UNIT

01 Introduction to Financial Accounting

Names of Sub-Units

Meaning and Objectives of Accounting, Branches of Accounting, Users of Financial Statements, Types
of Organisations

Overview

In this unit, firstly, you will study the concept of financial accounting. Then, you will gain insight
into Meaning of Financial Accounting. The chapter will also shed light on Objectives of Financial
Accounting, and Types of Accounting. In the end, you will be acquainted with the study of Users of
Financial Statements and Types of Business Entities.

Learning Objectives

In this unit, you will learn to:

 Discuss the Meaning and objectives of financial accounting
 Classify the Various branches of accounting
 Describe the Users of financial statements
 Extent the Different types of business entities
JGI JAIN
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Accounting for Business

Learning Outcomes
At the end of this unit you would:
 Assess the accounting and why is accounting needed
 Appraise the different branches of accounting
 Evaluate the various users of financial statements
 Analyse the different types of business entities

Pre-Unit Preparatory Material

 http://www.ddegjust.ac.in/studymaterial/mba/cp-104.pdf
 https://www.ccs.edu/cms/lib/NY01913591/Centricity/Domain/199/CHAPTER%201%20SUPA%20
MY%20NOTES.pdf

1.1 INTRODUCTION
An accountant’s main function has always been to provide owners managers of an organisation with
accurate and timely financial information. This information serves as the foundation from which
tactical and strategic decisions are often made. However, much more is expected of accountants today.
The view of accountants being pure “number crunchers” or gatherers of information is fading.
Today accountants are becoming increasingly involved in the operational and strategy formulation
side of business. They now advise and consult with owners and managers on productivity, profitability
and other business issues. In short, an accountant is now expected to become an integral part of the
organisation. To do this, he will need to understand the nature of organisations, their structure and
their operations.
This unit is the foundation of your knowledge: if you can build a solid base, everything you “construct”
will have to be consistent and will last over time. By the end of working through this unit, you should be
able to understand the meaning and objectives of financial accounting, the various types of business
entities, the various users of financial statements, and various types of accounting.

1.2 OVERVIEW OF FINANCIAL ACCOUNTING

Financial accounting is a specific branch of accounting involving a process of recording, summarizing,
and reporting the myriad of transactions resulting from business operations over a period of time.
These transactions are summarized in the preparation of financial statements, including the balance
sheet, income statement and cash flow statement, that record the company’s operating performance
over a specified period.
Work opportunities for a financial accountant can be found in both the public and private sectors. A
financial accountant’s duties may differ from those of a general accountant, who works for himself or
herself rather than directly for a company or organization.
Financial accounting utilizes a series of established accounting principles. The selection of accounting
principles to use during the course of financial accounting depends on the regulatory and reporting
requirements the business faces. For U.S. public companies, businesses are required to perform financial

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accounting in accordance with generally accepted accounting principles (GAAP). The establishment of
these accounting principles is to provide consistent information to investors, creditors, regulators, and
tax authorities.
Financial accounting results in the determination of net income at the bottom of the income statement.
Assets, liabilities and equity accounts are reported on the balance sheet. The balance sheet utilizes
financial accounting to report ownership of the company’s future economic benefits.

1.2.1 Meaning of Financial Accounting

The New York state society of CPAs defines financial accounting as recording and reporting financial
transactions, including the origination of the transaction, its recognition, processing and summarisation
in the financial statements.
From the start of a business, various transactions and events will start to take place. All transactions
should have as their base certain source documents such as invoices or receipts, from which we record
information in the accounting books and then summarise this information in the financial statements.
The accountant will be responsible for accounting for business transactions and reporting them to
external users. The accounting will therefore consist of the following:
1. Identifying and recording the transactions that take place during the year
2. Analysing them and
3. Summarising and reporting them in the financial statements.

Recording
Recording refers to writing the transactions in words and figures so that reliable information regarding
the position of the business can be made available at any point in time. The books where this information
is recorded are known as the books of original entry.
The transactions are recorded in the books of accounts on the basis of documents such as:
 Invoices
 Receipts
 Vouchers
 Bank statements etc.

