Financial and Management Accounting

Unit 1

Unit 1

Financial Accounting An Introduction

Structure: 1.1 Introduction Objectives 1.2 Meaning of Accountancy, book-keeping and Accounting 1.3 Accounting Process 1.4 Objectives for accounting 1.5 Differences between book-keeping and accounting 1.6 Users of accounting information 1.7 Limitations of Accounting 1.8 Basic terminologies 1.9 Summary 1.10 Terminal Questions 1.11 Answers

1.1 Introduction
All of you at one point of time would have visited a grocery shop or a medical shop. You might have wondered how the business person maintains the record of all the transactions done during a particular period of time say a year. You might have also thought why he or she has to maintain a record, how is it beneficial and whether it is mandatory or not? As against this, imagine the role of a business organization. They provide goods that might range from simple safety pin to fighter aircrafts. Those who are in service industry provide various services such as transportation services, hospitality services, developing complex software programmes etc. To make sound decision a business enterprise need accounting information. This information is also needed by government agencies, regulatory bodies, analyst and individuals at various point of time and at different levels. Accounting is perhaps one of the oldest, structured management information system. It has evolved in response to the social and economic needs of society. Accounting as an information system is concerned with identification, measurement and communication of economic information of an organization to its users who may need the information for rational

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decision making. The accounting system is a means to provide relevant and reliable financial information to all the interested parties. In this unit we are dealt the meaning of accounting, book-keeping and accountancy, the steps involved in accounting process. It explains the various objectives of accounting, discusses the difference between bookkeeping and accounting and how accounting information is used by various users of accounting information. This unit concludes with basic terminologies in accountancy. Objectives: After going through this unit, you should be able to: 1. Define book keeping, accounting and accountancy 2. Describe the accounting process 3. Explain the objectives of accounting 4. Distinguish between book keeping and accounting 5. Categorize various users of accounting information 6. Acquaint with the basic terminology used in the subject.

1.2 Meaning of Book-keeping, Accounting and Accountancy

Accounting as a discipline was introduced to have permanent and systematic record of business transactions. This would help a business person to record all relevant business transactions, to ascertain the profit earned during a particular period and finally evaluate the financial position of his/her business. Book keeping, accounting and accountancy are the terms used in the science of financial accounting. Book-keeping is defined as the science and art of recording business transactions in a systematic manner in a certain set of books known as books of accounts. It identifies the transactions and events, measures the identified transactions and events in a common measuring unit, records them in proper books of accounts and finally classifies them in another book called the ledger. Accounting is termed as language of business which records all events and transactions that are of monetary value and facilitates communication among individuals in a society.

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Accountancy refers to a systematic knowledge of accounting. It explains why to do and how to do of various aspects of accounting. It tells us why and how to prepare the books of accounts and how to summarize the accounting information and communicate it to the interested parties.

1.3 Accounting Process

Accounting is the process of identifying the transactions and events, measuring the transactions and events in terms of money, recording them in a systematic manner in the books of accounts, classifying or grouping them and finally summarizing the transactions in a manner useful to the users of accounting information.
ACCOUNTING ENCOMPASSES

1. IDENTIFICATION

2. MEASURING

3. RECORDING

4. CLASSIFYING

5. SUMMARISING

6. ANALYSING

7. INTERPRETING

8. COMMUNICATING

1. Identifying the transactions and events: This is the first step of accounting process. It identifies the transaction of financial character that is required to be recorded in the books of accounts. Transaction is transfer of money or goods or services from one person or account to another person or account. Events happen as a result of internal policies or external needs. Events of non financial character cannot be recorded even though such events may have an impact on the operational results of the firm. 2. Measuring: This denotes expressing the value of business transactions and events in terms of money (in terms of rupees in India).
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3. Recording: It deals with recording of identifiable and measurable transactions and events in a systematic manner in the books of original entry that are in accordance with the principles of accountancy. 4. Classifying: It deals with periodic grouping of transactions of similar nature that appear in the books of original entry into appropriate heads by posting or transfer entries. For Eg: All purchases of goods made for cash or on credit on different dates are brought to purchase account. 5. Summarizing: It deals with summarizing or condensing transactions in a manner useful to the users. This function involves the preparation of financial statements such as income statement, balance sheet, statement of changes in financial position and cash flow statement. 6. Analyzing: It deals with the establishment of relationship between the various items or group of items taken from income statement or balance sheet or both. Its purpose is to identify the financial strengths and weaknesses of the enterprise. The above six process in the present day scenario are generally performed using software packages. 7. Interpreting: It deals with explaining the significance of those data in a manner that the end users of the financial statement can make a meaningful judgment about the profitability and financial position of the business. The accountants should interpret the statement in a manner useful to the users, so as to enable the user to make reasoned decision out of the alternative course of action. They should explain various factors on what has happened, why it happened, and what is likely to happen under specific conditions. 8. Communicating: It deals with communicating the analyzed and interpreted data in the form of financial reports/ statements to the users of financial information eg Profit and loss account, Balance Sheet, Cash flow and Funds Flow statement, Auditors report etc.

