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Chapter 1: Introduction to Financial Accounting
Accounting is the language of business
...
The
primary intension of financial accounting is the preparation of the statement revealing the income and
financial position of the business on the basis of the events
...
UNDERSTANDING BUSINESS ORGANIZATIONS:
Business organizations offer goods and services in order to earn a profit
...
Business organizations that provide goods are of
two kinds:

Merchandising (Trading) Organizations: buy and sell goods without any processing
...


Service Organizations: are businesses that provide services
...


Book-Keeping is mainly concerned with recording of financial data relating to the business operations in
a significant and orderly manner
...
A
substantial portion of the book keeper work is of a clerical in nature and is increasingly being
accomplished through the use of mechanical and electronical devices
...
What is Accounting?
•
•

Accounting is often called the language of Business
...

The American Institute of Certified Public Accountants defines accounting 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
...

The record should reflect the importance of the transactions so recorded both individually and
collectively, which includes summarization, thereby making it amenable to analysis
...


The Accounting Information System
INPUT

Economic
events
measured in
financial terms

PROCESS







Recording
Classifying
Summarizing
Analyzing
Interpreting

OUTPUT

Communicating
information to
users ( P&L A/c,
B/S, CFS, etc)

Accounting Process:
Recording: Recording commences when a business transaction occurs and it has been quantified
...

Classifying: It refers to the rational segregation of the recorded information into related groups so as to
make the record useful
...
For example, all the receipts forming
inflows and the payments forming outflows are grouped to ascertain the net cash position of the firm
...

Summarizing: After the Recording and Classification phases are complete the accounts containing
relevant information in the Ledger Book are to be balanced and the balances listed
...
On the basis of
the Trial Balance the summaries are generated to provide information about the Profit / Loss and the
Position of the firm
...

Financial Statements can be defined to include the Balance Sheet, the Profit and Loss Account,
Notes to the Accounts and other incidental statements and explanatory material which are identified as
part of financial statements
...
That suggests it will have
predictive and feedback value and should be timely
...
To
do so, it must be free of bias and verifiable
...
Users are assumed to
have a general knowledge of business and a very basic knowledge of accounting
...

Consistency--the same accounting methods must be used from period to period to evaluate
results over time
...
1: The Accounting Process
III
...
Accounting reports are designed to meet the common information needs
of most decision makers
...

2
...

4
...

6
...

8
...

Assess the stewardship or accountability of mgt
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Assess the security for amounts lent to the enterprise
...

Determine taxation policies
...

Regulate the activities of enterprises
...
A

sophisticated understanding of accounting is an indispensable part of the tool-kit for most decision
makers
...
CLASSIFICATION OF ACCOUNTING:
In order to satisfy needs of different people interested in the accounting information, different
branches of accounting have developed
...


Accounting

Financial
Accounting

Cost
Accounting

Management
Accounting

Figure 1
...

But this information, though of immense vitality does not adequately aid the management in
planning, controlling, organizing and efficiently conducting the course of the business as a result of
which Cost Accounting and Management Accounting are in place
...
It also deals with cost computation, cost saving, cost reduction, etc
...
It deals with the processing of data generated in financial accounting and cost
accounting for managerial decision-making
...

V
...
Once recording is complete, the
records are classified and summarized to depict the financial performance of the enterprise
...
Calculating the results of Operations: The Income Statement also known as the Profit and Loss
Account is prepared to reflect the profits earned or losses incurred
...

1
...
On the right hand side of the Balance Sheet are the Assets or the resources owned by
the firm
...
The owners' portion is called the Capital and is to be distinguished from that of the
other liabilities such as loans and creditors
...
This information on the assets and liabilities, with the help of accountancy, provides
control over the resources of the firm
...
Accounting is the precursor to financial reporting: The vital liquidity / solvency position is
comprehended through the Cash and Funds Flow Statement elucidating the capital transactions,
obtaining of cash and the way it has been expended, loans and their repayment, cash dividends, etc
...
Communicating the information to the users: Financial statements so compiled are of great use to a
variety of users including the provision of a firm base for the computation of the statutory tax
liability and the consequent filing of return of income
...
ADVANTAGES OF ACCOUNTING:
3
...


to comply with legal requirements
...


to ascertain Financial position
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
a compliance study
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
the settlement of tax liability
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
raising of funds
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USERS OF FINANCIAL STATEMENTS:
Investors and lenders are the most obvious users of accounting information
...
However, financial reports are also extensively used by other individuals and groups who have
to rely on them as their major source of financial information
...



II
...

 Managers use accounting information to evaluate potential investment projects
...

