Basics of Financial Accounting
Basics of Financial Accounting
– Owners, being businessmen, always keep an eye on the returns from the
investment.
– Comparing the accounts of various years helps them to get good pieces of
information.
Users of Accounting Information /
Importance of Accounting
• Management: The management of the business is greatly interested in knowing the
position of the firm.
– The accounts are the basis as the management can study the merits and demerits of
the business activity through it.
– The financial accounting is the “eyes and ears of management and facilitates in
drawing future course of action, and further expansion, etc.”
Users of Accounting Information /
Importance of Accounting
• Creditors: Creditors are the persons who supply goods on credit, or bankers or lenders
of money.
– It is normal that these groups are interested to know the financial stability of the
firm before granting credit.
– The progress and prosperity of the firm, to which credits are extended, are largely
watched by creditors from the point of view of security and further credit.
– Profit and Loss Account; and Balance Sheet of the firm are the nerve centres to
know its soundness.
Users of Accounting Information /
Importance of Accounting
• Creditors: Creditors are the persons who supply goods on credit, or bankers or lenders
of money.
– It is normal that these groups are interested to know the financial stability of the
firm before granting credit.
– The progress and prosperity of the firm, to which credits are extended, are largely
watched by creditors from the point of view of security and further credit.
– Profit and Loss Account; and Balance Sheet of the firm are the nerve centres to
know its soundness.
Users of Accounting Information /
Importance of Accounting
• Employees:
– Payment of bonus depends upon the size of profit earned by the firm.
– The more important point is that the workers expect regular income for bread and
butter.
– The demand for rise in wages bonus, better working conditions, etc. depends upon
the profitability of the firm and that in turn depends upon its financial position.
Users of Accounting Information /
Importance of Accounting
• Employees:
– Payment of bonus depends upon the size of profit earned by the firm.
– The more important point is that the workers expect regular income for bread and
butter.
– The demand for rise in wages bonus, better working conditions, etc. depends upon
the profitability of the firm and that in turn depends upon its financial position.
Users of Accounting Information /
Importance of Accounting
• Investors: The prospective investors, who want to invest their money in a firm, would
wish to see the progress and prosperity of the firm, before investing their amount, by
going through the financial statements of the firm.
• This group is eager to go through the accounting as it enables them to know the safety
& worth of their investment.
Users of Accounting Information /
Importance of Accounting
• Government: The Government keeps a close watch on the firms which yield good
amount of profits.
• The state and central Governments are interested in the financial statements to know
the earnings for the purpose of taxation.
• To make a study into the financial operations of a particular firm, the research scholar
needs detailed accounting information related to purchases, sales, expenses, cost of
materials used, current assets, current liabilities, fixed assets, long-term liabilities and
share-holders funds which is available in the accounting record maintained by the firm.
Branches of Accounting
Branches of Accounting
Financial Accounting
Cost Accounting
Management Accounting
Branches of Accounting
• concerned only with the financial state of affairs and results
of financial operations.
Financial Accounting • original form of accounting
• concerned with the preparation of financial statements for
the use of stakeholders.
Non-Current Liabilities
• It refers to long term liabilities which are payable after a
period of one year.
• Also known as Long term liabilities.
• E.g. Long term loans etc.
Financial Statements
Financial Statements
A set of accounting documents prepared for a
business that cover a particular time period and
describe the financial health of the business.
Liabilities Assets
Non-Current Assets
Shareholders Fund
(Fixed Assets)
Currents assets
Current Liabilities
(Short Term Assets)
Equal
Cash Flow Statement
• A cash flow statement is a financial statement that
summarizes the amount of cash and cash equivalents
entering and leaving a company.
• The cash flow statement measures how well a company
manages its cash position, meaning how well the company
generates cash to pay its debt obligations and fund
its operating expenses.
• The cash flow statement complements the balance sheet
and income statement and is a mandatory part of a
company's financial reports.
Key Components of Cash Flow Statement
• The main components of the cash flow statement are:
– Cash From Operating Activities: Include any
sources and uses of cash from business activities. In
other words, it reflects how much cash is generated
from a company's products or services.
– Cash From Investing Activities: Includes include
any sources and uses of cash from a company's
investments. A purchase or sale of an asset or long
term investments.