Analysing
From the books of original entry, the transactions are analysed and posted to the ledgers. The ledger
book contains separate categories such as purchases account, sales accounts, cash account, expenses
account, etc. Every transaction has two effects. As each transaction will have a double effect, two ledger
accounts will be affected when a transaction is posted.

Summarising
Millions of transactions could occur during a year. Once they are categorised, we need to be able to
summarise them in a structured manner to understand an entity’s financial position at the end of a
period and its performance during the period.

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Accounting for Business

The final products of accounting are the business financial statements. The two main financial
statements that summarise all the transactions and events of a business during a period are the:
 Profit and loss account
 Balance sheet

The profit and loss account is a statement that reflects all the items of income and expenses incurred
by a business during a certain period. The bottom line of the profit and loss account is the profit/loss
generated by the business during that period.
The balance sheet is a statement reflecting everything that the entity owns (its assets such as fixed
assets, trade receivables and cash) and everything it owes (its liabilities to the owners and third parties
such as loan and trade payables) as at a certain point in time.

1.2.2 Objectives of Financial Accounting

 The primary objective of accounting is to systematically record the financial information of a
business and provide that information to various stakeholders to enable them to make necessary
decisions.
 Accounting enables finding profit or loss made by the business in a particular period.
 Accounting enables ascertaining the financial position of a business, such as its assets and its
liabilities.
 Accounting helps to ensure statutory compliance and tax filing.
 Accounting aids in evaluating the performance of the business over a particular period and helps
make decisions like an investment of funds, expansion of business, closing down a branch etc., to
improve performance. Thus, it helps in decision-making.
 Accounting also helps in predicting future trends based on past records.
 Properly maintained accounts are required for getting loans and advances from banks and financial
statements.

1.3 TYPES OF ACCOUNTING

Accounting can be divided into three types as financial accounting, management accounting and cost
accounting.

Financial Accounting
Financial accounting is collecting, classifying, recording and summarising the financial transactions
for the purpose of presenting the financial results of an organisation for the given period.

Management Accounting
Management accounting primarily focuses on accumulating and providing information to the
management of the entity to ensure effective fulfillment of their functions of planning, organizing,
directing and controlling the business. The objective of management accounting is to assist the internal
users with the necessary information in order to enable them to make business decisions.

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Cost Accounting
Cost accounting deals with involves collecting, recording and analysing data relating to costs of a
product or a process or a project with the objective of controlling those costs. There are various types of
costs such as fixed cost, variable cost, opportunity cost, direct cost and indirect costs.

1.4 USERS OF FINANCIAL STATEMENTS

The financial statements provide a deep insight into the financial health of a company which is the
basis of making various types of decisions. There are many internal as well as external users of financial
statements as follows:

Owners/Shareholders and Potential Investors

The primary users of an organisation’s financial statements are its owners/shareholders. In fact, the
financial statements are specifically addressed to this very group. This is because owners/shareholders
have provided the capital that makes it possible for an organisation to begin its operations. Therefore it is
their capital that is at risk if the company goes bankrupt. Naturally, they will want as much information
and detail as possible in order to determine if their investment is not only still safe but also growing.

Management
Management will use the financial statements of the organisation as a kind of “report card” on their
decisions/activities throughout the year. This is because the statements reflect how profitable (or
unprofitable) these decisions or activities have ultimately been for the organisation.

Providers of Finance e.g. Banks or Other Financial Institutions

Creditors such as banks and other financial institutions typically provide the funding an organisation
needs to carry on its operations and/or expand its business. The information they will seek from the
organisation’s financial statements include:
 How profitable the organisation has been.
 Whether the company will continue to operate in the coming years or is it likely that it will go out of
business.
 Whether operations of the organisation have generated sufficient cash flow to satisfy their loan
repayments going forward.
 The value of the assets the organisation may have pledged as security/collateral.

