Financial Accounting

INTRODUCTION

In any type and size of business enterprise there are numerous transactions taking place
every day. Every businessman is interested in knowing the result of the business after
certain equal intervals. These intervals are generally accounting years (financial years)
having twelve months span starting on 1stApril of the year and ending on 31 st March of
the next year. Thus, in order to ascertain the business result, there is a need of
maintaining appropriate record of all the business transactions and at the end of an
accounting year, finalizing the recorded information. This process of regularly recording
the business transactions and finalizing the results at the end of an accounting year is
considered to be the core scope of financial accounting. This scope is further extended to
understand the financial position and profitability of the business through further analysis
of financial statements with the help of accounting tools such as ratio, fund flow and cash
flow.

MEANING OF FINANCIAL ACCOUNTING

Accounting is an information system which involves identification, measurement and
communication of economic information of an organization to its users who need the
same for different types of decision making. Thus, accounting may be understood as the
process of identifying the transaction, recording the transaction, measuring the results and
communicating the results to users of financial accounting information.
1. Identifying transactions
2. Recording the transactions
3. Measurement of business results
4. Communication of business results
Exhaustively, financial accounting is the process of recording, classifying, summarizing,
analyzing, interpreting and communicating business results.
The definition brings out the following attributes of financial accounting.

a) Events and transactions of financial nature (expressed in monetary term) are recorded
whereas the non-financial events and transactions can not be recorded.

b) It is a total process commencing from recording of transaction and ending with the
communication of summary of entire business efforts.

c) It finally includes interpretation of business results so as to enable all the concerned

users to take appropriate decision beneficial to them.

PRIMARY OBJECTIVES OF FINANCIAL ACCOUNTING

Basically, financial accounting is an objective oriented discipline which focuses on
enabling the decision making by all the concerned users of financial accounting
information. Following are the specific objectives of financial accounting:

To maintain record of all the accounting transactions in appropriate books.

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To calculate the results of business operations conducted during the specific period.
To ascertain the financial position of the business as on particular date.
To analyze in detail the profitability and current financial position of the business.
To communicate the financial accounting information to various users in proper form

NEED FOR FINANCIAL ACCOUNTING Financial accounting statements are needed

for various purposes such as to know the business results, for procurement of loans from
banks and financial institutions, to submit to the government for various purposes and so
on. Thus, the specific needs for financial accounting are discussed as below:

Financial accounting is needed for understanding profitability of the business.

Financial accounting records reveal the financial position of the business.
It helps understand overall efficiency of the business.
It provides appropriate numerical information to the creditors of the business for decision
making regarding the period and amount of credits to be sanctioned.
It is required to be submitted to various government departments for payments of taxes
such as income tax, sales tax, excise duty etc.
It helps management of the business for taking appropriate decision at right time.

DISTINGUISHING FINANCIAL ACCOUNTING FROM OTHER

BRANCHEHES OF ACCOUNTING

Financial accounting is one of the branches of accounting discipline. There are other
branches of accounting such as Cost accounting; Management accounting etc. Each of
this .branches performs the specific function appropriate to the purpose of its existence.
Hence it is appropriate distinguish the financial accounting from the other specific
branches of accounting

USERS OF FINANCIAL ACCOUNTING INFORMATION

Financial accounting records the transactions regularly and generates the financial
statement at the end of every accounting year. These financial accounting statements are
frequently and regularly used by various users internal as well as external to the
organizations. These internal and external users of financial statements are as under:

Management
The owners or shareholders elect a group of people to manage day to day affairs of the
company. Since these people are ultimately responsible for the financial performance,
they must periodically review the financial statements.

Shareholders
Shareholders are the true owners of the company. They have full right to know the
financial details of an organization. Further, the information provided by the financial
accounting statements helps them take decisions regarding whether to stay invested or
withdraw the funds. They may also decide about the additional investment to be made in
the same organization. Shareholders can compare their company's performance with the
other companies' performance with the help of financial statements.

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Prospective investors
Prospective investors are those investors who are planning to invest in a certain company.
They are always interested to know financial information provided by financial
accounting statement. They take the investment decision based on the information
provided by these statements.

Lenders
Banks, financial institutions and other lenders would willingly part with their money only
if they are assured of good performance and long term solvency of the business in hick
they are asked to invest.

Suppliers (Creditors)
The financial statement facilitates the creditors in ascertaining the capacity of the
Organization, to pay on time, the consideration for the goods or services to be supplied.

