Unit I

Introduction- Meaning, Scope and Importance of Financial Accounting

DEFINITIONAccounting is the art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events, which are in part atleast, of a financial character, and interpreting the results thereof Accounting is the language of the Business

Characteristics of Accounting

Recording of Financial transactions onlyRecording in JournalClassifying is grouping into accountsSummarising is balancing ledger & Trial Balance is preparedRecording in terms of moneyInterpretation of the results by preparing Trading and Profit & Loss Account and Balance Sheet

ACCOUNTING CYCLE

Recording of Financial TransactionsOnly those transactions which can be measured in terms of monetary value are recorded. Though there are some events which are very important for the business they cannot be recorded in the books as they cannot be expressed in terms of money.For E.g.- Resignation by an able and experienced manager

RecordingIt is an art of recording business transac-tions, according to some specified rules. In a small business where the no.of tran-sactions are quite small, they are recorded in a book called Journal. But where the number of transactions increase the Journal is further divided into various subsidiary books viz., Cash Book, Purchases Book, Sales Book, etc.

ClassifyingIt is the process of grouping the transactions of one nature at one place, in a separate account. The book in which various accounts are opened is called LedgerFor E.g.- Wages Account, Advertisement Account, etc,.

SummarisingIt is the art of presenting the classified data in a manner which is understandable and useful to the management and the other users of such data. This involves the balancing of ledger accounts and the preparation of Trial Balance with the help of such balances. Final Accounts are prepared with the help of Trial Balance.

Recording in terms of moneyEach transaction to be recorded in terms of money only.For E.g. If a business possesses Rs.5000 in cash, land measuring 200 mts., 5 trucks, 5 machines, 10 ton of raw materials, 200 chairs, etc., then in the absence of money measurement concept these assets cannot be added and hence of no use unless specified in terms of money.

Interpretation of the resultsThe results of the business are presented in such a manner that the parties interested in the business such as proprietors, managers, banks, creditors, employees, etc. can have full information about the profitability and the financial position of the business.

Objectives or Functions Of AccountingTo keep systematic record of business transactions-Complete record of business transactions according to specific rules so as to avoid omission or fraud- Journal Ledger

To calculate profit or loss-purchases, sales, various expenditures, revenues, etc,-Trading and Profit & Loss Account

To know exact reasons leading to net profit or net loss

Advantages and Uses of AccountingHelpful in Management of business-Planning, Decision-Making, ControllingProvides Complete and Systematic RecordInformation regarding profit or lossInformation regarding financial positionEnables comparative study

Evidence in legal mattersFacilitates Sale of BusinessHelpful in Raising loansHelpful in Prevention and Detection of Errors and FraudsHelpful in Assessment of tax liability

To prevent and detect errors and frauds

To ascertain the financial position of the business- Balance Sheet- Recovery from Debtors, payment to creditors, Balance cash, Closing Stock, Fixed Assets, etc.

To provide information to various parties

Limitations of AccountingInfluenced by Personal JudgementsBased on Accounting Concepts and ConventionsIncomplete InformationOmission of Qualitative InformationBased on Historical CostsAffected by Window DressingUnsuitable for Forecasting

BASIC ACCOUNTING TERMSAssets Fixed assets Are held for continuous use in the business for purpose of producing goods and are not meant for resale Eg.-Land and Building, Plant and Machinery

Current assets Are meant for sale or easily convertible into cash within one yearEg.- Cash, Debtors, Stock

LiabilitiesLong Term Liabilities- Those which fall due for payment after more than one yearEg.- Long term loans, Debentures

Current Liabilities Those which have to paid within one yearEg.- Bills payable, Creditors

Capital Amount invested by the proprietor in a business enterprise. It is also known as Owners Equity or Net Worth or Net AssetsExpenses Cost incurred in producing and selling the goods and providing services for the purpose of generating revenue

Revenue Amount received from the sale of goods and providing services on a regular basis. It is related with day to day affairs of the business

Income = Revenue less Expenses

Capital Expenditure Expenditure incurred in acquiring or increasing the value of a fixed asset- Balance SheetRevenue Expenditure -The full benefit of this expenditure is received during one accounting period- Dr.in Trading and Profit & Loss A/c

Debtors-Those persons or firms to whom goods have been sold or services rendered on credit and payment has not been received from them

Creditors-Those persons or firms from whom goods have been purchased or services procured on credit and payment has not been made to them

Stock of Raw MaterialUnused raw material purchased for using them in products manufacturedStock of Work-in-progressSuch goods need further processing for converting into finished productsStock of Finished GoodsGoods which have been completely processed & are ready for sale but lying unsold

Purchases Purchases of goods in which the business deals or acquiring raw material for conversion into finished goods and then salePurchase Returns Purchased goods are returned. Also known as Returns outwards

Sales Goods which are purchased for resale purposes. It also includes revenues from services provided to customers.It includes both cash and credit salesSale Returns Sold goods returned back. Also known as Return Inwards

Trade Discount Discount allowed by a seller to its customers on a fixed percentage on the list price. It is not recorded in the books of accounts as it is deducted in the invoice

Cash Discount Discount allowed to the customers for making prompt payment. This transaction is to recorded in the books of Accounts.