Traderelations
Trade relations represent the suppliers and customers of an organisation. Suppliers or vendors of an
organisation will be interested in its financial statements. They will use these statements to determine
the financial condition and performance of the business in order to find out whether the organisation
will be able to pay for the goods/services it orders from them.

Employees
Employees of an organisation are interested in the financial condition and performance of an
organisation because that is the source of their salaries. Also, organisations that are performing poorly

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Accounting for Business

or are in a weak financial position are unlikely to offer much scope for promotions, career development,
etc. Employees can see the prospects from the financial statements.

Government
Financial statements of organisations serve as a data source for the government when it is compiling
national economic statistics such as the country’s GDP (Gross Domestic Product). This helps the
government in making different policy decisions.

Tax Authorities
Tax authorities use financial statements to determine tax amounts. Income shown by the profit and loss
account is used as the starting point for calculating taxable income. Revenue and purchase figures are
used to determine GST liability.

1.5 TYPES OF BUSINESS ENTITIES

Normally, on the basis of the objectives, organisations can be divided into two parts:
1. Commercial (profit-oriented) organisations and
2. Not-for-profit organisations.

Commercial Organisations
A commercial organisation is any entity that has been created for the purpose of generating profits.
There are three main types of commercial organisations as follows:
 The sole trader: A sole trader is a ‘one-man-band’ for example a hairdresser, a plumber, an
accountant and a lawyer. The entire business is owned and controlled by a single person. The owner
and the operator of the organisation are the same people. Although other persons may be employed,
ultimately, all responsibility and decision-making authority rests with this one individual. The
owner’s liability is unlimited for all debts of the business as he alone is responsible.
 Partnerships: When two or more individuals pool their resources and join forces, a partnership
is formed. A partnership is a mutual agreement between two or more individuals involving the
division of authority and profits among partners. Common examples of partnerships are law firms
or accounting firms.
 Companies: A company is a business entity registered under the Companies Act, 2013. The owners
buy shares in the entity and this money is used by the entity to carry out its activities. The owners
are known as shareholders.
Unlike the situation with sole traders and partnerships, there is a division between the personal
assets of the owners and their investment in the company. The company is a separate legal entity
from the owners.
Entities may be incorporated as private limited companies or public limited companies.
 Private Limited Companies: An entity formed as a private limited company is usually held by a
small group of people.
The liability of the owners of a private limited company is limited to their investment in the company.
 Public Limited Companies: Public limited companies also have the protection of limited liability.
However, unlike private limited companies, ownership of the organisation is open to the public.

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Public limited companies are listed on a Stock Exchange therefore, they can have thousands of
shareholders and they are generally medium to large entities.

Not-For-Profit Organisations
In direct contrast to commercial organisations, not-for-profit organisations are started and run for the
purpose of providing benefits. These benefits may be provided on an individual level or to society as a
whole.
These organisations generally do not earn a profit but aim to provide or deliver a service. Not-for-profit
organisations derive their revenue from three sources:
 their revenue generating activities;
 government funding and
 donations (from both individuals and organisations).

Not-for-profit organisations vary greatly in terms of both size and type. Examples include trade unions,
hospitals and universities. All of these organisations have been created and are run for providing a
beneficial service.

Public Sector
Public sector organisations are organisations that are owned by society. They also do not operate for a
profit. They are set up and run by governments to provide goods or services to the people of the society.
Although these organisations charge their customers, their main aim is to efficiently provide the
products/services the society needs.
Public sector organisations are financed by governments and their own revenue-generating activities.
Examples include the post office, electricity and water boards as well as public transportation such as
the bus and railway systems.

Non-Governmental Organisations
Non-governmental Organisations (NGOs) are any organisations that work towards a social, cultural,
economic, or educational cause.
They are usually started and run to provide a good or service that the government is not providing or
to better the interests of citizens. NGOs cover a wide spectrum of aims ranging from education to the
environment.
Examples include Amnesty International, Greenpeace and the Red Cross. Amnesty International
campaigns for human rights across the globe. Greenpeace activities are all geared towards protecting
and preserving the natural environment. The Red Cross’s mission is to provide relief to victims of wars
and internal conflicts.