External Users:
A)
...
They need information to decide which investments to
buy, retain, or sell, as well as the timing of the purchases or sales of those
investments
...

b) Lenders: Lenders such as banks and denture-holders need to know about the
financial stability of a business that approaches them for funds
...

c) Suppliers: Present and potential suppliers are interested in the enterprise as an
outlet for their products or services and, if the enterprise is a major customer, they
will be interested in assessing the likelihood of the situation continuing
...

B)
...
They also require information in order to regulate the business
practices of enterprises, determine taxation policies, and provide a basis for national
income and similar statistics
...

c) Customers: Present, potential and past customers are interested in the financial
affairs of an enterprise in deciding how much business to do with it, and in assessing
the likely ability of the enterprise to service to the product or to honor warranty
agreements
...
Securities firms to
recommend to their clients whether to buy, sell or hold their investments use
Analysts’ reports
...
Store operating expenses, General and administrative expenses, Interest expense

• Auditor's Report
General Guide for Financial Accounting
•
•
•
•

Generally
Accepted
Accounting
Principles

Accounts Provide the the most useful financial information for…Decision Making
Primary Accounting Setting Body in the U
...

1
...

•
•

Accounting Concepts
– Basic assumptions or conditions upon which the science of accounting is based
...


• Money Measurement Concept: In financial accountancy, an event is recorded, only if it
can be expressed in monetary terms
...

Hence, all transactions are recorded through a common denominator – money
...
Money is
expressed in terms of its value at the time an event is recorded in the accounts
...
A business entity or a company is an artificial company created by law, who has a
common seal, which has a perpetual existence and does not die natural death
...
Accounting
records are kept from the point of view of the business unit and not the owner
...

• Going Concern Concept: A business entity is having a perpetual existence, which does
not die a natural death
...
It implies that the
resources of the concern would continue to be used for the purposes for which they are
meant to be used
...
, are
primarily required for carrying out the production and selling of certain products
...
, would continue to be used for
this purpose
...
For example, if a piece of land is acquired for
Rs
...
1 lakh, even when the
market value of the land rises to say Rs
...
Why should this be so? This is because
cost concept is in fact closely related to the going concern concept
...
To reflect the two types of equities, the equation is
more commonly expressed as
ASSETS =LIABILITIES + OWNERS’EQUITY
OR

TOTAL ASSETS =TOTAL LIABILITIES

The Accounting Identity
Each of the permanent accounts are
affected by debits and credits
...
To
measure income generated by the business or loss incurred by the business, the infinite
life of the business is broken into small pieces called accounting periods
...
Generally accounting period is one year – January 01 to
December 31 as in US and April 01 to March 31 as in India
...

• Realization Concept: Realization concept deals with the point in time at which revenue may
be deemed to be realized or when a sale can be said to have taken place
...

For example: If a customer buys Rs 500 worth of the items at grocery stores, paying cash, the stores
realizes Rs 500 from sale
...




Accrual Concept: The accrual basis of accounting recognizes revenues when sales
are made or services are preformed, regardless of when cash is received
...
Net profit equals the revenues earned less expenses
incurred during a period
...
The following are the important accounting concepts:
1
...
Full Disclosure
3
...
Materiality

• Conservatism Concept: This principle emphasizes that revenues and profits should be
accounted only when there is a reasonable surety of recognizing it but any anticipated loss
or expense should be immediately accounted for
...

• Consistency Concept: The consistency concept requires that once an entity has decided
on one method, it will treat all subsequent events of the same character in the same
fashion unless it has a sound reason to change the method of treatment of that transaction
...

• Full Disclosure: According to this convention all accounting statements should be
honestly prepared and to that end full disclosure of all significant information should be
made
...

FORMS OF BUSINESS ORGANISATION:
1
...
All the profits the business might
earn go to him
...

2
...
As well as sharing the profits, each partner shares unlimited liability for all the
debts and obligations of the firm
...
Limited Company: It is a legal entity and is treated by the law like a natural person
...

Systems of Accounting
–

Cash Basis: Revenue recorded only when cash is received
...
Cash Basis in not GAAP

– Accrual Basis: Adheres to the: Revenue Recognition Principle, Matching principle
–

Revenue recorded only when earned not when cash is receivedExpense recorded only when
incurred not when cash paid
– Accrual Basis adheres to
...
Recording
Journalizing: The daily business transactions are recorded in the order of their occurrence in a book
called Journal
...
Journals aid the recording
process by
• Disclosing in one place the complete effect of a transaction;
• Providing a chronological record of transactions;
• Helping prevent or locate errors because debit and credit amounts can be easily compared
...
Classifying


Ledger preparation: The process of transferring entries from the journal to the ledger is
called ledger posting
...

3
...
If debit side is bigger than the credit side, the
difference between the two sides is known as debit balance and vice versa
...