Drawing Cash or value of goods withdrawn by the owner for personal use or any private payments made out of business funds

Kinds of Accounting PrinciplesACCOUNTING CONCEPTS

ACCOUNTING CONVENTIONS

ACCOUNTING CONCEPTSBusiness Entity ConceptMoney Measurement ConceptGoing Concern ConceptAccounting Period ConceptHistorical Cost Concept

Dual Aspect ConceptRevenue Recognition ConceptMatching ConceptAccrual ConceptObjectivity Concept

ACCOUNTING CONVENTIONS

Convention of full disclosureConvention of ConsistencyConvention of ConservatismConvention of Materiality

Business Entity ConceptBusiness is treated as a unit separate and distinct from its owners, creditors, managers and others. i.e. the owner of the business is always considered as distinct and separate from the business.For E.g. Harshpreet Traders Ltd. borrowed money and invested in business. When lenders asked Harshpreet to return the invested money, Harshpreet responded by stating that he invested them into business and it went bankrupt. Thus, he cant be personally held liable for loss in business as they are separate legal entities.

Money Measurement ConceptOnly those transactions and events are recorded in accounting which are capable of being expressed in terms of money. An event, even though it may be very important for the business will not be recorded in the books unless it can be measured in terms of money.For E.g. It does not record the beginning of the strike.

Going Concern ConceptIt is assumed that the business will continue to exist for a long period in the future. It is because of this concept that the outside parties enter into long term contracts with the enterprise.For E.g.Batuk Maharaj is a well known astrologer. One day, Batuk predicted that the world is going to end in 2009.The Chief Financial Officer of the well known company, Ms Aishwarya, has a strong belief in his predictions. The Accountant, Ms.Avani decided to show in her accounts by taking business having a finite duration. Is she correct?OF COURSE NOT.Business has eternal life.

Accounting Period ConceptThe entire life of the firm is divided into time intervals for the measurement of the profits of the business. Twelve month period is usually adopted for this purpose. According to the Income Tax Law, a business has compulsorily to adopt financial year beginning on 1st April and ending on 31st March in the next calendar year, as its accounting period.

Historical Cost ConceptAn asset is ordinarily recorded in the books of accounts at the price at which it was acquired. This cost becomes the basis of all subsequent accounting for the asset and as this cost relates to the past, it is referred to as historical cost. For E.g. If a business entity purchases a building for a particular price, it will be recorded in the books at that price only. Subsequent increase or decrease would not be recorded in the books of accounts.

Dual Aspect ConceptAccording to this concept, every transac-tion affects at least two accounts. If one account is debited, any other account must be credited. The system of recording transactions based on this concept is called as Double Entry System. It is because of this principle that the two sides of Balance Sheet are always equal.

Revenue Recognition ConceptConcept of revenue recognition determines the time in which the revenue is realized. It should be remembered that revenue recognition is not related with the receipt of cash. Revenue is deemed to be realized when the ownership of the goods is transferred to the purchaser.For E.g. If a firm gets an order of goods on 1st Jan, supplies on 20th and receives cash on 1st April, the revenue will be deemed to have been earned on 20th Jan, as ownership of goods was transferred on that day.

Matching ConceptFor matching costs with revenue, first revenues should be recognized and then costs incurred for generating that revenue should be recognized. When an item of revenue is included in the profit and loss account, all expenses incurred on it, whether paid or not should be shown as expenses in the profit and loss account. Similarly, incomes receivables must be added in revenues and incomes received in advance must be deducted from revenues.

Accrual ConceptIn this concept revenues is recorded when sales are made or services are rendered & it is immaterial whether cash is received or not. Similarly expenses are recorded in the accounting period in which they assist in earning the revenues whether the cash is paid for them or not. Thus, to ascertain the true profit or loss for an accounting period all expenses and incomes relating to the accounting period are recorded whether actual cash has been paid or received or not.

Objectivity ConceptThe accounting transaction should be recorded in an objective manner, free from the personal bias of either the management or the accountant who prepares the accounts. It is possible when each transaction is supported by verifiable documents. Objectivity is one of the reasons for adopting the Historical Cost as the basis of recording accounting transaction because cost actually paid for an asset can be verified from the documents.

Convention of Full DisclosureThis principle requires that all significant information relating to the economic affairs of the enterprise should be completely disclosed. i.e.there should be sufficient disclosure of information which is of material interest to the users of financial statements. Disclosing of material facts does not mean leaking out the secrets of the business but disclosing sufficient information which is of material interest to the users of financial statements.

Convention of ConsistencyThe Accounting principles and methods should be consistent from one year to another. They should not be changed from one year to year, in order to enable the management to compare the Profit & Loss Account and Balance Sheet of different periods and draw important conclusions about the working of the enterprise. The nature of the effect of change of method and justification for the change must be stated clearly by way of footnotes to enable the users of financial statements to be aware of the change.