– Cash From Financing Activities: includes the
sources of cash from investors or banks, as well as
the uses of cash paid to shareholders. Payment
Cash Flow Statement
Liquidity
• Ability to meet current obligations with cash or
other assets that can quickly be converted to
cash.
The more cash, the more liquid.
The less cash, the less liquid.
• Liquidity means how quickly you can get your hands on your
cash. In simpler terms, liquidity is to get your money
whenever you need it.
• Liquidity is important to know about short term financial
Solvency
• Solvency is the ability of a company to meet its long-term
debts and financial obligations.
• Solvency is important to know about long term financial
position.
Profitability
• Profitability is the ability to generate profits out of business
operations and evaluates the return on capital and funds
provided by owner and creditors.
• Evaluates the financial performance of the business and its
controlled resources.
Accounting Principles
• Accounting Concepts
• Accounting Conventions
• Accounting Assumptions
Accounting Principles
Accounting Principles: Accounting principles refer, to certain rules, procedures and conventions
which represent a consensus view by those indulging in good accounting practices and procedures.
•Accounting Assumptions: Defines the rules of action or conduct which are derived from
experience and practice, and when they prove useful, they become accepted principles of
accounting.
•Accounting Concepts: Concepts are logical considerations or notions which is generally and
widely acceptable. Provides the foundations of accounting. Concepts helps in selection of
accounting methods appropriate according to circumstances.
•Accounting Conventions: Guidelines used to help companies determine how to record
business transactions not yet fully covered by accounting standards.
Accounting Principles
Accounting Principles
• The American Institute of Certified Public Accountants (AICPA) has viewed the word
‘principle’ as a “general law of rule adopted or professed as a guide to action; a
settled ground or basis of conduct of practice.”
• To be more reliable, accounting statements are prepared in conformity with these
principles.
Accounting Principles
Accounting Assumptions Accounting Concepts Accounting Conventions
Historical Cost
Accounting Period Conservatism
Concept
Money
Matching Materiality
Measurement
Accrual Concept
Objective Evidence
Accounting Principles
- Assumptions
Going Concern Concept
• Going Concern Concept: Under this concept, the transactions are recorded assuming that the business will
exist for a longer period of time, i.e., a business unit is considered to be a going concern and not a
liquidated one.
• Keeping this in view, the suppliers and other companies enter into business transactions with the business
unit.
• This assumption supports the concept of valuing the assets at historical cost or replacement cost.
• This concept also supports the treatment of prepaid expenses as assets, although they may be practically
unsaleable.
56
Business Entity Concept
• Business Entity Concept: A business unit is an organisation of persons established to
accomplish an economic goal.
• Business entity concept implies that the business unit is separate and distinct from the
persons (owners) who provide the required capital to it.
• The equation clearly shows that the business itself owns the assets and in turn owes to
various claimants.
57
Business Entity Concept
• Business Entity Concept: It is worth mentioning here that the business entity concept as applied in
accounting for sole trading units is different from the legal concept. The expenses, income, assets and
liabilities which are not related to the sole proprietorship business are excluded from accounting.
• However, a sole proprietor is personally liable and required to utilise non-business assets or private
assets to settle the business creditors as per law. Thus, in the case of sole proprietorship, business and
non-business assets and liabilities are treated alike in the eyes of law.
• In the case of a partnership firm, for the payment of the business liabilities the business assets are
used first and if any surplus remains thereafter, it can be used for paying off the private liabilities of
each partner. Similarly, the private assets are used first to pay off the private liabilities of partners and
if any surplus remains,it is treated as part of the firm’s property and is used for paying the firm’s
liabilities.
• In the case of a company, its existence does not depend on the life span of any shareholder.
58
Business Entity Concept
• Examples
– Insurance premiums for the owner’s house should be excluded from the expense of
the business
– The owner’s property should not be included in the premises account of the business
– Any payments for the owner’s personal expenses by the business will be treated as
drawings and reduced the owner’s capital contribution in the business
59
Accounting Period Concept
• Periodicity Concept: Under this concept, the life of the business is segmented into
different periods and accordingly the result of each period is ascertained.
• Though the business is assumed to be continuing in future(as per going concern concept),
the measurement of income and studying the financial position of the business for a shorter
and definite period will help in taking corrective steps at the appropriate time.