 Preparation of Profit and Loss A/c: It is prepared to know the operating efficiency of the
firm in terms of profit made or loss incurred during an accounting period
...
It gives a true and fair view of the
states of affairs of the business
...
DOUBLE ENTRY SYSTEM:
The method of writing every transaction in two accounts is known as Double entry System of
Accounting
...
Thus, on any date, the total of all debits must be equal to the total of all credits
because every debit has a corresponding credit
...
1 Rules of Double entry
III
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These account can be classified into three categories
1
...

2
...
Example: Account of club, Government, Bank
...
Representative Personal account-An account indirectly representing a person is known as a
representative personal account
...

B) Impersonal Accounts:
1
...
As on a
particular date, this account shows the worth of the asset
...
Nominal Account: It consists of different types of expenses or incomes or loss of profit
...


Accounts

Personal Accounts

Impersonal Accounts

Eg
...


Real Accounts

Assets like cash, land,
buildings, plant and
machinery, patents,
goodwillm, etc
...


Figure 2
...
All asset a/c’s are debited All liability a/c’s are credited
...


Chapter 2: Final Accounts
TRIAL BALANCE
A list of all the accounts and their balances at a given time
...
It aids in the preparation of financial statements
...
Profit and Loss A/c: It summarizes the results of the operations of an enterprise for a given time
period by disclosing the revenues earned and expenses incurred
...

2
...
It summarizes the resources of an enterprise and the claims to those resources by
owners and creditors of the enterprise on a certain date
...
Statement of Cash Flows: It reflects the major sources of cash receipts and cash payments of an
enterprise
...

CAPITAL AND REVENUE ITEMS
Capital Expenditure:

•The benefit of which is not fully derived in one year but spread over several periods
...

•Eg: Raw material, Rent, wages and salaries
...
e
...


Trading Account
• Overall Result of trading
• Gives out Gross profit
• Gross Profit = Sales - Cost of Goods Sold
• Gross Profit = (Net Sales) – (Opening stock +Net purchases+ Direct Expenses - Closing Stock)
Trading Account
•
•

Opening Stock
Closing Stock – valuation

•
•
•

Purchases
Sales
Direct Expenses –Wages,Customs & Import Duty,Freight, carriage and cartage inwards,Royalty
– Gas, electricity, water, fuel,Packing materials
Closing Entries – Trading Account

1
...


Sales A/c

Dr

Purchase Returns a/c

Dr

Closing stock a/c

Dr
To Trading a/c

Trading Account - Importance
•
•
•
•

Gross profit disclosed helps in controlling operating expenses
Gross profit ratio is compared year after year to identify the fall in the figures
Comparison of stock figures help in preventing lock-up of funds in stocks
In case of new products, it is helpful to fix the sale price

P & L Account - Importance
• Net profit/Net loss is an index of profitability of business
• Comparison of profit over periods helps in assessing the business efficiency
• Analysis of expenses over periods help in effective control of expenses
• Profit and expense analysis helps in planning and forecasting the future course of action
...
This apart it not too uncommon that certain transactions take place during or
after the preparation of trial balance
...
This is done by passing some adjustment
entries
...
Put in other words, the
adjustment has to be carried out at two places
...

2
...

4
...

6
...

8
...


Closing Stock
Outstanding expenses
Prepaid Expenses
Accrued Income
Income received in advance or unearned income
Depreciation
Bad debts
Provision for bad debts
Provision for discount on debtors

Closing Stock
•

Adjustment
– Taken on credit side of trading account
Closing stock a/c
Dr
To Trading a/c

•

– Asset side of Balance Sheet
Given in the Trial balance
– Means that the closing stock is already adjusted in the cost of sales and hence already
accounted for
- Asset side of Balance Sheet

Outstanding expenses
•
•

Outstanding expenses are those expenses which are due during the accounting period but have
not yet been paid
Appears as adjustment
– Expense a/c Dr
To Outstanding expense a/c

– Addition to the concerned expense either in trading or P&L a/c
– Liabilities side of balance sheet
• Appears in trial balance
– Liabilities side of Balance sheet
Prepaid expenses
•
•

Prepaid expenses are those expenses which have been paid in advance during the accounting
period
Appears as adjustment
– Prepaid Expense a/c Dr
To expense a/c

– Deduction to the concerned expense either in trading or P&L a/c
– Assets side of balance sheet
• Appears in trial balance
– Assets side of Balance sheet
Outstanding Income & Accrued Income
•
•
•

Outstanding income is that income which is due during the accounting period but has not yet
been received
Outstanding income & Accrued income
Appears as adjustment
– Outstanding Income a/c Dr
To Income a/c

– Addition to the concerned income either in trading or P&L a/c
– Assets side of balance sheet
• Appears in trial balance
– Assets side of Balance sheet
Income received in advance
•
•