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The Accounting Information System

INPUTS Business Transaction External events measured in financial terms

PROCESSING Accounting concepts Conventions and Principles Management plans & policies Law & regulations Classification & Interpretation

OUTPUT Profit & Loss a/c Balance Sheet Cash Flow statement Explanatory Notes Auditors report Regulatory filings

USERS Shareholders Regulators Lenders Employees Management Rating agencies

Source: Adapted from Financial Accounting, Management perspective by R. Narayaswamy. Self Assessment Questions 1. Book keeping _________ the transactions and events, _________the identified transactions and events in a common measuring unit, records them in proper books of accounts and finally classifies them in the ledger. 2. Accounting in addition to book keeping involves ________ the classified transactions and ________ the summarized results. 3. ____________ interprets the analyzed results and communicates the interpreted information to the interested parties.

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Activity 1: Take a balance sheet of a company and a bank balance sheet from a published source say a newspaper or annual report or web site. Reading the balance sheets give at least 10 differences.

1.4 Objectives of Accounting

From the above paragraphs, it can be concluded that accounting involves the following functions and objectives. a) Accounting helps in systematic recording of all business events or transactions. Written records are more preferable to memorizing (oral recording) because the latter may fade away with time. Also systematic records can be used by different persons for different decision making purposes. b) Accounting measure the financial performance of the enterprise. The results of operations are ascertained by preparing profit and loss account, balance sheet and cash flow statements. This will enable the business person to ascertain what the business owes to others, what others owe them and whether his/her capital remained same or increased or decreased. c) Accounting facilitates in reporting the results to both internal and external users. The management requires information for internal purpose at various levels of operations. They need to prepare various reports such as production report, idle time report, cash budget report, receivable report, accounts payable report, project appraisal report, capital budgeting report etc. The management reports the financial performance of the firm to external users such as shareholders, creditors, bankers, investors, stock brokers, stock exchanges, employees, governments etc.,

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d) Accounting is required to fulfill the statutory requirements of various regulatory bodies such as Registrar of Companies, SEBI (Securities Exchange Board of India) income tax authorities and the Government. e) Accounting helps in internal control by holding the concerned persons responsible for any errors, lapses or under performance. Equally it helps to identify the strong /weak areas of each unit or department. Accounting is a tool for effective planning. Current years financial performance becomes the basis for future predictions and estimations. Since it is tool for planning, it also acts as tool for controlling. Preparation of budgets, cost analysis, tax planning, auditing are some of the functions of accounting. Self Assessment Questions: 4. Accounting is a tool for _______________ and ________ 5. Expand SEBI. 6. Mention any five stakeholders.

1.5 Distinction between Book-keeping and Accounting

Accountancy is the profession and the practitioners of accountancy are called accountants. Book keeping is the basic activity of recording. On recording the transactions and events in the books of accounts, accounting does the role of analysis and reporting. Accountancy is the profession of carrying the activities of book keeping and accounting. Accounting enjoys wider scope and includes not only book keeping but also analysis, interpretation and reporting of financial information. The later part of accounting is the core function of accounting. In the present day environment, sophisticated software packages are available, which facilitate entry of transactions and preparation of ledger accounts.