• Each segmented period is called “accounting period” and it is normally a year.
• The businessman has to analyse and evaluate the results ascertained periodically.
• At the end of an accounting period, an Income Statement is prepared to ascertain the profit
or loss made during that accounting period and Balance Sheet is prepared which depicts
the financial position of the business as on the last day of that period.
• During the course of preparation of these statements capital revenue items are to be
necessarily distinguished.
Money Measurement Concept
• Money Measurement Concept: In accounting, all the events and transactions are recorded in terms of
money.
• Money is considered as a common denominator, by means of which various facts, events and transactions
in a business can be expressed in terms of numbers.
• In other words, facts, events and transactions which cannot be expressed in monetary terms are not
recorded in accounting.
• E.g. Market conditions, technological changes and the efficiency of management would not be disclosed in
the accounts.
• E.g. Qualities like workforce skill, morale, market leadership, brand recognition, quality of management
etc. cannot be quantified in monetary terms and so not accounted for in books of accounts.
61
Accounting Principles
- Concepts
Dual Aspect Concept
• According to this basic concept of accounting, every transaction has a two-fold aspect,
i.e., giving certain benefits and receiving certain benefits.
• The basic principle of double entry system is that every debit has a corresponding and
equal amount of credit. This is the underlying assumption of this concept.
• Therefore, the accounting equation is:
Assets = Capital + Liabilities
or
Capital = Assets – Liabilities.
• To further clarify this concept, at any point of time the total assets of the business units
are equal to its total liabilities.
• Liabilities here relate both to the outsiders and the owners. Liabilities to the owners are
considered as capital.
Revenue Realisation Concept
• This concept assumes or recognises revenue when a sale is made.
• Sale is considered to be complete when the ownership and property are transferred from the seller
to the buyer and the consideration is paid in full.
• However, there are two exceptions to this concept:
– Hire a purchase system, where the ownership is transferred to the buyer when the last
instalment is paid.
– Contract accounts, in which the contractor is liable to pay only when the whole contract is
completed, the profit is calculated on the basis of work certified each year.
Cont…
Cont… Recognition of Revenue
• The realization concept develops rules for the recognition of revenue
• The concept provides that revenues are recognized when it is earned, and not when money
is received
• A receipt in advance for the supply of goods should be treated as prepaid income under
current liabilities
• Since revenue is a principal component in the measurement of profit, the timing of its
recognition has a direct effect on the profit.
• The uncertain profits should not be estimated, whereas reported profits must be verifiable.
• Revenue is recognized when
1. The major earning process has substantially been completed
2. Further cost for the completion of the earning process are very slight or can be accurately
ascertained, and
3. The buyer has admitted his liability to pay for the goods or services provided and the ultimate
collection is relatively certain. 65
Historical Cost Concept
• Historical Cost Concept: According to this concept, the transactions are recorded in the
books of account with the respective amounts involved.
• For example, if an asset is purchased, it is entered in the accounting record at the price
paid to acquire the same and that cost is considered to be the base for all future
accounting.
• It means that the asset is recorded at cost at the time of purchase, but it may be
methodically reduced in its value byway of charging depreciation. However, in the light
of inflationary conditions, the application of this concept is considered highly irrelevant
for judging the financial position of the business.
66
Historical Cost Concept
• Meaning
– Assets should be shown on the balance sheet at the cost of purchase instead of
current value
• Example
– The cost of fixed assets is recorded at the date of acquisition cost. The
acquisition cost includes all expenditure made to prepare the asset for its
intended use. It included the invoice price of the assets, freight charges,
insurance or installation costs
67
Matching Concept
• The essence of the matching concept lies in the view that all costs which are associated to a particular
period should be compared with the revenues associated to the same period to obtain the net income of
the business.
• It is necessary to match the revenues with the costs of that particular period to know the profit or loss
during that period.
• For example, if a salesman is to be paid commission for the sales made, for comparison of sales, it is
immaterial whether the commission is paid or not. If sales are made in the month of March (year 2006-
07) and commission, in cash, is paid in the subsequent month, April (year 2007-08), it is necessary to
make provision for the commission in the year 2006-07 for proper comparison of the net profits.