Customers
Legal. Obligation associated with guarantees, warranties and. after sale service contracts
tend to establish long term relationships with customers. The financial statements may e
used by the customers to check the long term viability of the business.

Employees
Employees have vested interest in the organizations in which they are working. Financial
statements can be used as important source for obtaining information regarding the
current position of the business as well as the future viability of the business
organization.

Government
To calculate correct income tax, sales tax, excise duty, etc. requires the close scrutiny of
the financial statements, especially to detect tax evasion, if any. Government, as guardian
of public interest, must also keep a close watch on various industries which can be done
effectively through the scrutiny of the financial statements.

Researchers
Academicians, research scholars, and analysts use the financial accounting information
for the purpose of their study and interpretations for further reporting of findings from
various different angles.

Accounting Principles: is developed over a time from experience and general

understanding of accounting transaction. These accounting principles are judged on basis
of general acceptability. Accounting principles are broadly classified into accounting
conventions and accounting principle

ACCOUNTING CONVENTIONS

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Accounting conventions are the traditional guidelines for preparation of accounting
records
And statements. Following are the conventions in accounting

Consistency means following the same accounting policies consistently without

initiating frequent changes. The comparison of business results of one period with the
other is possible only when the accounting policies once implemented are followed
consistently. For e.g. if the plant and machinery started depreciating at 10% under fixed
installment method, then the same policy should continue for all the subsequent years so
as to enable comparison of profits for various different accounting periods. Again,
consistency does not mean rigidity. If there are certain wrong policies implemented, then
such policies can be changed for correction but the entire consequence of change and all
the affected accounts should be duly reported at all the appropriate places in the financial
statements so as to bring the same to the notice of users of financial accounting
information.

Materiality As per 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 the informed investor". It indicates that the details which will have impact on the
decisions of the users of the financial accounting information should be considered
important and properly reported. Certain insignificant and immaterial information can be
avoided from the financial statement so as to make it more simple and understandable.

Disclosure This convention means full disclosure of all the material facts with 'the true
and fair view and as required by all the users of financial accounting information such as
shareholders, creditors, banks, government, etc. Especially, in case of large business
enterprises like Joint Stock Company where there is separation of ownership and
management, the disclosure takes highest importance as the shareholders money is at
stake. However the term full disclosure does not mean disclosure of each and everything.
It simply means providing information of significance to the relevant users.

Conservatism It refers to the policy of playing safe. As per this convention, all the
probable losses are taken into consideration but not the probable gains. Probable losses or
gains are decided on the basis of previous experience of the concern like there may be
possibility of debt becoming irrecoverable to the tune of 2% of the total outstanding
debtors as on the last date of the year. This gives rise to making provision in advance for
the loss due to bad debts under the heading 'Reserve for doubtful debts'. But such a
provision is not being made for probable profits or gains. Some of the examples of the
conservatism are making provision for doubtful debts and discount on debtors, valuing
the stock at cost or market price whichever is less, creating provision against price
fluctuation of investment, valuing joint life policy at surrender value in stead of paid up
value, etc.

Accounting Concepts

1 Going concern

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It is assumed that the business organization will continue its activities for fairly long
period unless and until it enters the state of liquidation. Hence in the books of accounts
depreciation is provided on the fixed assets considering their expected life. For the
various other accounting treatments the assumption of going concern is applicable.

2. Dual aspect concept

This is extremely important and everywhere applicable concept of accounting. As per the
dual aspect concept, every transaction has two effects while recording it into the books of
accounts. For e.g. if goods purchased for cash then there are two effects like goods is
coming into the business and cash is going out from the business. This principle of
accounting is observed at the time of recording every transaction in the books of accounts
will show Rs10 lakhs only (as the land is non depreciable)

3. Cost concept

Cost concept suggests that the assets should be recorded at cost only. Here cost means
price at the time of purchase of asset. It can't be recorded at realizable value or current
sales price or current market price or any replacement value. For e.g. a piece of land
purchased for Rs. 10 Lakhs and recorded in the books. After say five years, even if the
same land is valued at Rs. 50 Lakhs as per market valuation but the books of account will
show Rs. 10 Lakhs only (as the land is non depreciable asset).

4. Money measurement concept

In accounting everything is recorded in terms of money. Events or transactions which

cannot be expressed in monetary value are not recorded in the books of accounts eve if
they are significant for the business. For e.g. the efficiency of management of the
business is very important factor for the success of any business but as the efficiency can
not be measured in terms of money so it cannot be recorded in the books of accounts

5. Accrual concept
Accrual concept refers to the system or method whereby revenue and expenses are
identified with the specific period of time, generally an accounting year. It indicates that
the transactions of a particular period are recorded in the books of accounts eve if they
aren't paid or received in cash. For e.g. if Mr. X is employed with EXL Ltd. an salary for
the last month of year say March 2008 is not paid till the year end. The same salary will
be recorded in the books as outstanding salary on accrual basis thou not paid in cash.