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Book keeping It is a process of identifying, measuring, recording and analyzing the transactions in books of accounts Adopt principles of accounting for recording Book keeping is the first stage of accounting process The objective is to prepare final accounts and balance sheet in a systematic manner at the end of accounting period Accounts executives who perform this function may not require higher level of knowledge. The nature of job is routine and clerical

Accounting It involves summarizing the classified transaction, interpreting the analyzed results and communicating the information to the users of financial statement. Analyzing and interpreting requires skill, knowledge and experience Accounting follows book keeping. It is the secondary stage The objective is to ascertain net results of financial operations and communicate the results to all stakeholders in a manner they understand. Accountants who perform this function need higher analytical skills to interpret the data and to take appropriate decisions. The nature of job is non routine but analytical.

1.9 Users of Accounting Information

Accounting reports are designed to meet the common information needs of most decision makers. These decisions include when to buy, hold or sell the enterprise shares. It assesses the ability of the enterprise to pay its employees, determine distributable profits and regulate the activities of the enterprise. Investors and lenders are the most obvious users of accounting information. a) Investors: Investors may be broadly classified as retail investors, high net worth individuals, Institutional investors both domestic and foreign. As chief provider of risk capital, investors are keen to know both the return from their investments and the associated risk. Potential investors need information to judge prospects for their investments. b) Lenders: Banks, Financial Institutions and debenture holders are the main lenders and they need information about the financial stability of
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the borrower enterprise. They are interested in information that would enable them to determine whether their borrower has the capability to repay the loans along with the interest due on it. They also use the information for monitoring the financial condition of the borrowers. They may stipulate certain restrictions (known as covenants) such as upper limit on the total debt borrowed from all sources or ask for additional security etc. Short term lenders (trade creditors) who provide short term financial support need information to determine whether the amount owing to them will be paid when due and whether they should extend, maintain or restrict the flow of credit. c) Regulators, Rating Agencies and Security Analyst: Investors and creditors seek the assistance of information specialist in assessing prospective returns. Equity analyst, bond analyst and credit rating agencies offer a wide range of information in the form of answering queries on television shows, providing trends in business newspapers on a particular stock, offer valuable information in seminars, discussion groups, meetings and interviews. Security analyst obtain valuable information including insider information by means of face-to-face meetings with the company officials, visit their premises and make constant enquiry using e-mails, teleconference and video conference. Firms build a good rapport with such type of information seekers to gain visibility in the market. d) Management: Management needs information to review the firms short term solvency and long term solvency. It has to ensure effective utilization of its resources, profitability in terms of turnover and investment. It has to decide upon the course of action to be taken in future. Management may also be interested in acquiring other business which is undervalued. When managers receive a commission or bonus related to profit or other accounting measures, they have a natural interest in understanding how those numbers are computed. Further when faced with a hostile takeover attempt, they communicate additional financial information with a view to boosting the firms stock price. e) Employees, Trade Union and Tax authorities: Employees are keen to know about the general health of the organization in terms of stability and profitability. Current employees have a natural interest in the
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financial condition of the firm as their compensation will depend on the financial performance of the firm. Potential employees may use financial information to find out the future prospects of the firm. Trade unions use financial reports for negotiating wage package, declaration of bonus and other benefits. Tax authorities need information to assess the tax liability of the firm. f) Customers: Customers have an interest in the accounting information about the continuation of company especially when they have established a long term involvement with or are dependent on the company. For Eg. Car owners, buyers of white goods, electronic gadgets, depend on the manufacturer for warranty service support, continued supply of spare parts. The sales of Matiz car was badly affected due to the abrupt closure of Daewoo Motors. g) Government and regulatory agencies: Government and the regulatory agencies require information to obtain timely and correct information, to regulate the activities of the enterprise if any. They seek information when tax laws need to be amended, to provide institutional support to the lagging industries. The regulatory agencies use financial reports to take action against the firm when appropriate returns are not filed in time or when the returns fails to provide true and fair position of the business or to take appropriate action against the firm when complaints / misappropriation are being lodged. Stock exchange has a legitimate interest in financial reports of publicly held enterprise to ensure efficient operation of capital market. h) The Public: Every firm has a social responsibility. Firms depend on local economy to meet their varied needs. They may get patronage from local government in the form of capital subsidy, cheap land or tax sops in the form of tax holidays for certain period of time. Prosperity of the enterprise may lead to prosperity of the economy both directly and indirectly. Growth in software industry in Bangalore, Karnataka State, led to boom in housing sector, education sector, entertainment sector, travel sector and tourism sector in and around Bangalore. Published financial statement assist public by providing information about the trends and recent developments of the firm.