Matching Concept
• Under this concept, the accounting period concept is relevant and it is this concept
(matching concept) which necessitated the provisions of different adjustments for
recording outstanding expenses, prepaid expenses, outstanding incomes, incomes
received in advance, etc., during the course of preparing the financial statements at the
end of the accounting period.
Accrual Concept
• According to this concept, the revenue is recognised on its realisation and not on its
actual receipt. Similarly the costs are recognised when they are incurred and not
when the payment is made.
• Accruals are needed for any revenue earned or expense incurred, for which cash has not
yet been exchanged.
• This assumption makes it necessary to have certain adjustments in the preparation of
income statement regarding revenues and costs.
• However under the cash accounting system, the revenues and costs are recognised only
when they are actually received or paid.
• Hence, the combination of both cash and accrual system is preferable to get rid of the
limitations of each system.
Accrual Concept
• Accruals are revenues earned or expenses incurred which impact a company's net
income on the income statement, although cash related to the transaction has not yet
changed hands.
• Accruals also affect the balance sheet, as they involve non-cash assets and liabilities.
• Accrual accounts include, among many others, accounts payable, accounts receivable,
accrued tax liabilities, and accrued interest earned or payable.
• Accruals improve the quality of information on financial statements by adding useful
information about short-term credit extended to customers and upcoming liabilities owed
to lenders.
• Accruals are created via adjusting journal entries at the end of each accounting period.
Objective Evidence
• This concept ensures that all accounting must be based on objective evidence, i.e. very transaction recorded in the books of
• The information should be based upon verifiable evidence such as invoices or contracts
• It is only then that the transactions can be verified by the auditors and declared as true or otherwise.
• The verifiable evidence for the transactions should be free from personal bias, i.e., it should be objective in nature and not
• However, in reality the subjectivity cannot be avoided in the aspects like provision for bad and doubtful debts, provision for
depreciation, valuation of inventory, etc., and the accountants are required to disclose the regulations followed.
Accounting Principles
-Conventions
Consistency
• The convention of consistency refers to the state of accounting rules, concepts, principles,
practices and conventions being observed and applied constantly, i.e., from one year to another
and there should not beany change.
• If consistency exists, then the results and performance of one period can be compared easily
and meaningfully with the other.
• It also prevents personal bias as the persons involved have to follow the consistent rules,
principles, concepts and conventions.
• This convention, however, does not completely ignore changes. It admits changes, wherever it
is indispensable and adds to the improved and modern techniques of accounting.
Consistency
Examples
– If a company adopts straight line method and should not be changed
to adopt reducing balance method in other period
75
Disclosure
• The convention of disclosure stresses on the importance of providing accurate, full and
reliable information and data in the financial statements which is of material interest to
the users and readers of such statements.
• This convention is given due legal emphasis by the Companies Act, 1956 / 2013 by
prescribing formats for the preparation of financial statements.
• However, the term disclosure does not state all information that one desires to get
should be included in accounting statements. It is enough if sufficient information,
which is of material interest to the users, is included.
• Financial statements should be prepared to reflect a true and fair view of the financial
position and performance of the enterprise
• All material and relevant information, which can influence the decision of stakeholders
must be disclosed in the financial statements.
Conservatism
• In the prevailing uncertainties of the present day, the convention of conservatism has its own
importance.
Provide for all losses but never to anticipate profits.
• This convention follows the policy of caution or playing safe.
• It takes into account all the possible losses, but not the possible profits or gains.
• A view opposed to this convention is that there is a possibility of creation of secret reserves when
conservatism is excessively applied, which is directly opposed to the convention of full
disclosure. Thus, the convention of conservatism should be applied very cautiously.
• Example
– Stock valuation sticks to rule of the lower of cost and net realizable value
– The provision for doubtful debts should be made
– Fixed assets must be depreciated over their useful economic lives
Materiality
• Meaning
– Immaterial amounts may be aggregated with the amounts of a similar nature or
function and need not be presented separately
– Materiality depends on the size and nature of the item
• Example
– Small payments such as postage, stationery and cleaning expenses should not be
disclosed separately. They should be grouped together as sundry expenses
– The cost of small-valued assets such as pencil sharpeners and paper clips should be
written off to the profit and loss account as revenue expenditures, although they can
last for more than one accounting period
78