company of Rs. 10 lakhs and its life span is 10 years. According to the Going concept, every year some amount of assets purchased by the business will be represented as an expense and the balance amount will be shown as an asset in the books of accounts. Thus, if an amount is incurred on an item that will be used in business for several years ahead, it will not be proper to charge the amount from the revenues of that particular year in which the item was purchased Only a part of the purchase value is shown as an expense in the year of purchase and the remaining balance is shown as an asset in the balance sheet. 6. Money Measurement Concept The money measurement concept assumes that the business transactions are made in terms of money i.e. in the currency of a country. In India, such transactions are made in terms of the rupee. Hence, as per the money measurement concept, transactions that can be expressed in terms of money should be recorded in books of accounts. For example, the sale of goods worth Rs. 10000, purchase of raw material Rs. 5000, rent paid Rs.2000 are expressed in terms of money, hence these transactions can be recorded in the books of accounts. 7. Accounting Period Concepts Accounting period concepts state that all the transactions recorded in the books of account should be based on the assumption that profit on these transactions is to be ascertained for a specific period. Hence this concept says that the balance sheet and profit and loss account of a business should be prepared at regular intervals. This is important for different purposes like calculation of profit and loss, tax calculation, ascertaining financial position, etc. Also, this concept assumes that business indefinite life is divided into two parts. These parts are termed accounting periods. It can be one month, three months, six months, etc. Usually, one year is considered as one accounting period which may be a calendar year or financial year. The year that begins on January 1 and ends on January 31 is termed as calendar year whereas the year that begins on April 1 and ends on March 31 is termed as financial year. 8. Realization Concept The term realization concept states that revenue earned from any business transaction should be included in the accounting records only when it is realized. The term realization implies the creation of a legal right to receive money. Hence, it should be noted that selling goods is considered as realization whereas receiving order is not considered as realization. In other words, the revenue concept states that revenue is realized when cash is received or the right to receive cash on the sale of goods or services or both have been created. 9. Matching Concepts The Matching concept states that revenue and expenses incurred to earn the revenue must belong to the same accounting period. Hence, once revenue is realized, the next step is to assign the relevant accounting period. For example, if you pay a commission to a salesperson for the sale that you record in March. The commission should also be recorded in the same month.  The matching concept implies that all the revenue earned during an accounting year whether received or not during that year or all the expenses incurred whether paid or not during that year should be considered while determining the profit and loss of the business for that year. This enables the investors or shareholders to know the exact profit and loss of the business. What are Accounting Conventions? Accounting conventions are certain restrictions for the business transactions that are complicated and are unclear. Although accounting conventions are not generally or legally binding, these generally accepted principles maintain consistency in financial statements. While standardized financial reporting processes, the accounting conventions consider comparison, full disclosure of transaction, relevance, and application in financial statements. Four important types of accounting conventions are:  Conservatism: While recording the business transactions we have to anticipate no profit but provide for all possible losses. It encourages the certain secret reserves by making excess provision to prevent losses. The income statement may show lower income and the Balance Sheet overstates the liabilities and understates the assets. This policy of recording is asking the accountant ‘to play safe’ while writing the accounts.  Consistency: A company is forced to apply the similar accounting principles across the different accounting cycles. Once this chooses a method it is urged to stick with it in the future also, unless it finds a good reason to perform it in another way. In the absence of these accounting conventions, the ability of investors to compare and assess how the company performs becomes more challenging.  Full Disclosure: The accounts must disclose all material information. The accounting reports should disclose full and fair information to the related parties. The financial position and performance should be disclosed very honestly to all the users. The financial position means the Balance Sheet of the business and financial performance mean business results in terms of profits or losses and income and expenses in profit and loss account. All the information disclosed should be relevant, reliable, and comparable and understood by all the concerned authorities.  Materiality: Materiality: According to this convention, financial statements should disclose all material items which might influence the decisions of the users of financial statements. Hence, any item which is not significant and is not relevant to the users need not be disclosed in the financial statements. This principle is basically an exception to the full disclosure principle. The term materiality is subjective in nature. Materiality depends on the amount involved in the transaction, size of the business, nature of information, requirements of the person making decision, etc. An item material to one person may be immaterial to another person Accounting Principles Accounting principles are a set of guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while presenting or recording financial transactions in the books of account. This enables companies to present a true and fair view of the financial statements. Here is the list of the top 6 accounting principles that companies follow quite often: 1. Accrual Principle 2. Consistency Principle  3. Conservatism Principle 4. Going Concern Principle 5. Matching Principle 6. Full Disclosure Principle  Voucher: Meaning, Preparation and Presentation A document that serves as evidence for a business transaction is called a Voucher. Sometimes, mistakenly seen as just a bill or receipt; it can have many other forms. It is not the appearance of it that matters it just needs to act as evidence of a transaction. When a transaction is entered, the evidence of that transaction is also confirmed. A voucher helps in recording expenses or liability and further helps in its payment. They are also called source documents as they help in identifying the source of a transaction. A few examples of vouchers include bill receipts, cash memos, pay-in-slips, checks, an invoice, a debit or credit note.