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Activity 2: The following is the abstract of annual report of Sundaram Clayton Limited for 2008 During the year under review, the vehicle industry registered a negative growth of 2.1%. While the medium / heavy commercial vehicles segment recorded a negative growth of 1%. The light commercial vehicle segment registered a growth 13%. Car segment achieved a positive growth of 14% and two wheeler segments suffered a negative growth of 5%. Despite this, the Company achieved sales of Rs. 427 crores during 2007-08 as against Rs. 309 crores in 2006-07, registering a growth of 38.2%. As an investment advisor tracking automobile sector how would you use this information?

Self Assessment Questions 7. ________ as chief provider of risk capital is keen to understand both the return from their investments and the associated risk. 8. _________ use financial reports for negotiating wage package, declaration of bonus and other benefits. 9. ___________ has a legitimate interest in financial reports of publicly held enterprise to ensure efficient operation of capital market. 10. The regulatory agencies use _____________ to take action against the firm when appropriate returns are not filed in time or when the returns fails to provide true and fair position of the business or to take appropriate action against the firm when complaints / misappropriation are being lodged.

1.7 Limitations of Accounting

1) Though accounting system is the only source for extracting financial information of the firm, it grossly lacks qualitative elements. Qualitative resources could include leadership of top brass, highly talented human resource, highly motivated team, best products, the power of resource and development, brand image etc.
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2) Accounting is not free from bias. The accountants have some leeway or freedom on the methods of depreciation charged, inventory valuation etc. Though the convention says consistency has to be maintained on the policies adopted, there is considerable room for bias, favourism and personal judgment. 3) Accounting reveals the estimated position and not the real position of the firm. Generally financial statements are prepared on separate entity concept, conservatism concept etc. which are based on the estimates that may lead to over valuation or under valuation of assets and liabilities. The exact picture of the financial situation can be ascertained only on the liquidation of an enterprise. 4) Accounting ignores the price level changes when financial statements are prepared on historical cost. Fixed assets are shown in the balance sheet at historical cost less accumulated depreciation and not at their replacement value. Land value is shown at historical cost but the replacement value could be far higher than the value stated in the balance sheet due to appreciation of land value over the period of time. 5) The danger of window dressing arises when the management decides to incorporate wrong figures to artificially inflate revenue or deflate losses or when there is a threat of hostile takeover. In such a situation the management fails to provide true and fair view of the financial position to the various users of the financial statement. Satyam Computer Services, the fourth largest software firm went into bust when the information on inflated income to the extent of Rs.7000 crore was revealed. Self Assessment Questions 11. Accounting grossly lacks ____________elements 12. The exact picture of the financial situation can be ascertained only on the ________of an enterprise. 13. The danger of ___________ arises when the management decides to incorporate wrong figures to artificially inflate revenue or deflate losses or when there is a threat of hostile takeover. 14. Accounting ignores the price level changes when financial statements are prepared on __________.