Income received in advance is that income which is received during the accounting period but is
not being earned
...
,
As an adjustment
Depreciation A/c
Dr
To Fixed Asset A/c

– Debit side of P&L a/c
– Deduction from the concerned asset account on assets side of balance sheet
• Appears in trial balance
– Debit side of P&L a/c
Bad debts
Bad debt is a debt that cannot be recovered and is a loss
•

As an adjustment
Bad debts A/c

Dr

To Debtors a/c
- Debit side of P& L A/c
- Deduction from debtors on the assets side of Balance sheet
• Appears in trial balance
– Debit side of P&L a/c
Provision for Bad & doubtful debts
•
•

Provision for the likely Bad and doubtful debts
As an adjustment
P&L A/c
Dr
To Provision for bad debts a/c

- Add to the bad debts on the debit side of P& L A/c
- Deduction from debtors on the assets side of Balance sheet
Provision for Discount on Debtors
•
•

Provision for discount is making a provision for the good debts
As an adjustment
P&L A/c
Dr
To Provision for discount on debtors a/c
-

Add to the discount a/c on the debit side of P& L A/c
Deduction from debtors on the assets side of Balance sheet

All balance sheets are built up from 3 main categories, namely assets, liabilities and
shareholders funds
...
Two forms of the fundamental balance sheet identity can thus be
derived:
Proprietary:

assets – liabilities = shareholder funds

Entity:

assets = liabilities + shareholder funds

Very broadly, all that is being said is that, firstly, what a company owns less what a
company owes is equal to the value of the shareholders funds invested in it and that,
secondly, what a company owns is financed partly by the owners (the shareholders) and
partly by outsiders (the liabilities)
...


A proprietary approach balance sheet will look like the following (vertical balance sheet)
...

LIABILITIES

=

ASSETS

Equity capital

Fixed assets

+

+

Long term liabilities

Current assets

+
Current liabilities

Assets
Fixed assets & Current assets:

Assets are something of value to the business, which can either be turned into cash or used
to produce revenue
...

Examples are buildings, equipment, vehicles
...
It is intention that
determines whether an asset is fixed or not
...


Concepts involved in valuation of fixed assets:
Matching
Fixed assets are an example of a good purchased for use over several periods and are not
charged entirely against profits of year of purchase but spread over their years of use
...
It is assumed that the business will last long enough for these
to be realised, which is quite different from an approach which valued assets at scrap
values
...

Investments Shares, loans, bonds and debentures held either as fixed tangible assets or
current assets
...

Intangible fixed assets
Non-monetary fixed asset which is without physical substance
...

Goodwill
A company is not just a collection of tangible assets
...
It is the difference between the total value and the sum of the parts which
constitutes goodwill
...
Goodwill is, however, very difficult to value

objectively and company law does not permit it to be appear in the balance sheet unless it
has been purchased, and even then it is usually written off immediately or quite quickly
...
This represents the excess of the cost of shares in subsidiary
companies over the book value of their net tangible assets at the date of acquisition; that is,
the parent company was willing to pay more to purchase a company than the sum of its
tangible and net current assets
...
Expected
to be turned into cash or used in course of trading which can normally be expected to be
turned into cash within one year from the date of the balance sheet
...

Stocks are another example of matching concept - just how far to take it depends upon the
materiality concept
...
Can be classified as current or long term
liabilities
...

Examples include amounts owing to creditors, bank overdraft, tax liability
Current assets- Current liabilities
= Net Current Assets or Working Capital (a measure of liquidity)
...
The major parts consist of
both long term loans (not wholly repayable within 5 years) and medium term loans
(repayable within 5 years)
...
These are not the only form of borrowings
...

Shareholders funds
The shareholders funds section of the group balance sheet is subdivided into Share Capital
and Reserves
...

Shares can be either ordinary or preference
...

Preference shares may be cumulative or non-cumulative
...
Shares can be issued at more than their par value: this gives rise
to a share premium reserve
...

A company does not have to issue all its shares at once, nor does it have to request full
payment on the shares immediately
...
e
...
Also shares can be
partly paid
...
Thus, in summary, one can distinguish
authorised, issued, called up and paid-up share capital
...
This is created as a result of the revaluation of fixed
assets on the other side of the balance sheet
...
To say that a company has large
reserves is not the same thing as saying that it has plenty of cash
...
g
...
Thus it is perfectly possible for a company to have both large reserves and a
large bank overdraft
...
How can a company grow – that is, how can it increase its assets? Look again
at the identity
Entity:

assets = liabilities + shareholder funds

It is clear that the only ways to increase the assets are to increase the liabilities (to borrow) or
to increase the shareholders funds
...
Ploughing back profits is the simplest but not necessarily the cheapest
source of long term finance for a company
...




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