Cooperative Societies
Cooperative societies are autonomous associations of persons united voluntarily to meet a common
economic, social and/or cultural objective, through a jointly-owned and controlled enterprise.

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Accounting for Business

In short, it is an organisation that is owned and managed jointly by those who use its facilities and
services. A cooperative’s purpose is to provide services on a non-profit basis to the shareholders or
members who control it.
An example of a cooperative (in certain countries) is apartment buildings. A cooperative would own the
building and the land it is on. Individual apartment owners would be granted shares in the cooperative
based upon the size/value of their apartments.
The cooperative would also be responsible for the maintenance of the building with financing from
members’ monthly dues.

Conclusion 1.6 CONCLUSION

 An accountant’s main function has always been to provide owners / managers of an organisation
with accurate and timely financial information.
 This information serves as the foundation from which tactical and strategic decisions are often
made. However, much more is expected of accountants today.
 The view of accountants being pure “number crunchers” or gatherers of information is fading.
 Financial accounting is a specific branch of accounting involving a process of recording,
summarizing, and reporting the myriad of transactions resulting from business operations over a
period of time.
 These transactions are summarized in the preparation of financial statements, including the
balance sheet, income statement and cash flow statement, that record the company’s operating
performance over a specified period.
 Work opportunities for a financial accountant can be found in both the public and private sectors.
 A financial accountant’s duties may differ from those of a general accountant, who works for himself
or herself rather than directly for a company or organization.
 Financial accounting utilizes a series of established accounting principles.
 The selection of accounting principles to use during the course of financial accounting depends on
the regulatory and reporting requirements the business faces. For U.S. public companies, businesses
are required to perform financial accounting in accordance with generally accepted accounting
principles (GAAP).
 The establishment of these accounting principles is to provide consistent information to investors,
creditors, regulators, and tax authorities.
 Financial accounting results in the determination of net income at the bottom of the income
statement.
 Assets, liabilities and equity accounts are reported on the balance sheet.
 The balance sheet utilizes financial accounting to report ownership of the company’s future
economic benefits.
 Accounting can be divided into three types as financial accounting, management accounting and
cost accounting.
 The primary users of an organisation’s financial statements are its owners/shareholders.

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 In fact, the financial statements are specifically addressed to this very group. This is because
owners/shareholders have provided the capital that makes it possible for an organisation to begin
its operations.
 Therefore, it is their capital that is at risk if the company goes bankrupt. Naturally, they will want
as much information and detail as possible in order to determine if their investment is not only still
safe but also growing.

1.7 GLOSSARY

 Accounting: Accounting is the process of recording and reporting financial transactions, including
the origination of the transaction, its recognition, processing and summarisation in the financial
statements.
 Recording: Recording refers to writing the transactions in words and figures so that reliable
information regarding the position of the business can be made available at any point in time.
 Financial accounting: Financial accounting is collecting, classifying, recording and summarising
the financial transactions for the purpose of presenting the financial results of an organisation for
the given period.
 Cost accounting: Cost accounting deals with involves collecting, recording, and analysing data
relating to costs of a product or a process or a project with the objective of controlling those costs
 Partnership: A partnership is a mutual agreement between two or more individuals involving the
division of authority and profits among partners.
 Public sector Organisations: Public sector organisations are organisations that are owned by
society.
 Non-governmental Organisations (NGOs): NGOs are organisations that work towards a social,
cultural, economic or educational cause.
 Cooperative societies: Cooperative societies are autonomous associations of persons united
voluntarily to meet a common economic, social and/or cultural objective, through a jointly-owned
and controlled enterprise.

1.8 CASE STUDY: BUSINESS RISK

Case objective
This case study highlights the way of study by which a Ana and Jay can reduce their business risk.

