FINANCIAL ACCOUNTING

Chapter One

Introduction to Financial Accounting

Summary

Why Financial Accounting?

Accounting all incomes, expenses, assets and

liabilities in monetary terms is the sole
determinant of all economic activities of all
businesses, industry, trade, commerce as well as of
fashion designers, software giants, media moghuls
and even NGOs like CRY and Lijjat papad.

Wealth is determined by counting, by accounting, by

recording, by valuing assets, estates, properties,
possessions and financial liabilities, if any.

Accounting helps preparation of :

$ Trial Balance.
$ Profit and Loss Account.
$ Balance Sheet.
$ Cash Flow Statement.
 These financial statements are used by several
segments of the society called stake holders.

• Shareholders • Investment Advisors

• Financial Analysts • Creditors, Suppliers
• Workers & Employees • Government
Local, State, Central
• Researchers • Students of Finance

Basic Principles of Accounting.

1. Accounting is a Science (Recording)

as well as
An Art (interpreting).

2. It records only financial transactions and

records only historical costs ( not current
market value ).

3. These are recorded and prepared on a going

concern basis ( not winding up).

4. It distinguishes Capital ( long term ) versus

Revenue ( short term ) transactions.

5. It aims at matching income versus expense.

6. It expects year to year consistency

(depreciation, stock valuation).

7. It follows conservative approach, hence

provides for unrealized losses but ignores
unrealized profits.

8. Recognizes business entity by separating

owner/s.
Limitations of Accounting.

1. Accounting reflects and records only monetary

value. So quantitative measurements are
recognized at the cost of qualitative aspects.

2. On account of inflation value of rupee

decreases, but accounting does not make any
adjustments to cover these.

Definition:

“Accounting is defined as an information system

which measures, processes and communicates
financial information to decision makers.”

External Internal

Business Owners Directors

Potential Owners Managers
Creditors Supervisors
Customers
Financial Institutions
Government Authorities
Economic Planners.

In Financial Accounting we are concerned with

External decision makers.

A management accounting system provides relevant

information to internal decision makers.

Both want answers to their questions. But their

questions are different. Hence two different, but
integrated systems.
 Questions Asked:

Decision makers.

External Internal

9 Is the company 9 Is available cash

earning satisfactory sufficient to pay
income? bills?

9 How does the company 9 What is the cost of

compare in size and manufacturing each
profitability with unit of product?
competitors?
9 Can we afford to
9 Will the company be provide annual pay
able to pay its raises to employees?
debts when they are
due? 9 What product line is
most profitable?

Branches of Accounting:

Financial
Management
Tax
Audit
Cost
etc.

“Accounting is the universal language of business,

and its basic understanding is essential for almost
any job in the business world.”
Business Goals:

Profitability – will the company earn sufficient

net income to successfully pay all expenses and
provide returns to the owners.

Liquidity – will the company generate sufficient

cash to pay its bills as they become due.

AND

Growth- in sales and profitability

Generally Accepted Accounting Principles. (GAAP)

GAAP are rules or guidelines that govern

financial accounting.
Many of these are mandatory by the law of
the country.
Some, which are not mandatory, have
considerable persuasive force.

These include

Entity Concept : An accounting entity is a separate

and distinct unit, standing apart
from its owners and shareholders.
As a result capital and reserves
of a company are shown as a
liability in the Balance Sheet
(amount it owes to owners) & loss
as an asset. (amount owners owe to
it)
Reliability
Principle : Accounting records must be based
on the most objective data
available. Hence importance of
bills, invoices, vouchers insisted
upon by auditors.
Historical Cost: Acquired assets, inventories and
services are recorded at their
actual cost (and not at realizable
or market values).

Going Concern: Assumed that the entity will

continue to operate in future.
Hence assets, stocks reflected at
original value ignoring their
current realizable value.
Stable
Monetary Unit: Transactions recorded in Rs in
India and $ in USA. No adjustments
for inflation that change the
value of Rupee or Dollar.

Full Disclosure: All circumstances and events that

are likely to make a difference to
users of the financial statements
must be disclosed.

Materiality: The constraint of determining

whether an item is large enough to
likely influence a decision.

Conservatism: The approach of choosing an

accounting method, when in doubt,
that will be least likely to
overstate assets and net income.
Hence unrealized losses are
accounted but the unrealized
profits are ignored.

“The primary agency responsible for GAAP in India

is the Accounting Standards Board of the Institute
of Chartered Accountants of India.”
A basic tool used by Accountants consists of
equations

Resources = Equities

Assets = Liabilities and Owner’s

(Shareholders’) Equity.

The end product of the accounting process is

production of financial statements required by
Indian GAAP. These are

€ Income Statement ( Profit & Loss Account)

€ Balance Sheet

€ Statement of Cash Flows

US GAAP call for Statement of Retained Earnings. In

India it is usually appended as “Profit & Loss
Appropriation Account” at the end of P & L Account.

Forms of Organization:

Proprietorship.

Partnership -Formed under Indian Partnership Act,

1932.

Company -Formed under Companies Act, 1956.

In this course we deal with Company form of

organization.