Convention of ConservatismAll anticipated losses should be recorded in the books of accounts, but all anticipated or unrealized gains should be ignored. Provision is made for all known liabilities and losses even though amount cannot be determined with certaintyFor E.g.- Closing stock is valued at cost or realisable value whichever is lessProvision for doubtful debts is created in anticipation of actual bad debts

Convention of MaterialityIt is an exception to the convention of full disclosure. According to this convention, items having an insignificant effect or being irrelevant to the user need not be disclosed. These unimportant items are either left out or are merged with other items. An item should be regarded as material if there is reason to believe that knowledge of it would influence decision of informed investor.

ACCOUNTAn account is a record of all business transactions relating to a particular person or item. In accounting we keep a separate record of each individual asset, liability, expense or income. The place where such a record is maintained is termed as an Account. All accounts are divided into two sides. The left hand side of the account is called Debit side and the right side of an account is called the credit side. Debit is written as Dr. and credit is written as Cr. An Account is abbreviated as A/c.

Rules of Debit and CreditFollowing rules of debit or credit in respect of various categories of accounts are as :Assets Account When there is an increase in the amount of an asset, such an increase is recorded on the debit side of the asset account and if there is a reduction in the amount of an asset, such reduction is recorded on the credit side of the asset account.

Liabilities Accounts When there is an increase in the amount of liability, such an increase will be recorded on the credit side of the liability account. On the contrary, if there is reduction in the amount of liability, it will be recorded on the debit side of the liability account.

Capital Account An increase in the capital is recorded on the credit side and the decrease in the capital is recorded on the debit side.

Revenue or Income Account

All increases in the gains and incomes are recorded on the credit side as it leads to the increase in the capital. On the contrary, if there is reduction in any income, the account will be debited as it leads to decrease in the capital

Losses or Expenses Account All increases in the losses and expenses are recorded on the debit side of the concerned expenses account as it leads to decrease in the capital. On the contrary, the reduction in the expenses is recorded on the credit side

The above rules maybe summarised as:Debit the increase in the asset and credit the decrease in the assetCredit the increase in the liabilities and debit the decrease in the liabilitiesCredit the increase in the capital and debit the decrease in the capitalCredit the increase in the incomes and debit the decrease in the incomesDebit the increase in the expenses and credit the decrease in the expenses.

JOURNALJournal is a book of original entry in which the transactions are recorded first of all, as and when they take place. The journal provides a date-wise record of all the transactions with details of the accounts debited and credited, according to the double entry system of book-keeping and the amount of each transaction. Each entry is followed by a brief explanation of the transaction which is called Narration.

Format of JournalJournal

DateParticularsLedger folioAmountDr.AmountCr.

1 2 3 4 5

Date In the first col., the date of the transaction is entered. The yr. and the mth.is written only once till they change.Particulars Each transaction affects two accounts out of which one account is debited and the other is credited. After each entry a brief explanation with the necessary details is given.Ledger Folio or L.F. All entries from the journal are later posted into the ledger accounts. The folio no.of the ledger account where the posting has been made from the journal is recorded in the L.F. Column.

Amount Dr. In the fourth column, the amount of the account being debited is written.Amount Cr. In the fifth column, the amount of the account being credited is written.

Double Entry SystemEvery business transaction has a two fold effect and that it affects two accounts in opposite directions and if a complete record were to be made of each such transaction, it would be necessary to debit one account and credit another account. It is this recording of the two-fold effect of every transaction that has given rise to the term Double Entry System.

Classification of Accounts

Personal Accounts The accounts which relate to an individual, firm, company or an institution are called personal accounts.For E.g.- Account of Mohan, Capital Account of the proprietor, Account of XYZ Ltd, etc.Rule Debit the Receiver and Credit the Giver

Types of Personal Accounts

Natural Personal Accounts Accounts of Natural Persons means the accounts of human beings.For E.g.- Proprietors Capital Account, Mohans Account, Etc,.Artificial Personal Accounts These accounts do not have physical existence as human beings but they work as personal accounts.For E.g.- Firms A/c, Ltd.Cos A/c, Accounts of Clubs,etc.

Representative Personal Accounts- When an account represents a particular person or a group of persons, it is termed as a Representative personal account.For E.g.- Salaries for the month of December are unpaid and put under one common title Salaries Outstanding Account.

Real Accounts The accounts of all those things whose value can be measured in terms of money and which are the properties of the business are termed as Real Accounts.For E.g.- Cash A/c, Furniture A/c, Etc.Rule -Debit what comes in and Credit what goes out.

Types of Real Accounts

Tangible Real Accounts These are the accounts of those things which can be touched, felt, measured, etc.For E.g. Cash A/c, Land A/c, etc,.Intangible Real Accounts These accounts represents such things which cannot be touched, but of course, their value can be measured in terms of money.For E.g. Goodwill A/c, Copyrights A/c, etc.

3.Nominal Accounts These accounts include the accounts of all expenses and incomes.For E.g. Salaries account, Discount received, etc.

Rule Debit the expenses and losses and Credit incomes and gains.

Some special entriesBad debts recovered-Cash A/c DrTo Bad Debts Recovered A/cOutstanding Expenses Expense A/c DrTo Outstanding expenses A/cPrepaid Expenses Prepaid Expenses A/c . DrTo Expense A/c