‘Say it with a Card, is a studio run by two friends Ana and Jay. The studio is famous for handmade
birthday cards, anniversary cards and seasonal greeting cards on the occasions of Diwali, Christmas
and New Year made by budding artists from Maharashtra. Pankaj Variety Stores (PVS) is a large retail
store having 12 branches in various cities of Maharashtra. PVS wants to order a very large quantity of
Diwali cards for its stores with payment to be made three months after delivery.
Having never dealt with PVS before, Ana and Jay are nervous about sending out such a large order, as
they are unsure as to whether they will be paid after three months. Ana and Jay believe they have only
two options: to ask for payment up-front (and risk losing the order) or to go ahead with the order and
hope for the best.

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Accounting for Business

However, their accountant suggests a third option. They should review the published financial statements
of PVS to ascertain its past financial performance and condition. These statements will indicate PVS’s
liquidity (i.e. ability to pay its debts). If the statements reflect that PVS is in a strong financial position,
then accepting the order becomes a much more calculated business risk.

Questions
1. Is ‘Say it with a Card’ an internal user or an external user of financial statement?
(Hint: ‘Say it with a Card’ is an external user.)
2. What constitutes financial statements?
(Hint: Financial statements primarily constitute a statement of profit or loss account and balance
sheet.)
3. Is it possible that ‘Say it with a Card’ is registered as an NGO?
(Hint: No, ‘Say it with a Card’ cannot be an NGO as it is a commercial organisation.)
4. ‘Say it with a Card’ is most likely to be what type of organisation?
(Hint: ‘Say it with a Card’ is more likely to be a partnership firm or a private limited company. Since
two people are managing the company, it cannot be a sole trader. Also, since it is closely held, it is
unlikely to be a public company.)
5. Can ‘Say it with a Card’ view management accounts of PVS to evaluate their financial position?
(Hint: ‘Say it with a Card’ cannot view PVS’s management accounts as management accounts are
available only to internal users. The external users only have access to financial statements based
on financial accounting.)

1.9 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. Describe the three main branches of accounting.
2. What type of information do the financial institutions normally seek from an entity’s financial
statements?
3. Explain what is commercial organisation.

1.10 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. The three main branches of accounting are financial accounting, management accounting, and
cost accounting.
Financial accounting is collecting, classifying, recording, and summarising the financial transactions
to present the financial results of an organisation for the given period. Financial accounting reflects
on the past performance of the entity and uses historical data to generate financial statements for
the use of internal as well as external users.
Management accounting accumulates and provides information to the management of the entity to
assist them with the necessary information to enable them to make business decisions. Management
accounting usually involves budgeting and forecasting, financial analysis, cost analysis, etc.
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Cost accounting involves collecting, recording and analysing data relating to costs of a product
or a process or a project to control those costs. Cost accounting uses various techniques such as
budgeting, activity-based costing, and variance analysis to evaluate cost data. This analysis helps
the management to improve efficiencies and save costs. Refer to section types of accounting
2. The information that the financial institutions normally seek from the organisation’s financial
statements include:
 How profitable the organisation has been.
 Whether the company will continue to operate in the coming years or is it likely that it will go
out of business.
 Whether operations of the organisation have generated sufficient cash flow to satisfy their loan
repayments going forward.
 The value of the assets the organisation may have pledged as security/collateral.
Refer to section Types of Business Entities
3. A commercial organisation is any entity that has been created for the purpose of generating profits.
This is the only criterion that needs to be satisfied for an organisation to be deemed a commercial
organisation. The primary goal of commercial organisations is to maximise profits. The type of
activity or work that the organisation does is of no relevance. The same rule applies in regards to
the size of the organisation. A small one-man consulting firm and the multiband empire of Reliance
Industries are both commercial organisations. Refer to section Users of Financial Statements.

@ 1.11 POST-UNIT READING MATERIAL

 https://idronline.org/the-laws-that-govern-indias-nonprofits/

1.12 TOPICS FOR DISCUSSION FORUMS

 Discuss the need and importance of public sector organisations.

 Discuss how the doctrine of a separate legal entity protects the interest of the business.

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