6. Periodicity concept

Though the assumption of going concern holds that the business is a continuous activity
there is a need to calculate the business results after every particular period call
accounting intervals. As per the concept of periodicity, the accounting interval is period
of twelve months for which the business results are measured though the business

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continues to operate. This helps organizations understand the profitability and financial
position of the business regularly and enables it to take appropriate actions for correcting
the deviations if any.

7. Matching Concept
This concept is based on periodicity concept. Generally, profit making is one of the very
important objectives of the business organisations which keep them busy with their
business activities. Hence, as per the matching concept, there is periodic matching of cost
and revenue to find out the profit and profitability of the concern. While matching the
revenue and expenses, the concept of accrual plays important-role as all the expenses and
revenue for the specified period is taken into consideration while ascertaining profit.

(8) Realization concept

According to this concept the profit should be accounted for only when it is actually
realized. Revenue is recognised only when the sale takes place or services are rendered.
Sale is considered to be made when the property in the goods is passed to the buyer and
he is liable to pay

9) Verified evidence concept

According to this concept all accounting transactions should be evidenced and
supported by objective documents. Such supporting documents provide the basis for
making accounting entries and for making verification by the auditor later on.

Distinguish between three branches of accounting:

S Financial accounting Cost accounting Management accounting

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Nature
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It records, reports and It records, reports and It analyses and interprets
analyses the financial analyses cost of each cost accounting information
transactions of a concern. centre such as product for further decision making
or processor contract. by management of a
0 System
It uses double entry system It has its own cost account It generates statements
of entering the transaction recording system under as per the requirements
in the books of accounts. costing ledgers. and forms suitable for
analysis and decision
making.

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 0 Period
Records are prepared for a Records are prepared for Records are free lanced
specific period i.e. a specific cost centre. and can be prepared as per
financial year. requirement.
0 Nature of data used
It uses past data (occurred It uses current data for
transactions) for recording future estimations. It is more of
into the system. futuristic nature and
develops records for
decision making.

0 Publication of records
Financial accounting Cost accounting records Management accounting
records are required are not published. records are generated
to be published as per It may be submitted purely for internal decision
the legal requirement making and hence do
to government
(in case of corporate in certain cases. not require any publication.
entity)
0 Compulsion
Financial accounting Management accounting
Cost accounting records are
records are required to be records are purely optional.
optional except for certain
maintained compulsorily corporate entities where
by every business government orders the
organizations. maintenance of costing
records.

STEP S IN ACCOUNTING CYCLE

Accounting cycle is a process which involves following steps.
Step1 Journalizing. Under this step the transactions are identified and recorded journal
book by providing two effects as per double entry book keeping system. Journal" is the
book of prime entry.
Step 2- Posting: It is the second step in accounting cycle. Under this step the transactions
recorded in journal are posted to respective ledger accounts opened specifically for the
purpose.
Step 3- Balancing: Under this step separately prepared ledger accounts are totaled and
balanced for understanding the position of individual ledger account. A ledger account
may not have any balance or may either have debit balance or credit balance.

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Step 4- Trial Balance: After balancing all ledger accounts a trial balance is prepared
which is generally defined as list of debit and credit balances of ledger accounts. Trial
balance should always tally.
Step 5- Preparation of financial statements: This is the final step in the accounting
cycle. Under this step profit and loss account is prepared to understand the profitability
whereas balance sheet is prepared to know the financial position of the business.
While preparing financial statements there are certain adjustments taken into
consideration such as providing for annual depreciation on fixed assets. This step of
accounting cycle is covered under the separate chapter of final account.

DOUBLE ENTRY BOOK KEEPING SYSTEM- is the most scientific system of

maintaining the accounts of business. It is the complete and accurate system of
accounting which records both the aspects of every business transaction. In other words
double entry book keeping system denotes that every transaction has two fold effect
termed as debit effect and credit effect. Double entry book keeping system is superior to
other systems of maintaining accounting records such as single entry, cash system etc. It
provides appropriate classification of various items of accounts involved in different
transactions and thereby helps to maintain the record of personal as well as impersonal
accounts. Due to double effect of every transaction it ensures arithmetical accuracy and
enables detection and correction of errors.