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1.8 Basic Terminologies

To understand the subject, proper understanding of the following terms is essential. 1. Transaction: It is transfer of money or goods or service from one person or account to another person or account. There are cash transactions, credit transactions and paper transactions. In all cash transactions, cash is paid or received immediately. Credit transaction is one where there is a promise to pay/receive cash at a future date. Paper transaction is one where there is no cash inflow or outflow but adjustment is made in the records only. (Bad debts of previous year are written off; depreciation provided on fixed assets etc.), 2. Capital: Funds brought in to start business, by the owner/s. In the case of a company, capital is collected by issue of shares. Capital used to purchase fixed assets is called fixed capital and that capital used for day to day affairs of business is known as working capital. From business point of view, Capital is a liability. 3. Share: A share in a company is one of the units into which the total capital of the company is divided. 4. Assets: An asset is a resources legally owned by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Eg: Land and buildings, plant and machinery, furniture and fixtures, cash in hand and at bank, debtors and stock etc., are regarded as assets, Assets may be fixed, current, liquid or fictitious. 5. Fixed assets are those which are held for use in the production or supply of goods and services. Ex: plant and machinery, which is used fairly for long period. 6. Current assets are those which are held or receivable within a year or within the operating cycle of the business. They are intended to be converted into cash within a short period of time. Ex: Stock in trade, debtors, bills receivable, cash at bank etc., 7. Liquid assets are those which can be easily converted into cash and for instance, cash in hand, cash at bank, marketable investments etc.,
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8. Fictitious assets are in the form of such expenses which could not be written off during the period of their incidence. For example, promotional expenses of a company which could not be treated as expenditure in the year of incidence are shown as fictitious asset. 9. Liability: It is a financial obligation of an enterprise arising from past event the settlement of which is expected to result in an outflow of resources embodying economic benefit. Eg. Loans payable, salaries payable, term loans. 10. Current liability is that obligation which has to be satisfied within a year. For example, payment to be made sundry creditors for the goods supplied by them on credit; bills payable accepted by the businessman; overdraft raised by the businessman in a bank etc. 11. Equity: Equity is the residual interest in the asset of the enterprise after deducting all its liabilities. The equity of a company is called shareholders equity. Its components include share capital, share premium and retained earnings. 12. Entity: It is an economic unit that performs economic activities. 13. Sole trader: A single individual carrying on business with or without the help of his kith and kin is called sole trader. 14. Partnership: It is a relationship between partners to contribute capital to start business, agree to distribute profits and losses in an agreed proportion and the business being carried on by all or any one acting for all. Partnership firm refers to business where as the partnership refers to relationship caused by agreement. 15. Joint Stock Company: It is an organization, for which the capital is contributed by shareholders to carry on business and it is registered under Companies Act and it has a legal entity, having perpetual existence and a common seal. 16. Goods: Goods refer to merchandise, commodities, products, articles or things in which a trader deals. It is the commodities or things meant for resale. Goods account is divided into six heads viz: purchase account, sales account, purchase return account, sales return account,

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opening stock account and closing stock account. Let us get the meaning of each one. Purchase: Goods purchased by a business are called purchase. Sales: Goods sold by a business are called sales. Purchase Return or Return Outward: Goods returned by the business to its suppliers out of the purchases already made from them are called purchase return. Sales Return or Return Outward: Goods returned to a business by its customers out of the sales already made to them are called Sales Return. Opening Stock: Unsold goods lying in a business at the beginning of a year, are called opening stock. Closing Stock: Unsold goods lying in a business at the end of a year, are called closing stock. 17. Inventory: Inventory refers to goods held by a business for sale in the ordinary course of business or for consumption in the production of goods or service for sale. It includes stock of raw materials, stock of work in progress and stock of finished goods. 18. Drawings: It refers to cash, goods or any other asset withdrawn by the proprietor from his business for his personal or domestic use. In short, amounts the owner withdraws from his business for living and personal expenses. 19. Debtor: A debtor is a person who owes money to the business. A debtor may be of 4 types. Trade debtor is a person who owes money to the business for the goods supplied to him on credit. A loan debtor is a person who owes money to the business for the loan advanced to him. Debtor for asset sold is a debtor who owes money to the business for any asset sold to him on credit. A debtor for service rendered is a debtor who owes money to the business for the service rendered to him on credit. 20. Debt: The amount due from a debtor to the business is called a Debt, generally debt may be of three types: Good debt refers to fully recoverable debt. Bad debt refers to debt, which is not recoverable (irrecoverable). Doubtful debt refers to debt whose recovery is doubtful.
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21. Creditors: A creditor is a person to whom the business owes money. A creditor also may be of 4 types. Trade creditor is a person to whom the business owes money for goods purchased from him on credit. Loan creditor is a person to whom the business owes money for the loan borrowed from him. Creditor for asset purchased is a creditor to whom the business owes money for any asset purchased from him on credit. Expenses creditor refers to a creditor to whom the business owes money for any service received from him on credit. For e.g.: salaries unpaid, commission unpaid etc. 22. Loss: It refers to money or moneys worth given up without any benefit in return. For e.g. loss of cash by theft, loss of goods by fire etc. It is a situation where in the expenses of the business exceeds revenues. An expense brings some benefits, but loss does not bring any benefit. 23. Profit: It is a situation where the revenue of a business exceeds its expenses. In other words, the amounts we earned were greater than our expenses. 24. Journal: A journal is a daily record of business transactions. It is a book of original, prime or first entry in which all the business transactions are first entered in the specified manner in the order of dates. A preliminary record where business transaction is first entered into the accounting system. 25. Ledger: A ledger is an account book in which all the accounts are maintained. It is the books of final entry as well as principal book of accounts. 26. Entry: It is the record of a transaction made in any book of account, either in the book of original entry or in the books of final entry. 27. Narration: It is a brief explanation to a journal entry, given below the journal entry, with in brackets. It gives the explanation for the particular journal entry. 28. Posting: Posting is the process of entering in the ledger the information already recorded in the journal or in any of the subsidiary books. In other words process of transferring balances from
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bookkeeping records called journals to a "final" bookkeeping record called the general ledger. 29. Voucher: It refers to any written document in support of a financial transaction. 30. Trial Balance: A worksheet listing of all the accounts appearing in the general ledger with the dollar amount of the debit or credit balance of each, used to make sure the books are "in balance" total debits and credits are equal. 31. Balance Sheet: It is the financial statement, which shows the amount and nature of business assets, liabilities, and owner's equity as of a specific point in time. It is also known as a Statement of Financial Position or a Statement of Financial Condition. 32. Carried Forward: The term carried forward or its abbreviation [c/f] is used at the foot of a page to indicate that the total amount at the foot of that page has been carried forward to the head of the next page. 33. Brought Forward: The term brought forward or its abbreviation [b/f] is used at the head of page to indicate that the total amount at the head of that page has been brought forward from the foot of the previous page. 34. Carried Down: The term carried down or its abbreviation [c/d] is written in a ledger account at the time of its closing to indicate that the balance in that account has been carried down to the next period. 35. Brought Down: The term brought down or its abbreviation b/d is written in a ledger account at the time of its opening to indicate that the opening balance in that account has been brought down from the previous period. 36. Bill of exchange: It is documentary evidence in writing containing an unconditional order signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or the bearer of the instrument. 37. Bills Payable: It is a bill of exchange stating an obligation to pay a certain sum of money at a specified date. In case of purchase of raw materials on credit the supplier or the creditor draws bills of exchange
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on the business entity. When the entity accepts the bill it becomes bills payable for the entity. The same bill for the supplier is termed as bills receivable. 38. Bills Receivable: It is a bill of exchange containing an acceptance from the drawee (or Payee) a certain sum of money at a specified date. On sale of goods on credit the entity draws a bill of exchange on the customer. When the customer or debtor accepts the bill it becomes bills receivable for the firm. Bills receivables can be discounted with banks or discount houses.

1.9 Summary
Accounting is the process of identifying the transactions and events, measuring the transactions and events in terms of money, recording them in a systematic manner in the books of accounts, classifying or grouping them and finally summarizing the transactions in a manner useful to the users of accounting information. The main objective of accounting is to determine income, financial reporting and disclosure of relevant and pertinent information to the users of financial information. The users of accounting information are investors, lenders, regulators, rating agencies, security analysts, management, employees, trade unions, tax authorities, customers, government and the general public. Accounting ignores qualitative aspects while providing information. It is not free from bias. It ignores price level changes and pose the danger of window dressing. Management accounting refers to the use of financial data for the purpose of planning and decision making, performance evaluation etc.

1.10 Terminal Questions

1. 2. 3. 4. Explain the process involved in accounting. What are the objectives of accounting? Distinction between book-keeping and accountancy. How accounting information is used by investors and lenders?

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5. How Government and Regulatory agencies use accounting information to regulate the activities of the firm? 6. Distinguish between financial accounting and management accounting

1.11 Answers to SAQs and TQs

1. Identifies, measures 2. Summarizing, analyzing 3. Accounting 4. Effective planning, controlling 5. Securities Exchange Board of India 6. Shareholders, Creditors, Bankers, Government, Employees 7. Investors 8. Trade Union 9. Stock Exchange 10. Financial Reports Answers to Terminal Questions 1. 2. 3. 4. 5. 6. Refer 1.3 Refer 1.4 Refer 1.5 Refer 1.6 Refer 1.6 Refer 1.8 11. Qualitative 12. Liquidation 13. Window dressing 14. Historical Cost

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