FA Notes – M1

Introduction to Financial Accounting

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 What is Accounting:

Accounting is considered as a system which collects and processes financial

information of a business. Accounting, which has been called the "language of business",
measures the results of an organization's economic activities and conveys this information to
a variety of users.

 Book keeping :

Book-keeping is that branch of knowledge which tells us how to keep a record of

business transactions. It is often routine and clerical in nature. It is important to note that only
those transactions related to business which can be expressed in terms of money are recorded.
The activities of book-keeping include recording in the journal, posting to the ledger and
balancing of accounts.

 Definition of Accounting:

Accounting is the art of recording, classifying and summarising 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 & communicating it to the
people who are interested in such kind of information.

 RECORDING: The function of accounting is to keep a systematic record of all

business transactions, which are identified in an orderly manner, soon after their
occurrence in the journal or subsidiary books.
 CLASSIFICATION: This is concerned with the classification of the recorded
business transactions so as to group the transactions of similar type at one place. i.e.,
in ledger accounts.
 SUMMARIASATION: The classified information available in ledger is summarized
in the trial balance. It is prepared to verify the arithmetical accuracy of the accounts.
 ANALYSIS: The trial balances are used to prepare profit and loss account and
balance sheet in a manner useful to the users of accounting information. It establishes
the relationship between the items of the profit and loss account and the balance sheet.
The purpose of analyzing is to identify the financial strength and weakness of the
business. It provides the basis for interpretation.

 INTERPRETATION: It is concerned with explaining the meaning and significance

of the relationship so established by the analysis. Interpretation should be useful to the
users, so as to enable them to take correct decisions. This can be done with Ratio
Analysis.
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 COMMUNICATION: The results obtained from the summarized, analyzed and
interpreted information are communicated to the interested parties.
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 Users of Accounting Information:
o Internal users: Internal users are those individuals or groups who are within
the organization like owners, management, employees and trade unions.
i. Owners: To know the profitability and financial soundness of the
business.
ii. Management: To take prompt decisions to manage the business
efficiently.
iii. Employees and Trade unions: To form judgment about the earning
capacity of the business since their remuneration and bonus depends on it.
o External users: External users are those individuals or groups who are
outside the organization like creditors banks and other lending institutions,
present and potential investors, Government and tax authorities, regulatory
agencies and researchers
i. Creditors, banks & other lending institutions: To determine whether
the principal the interest thereof will be paid in when due.
ii. Present investors: To know the position, progress and prosperity of the
business in order to ensure the safety of their investment.
iii. Potential investors: To decide whether to invest in the business or not.
iv. Government and Tax Authority: To know the earnings in order to
assess tax liabilities of the business.
v. Regulatory agencies: To evaluate the business operation under the
regulatory legislation.
vi. Researchers: To use in their research work.

Accounting

Financial Cost Management

Accounting Accounting Accounting
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 Financial Accounting
This involves recording, classifying and summarizing transactions of financial nature.
The primary intention is to prepare financial statements for revealing operating results
and financial position of an enterprise.
 Cost Accounting
It shows classification analysis of cost on the basis of functions, processes, products
etc. it also deals with cost computation, cost saving and cost control.
 Management Accounting
Deals with processing of data generated from financial accounting and cost
accounting for managerial decision making.

 Accounting Cycle
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Balance
sheet
Balance
sheet
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(Closing) (Opening)
Profit
and Loss Transaction
Account

Trading
Journal
Account

Trial
Ledger
Balance
 Basic Terms in Accounting
Capital
Capital generally refers to the amount invested in an enterprise by its owners.
For example if Mr. Anand starts business with Rs.5,00,000, his capital would
be Rs.5,00,000.
Assets
Assets are the properties of every description belonging to the business. Cash
in hand, plant and machinery, furniture and fittings, bank balance, debtors,
bills receivable, stock of goods, investments, Goodwill are examples for
assets. Assets can be classified into tangible and intangible.
Tangible Assets
These assets are those having physical existence. It can be seen and touched.
For example, plant & machinery, cash, etc.

Intangible Assets
Intangible assets are those assets having no physical existence but their
possession gives rise to some rights and benefits to the owner. It cannot be
seen and touched. Goodwill, patents, trademarks are some of the examples.
Assets refer to the tangible objects or intangible rights owned by an enterprise and
carrying probable future benefits.
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Liability
Liabilities refer to the financial obligations of a business. These denote the
amounts which a business owes to others, e.g. loans from banks or other
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persons, creditors for goods supplied, bills payable, outstanding expenses,
bank overdraft etc.
Inventory/Stock
Inventory includes tangible property held for sale in the ordinary course of
business, or in the process of the production for such sale, or the consumption
in the production of goods or services for sale, including maintenance supplies
and consumables.
Sales
Sales refer to the amount of goods sold that are already bought or
manufactured by the business. When goods are sold for cash, they are cash
sales but if goods are sold and payment is not received at the time of sale, it is
credit sales. Total sales includes both cash and credit sales.
Sundry Debtor
Sundry debtors are persons from whom amounts are due for goods sold or
services rendered or in respect of contractual obligations. These are also
termed as debtor, trade debtor and account receivable.
Sales Return or Returns Inward
When goods are returned from the customers due to defective quality or not as
per the terms of sale, it is called sales return or returns inward. To find out net
sales, sales return is deducted from total sales.
Purchases
Purchases refer to the amount of goods bought by a business for resale or for
use in the production. Goods purchased for cash are called cash purchases. If it
is purchased on credit, it is called as credit purchases. Total purchases include
both cash and credit purchases.
Sundry Creditor
Sundry creditor is the amount owed by an enterprise on account of goods
purchased or services received, or in respect of contractual obligations. It is
also termed as trade creditor or accounts payable.
Purchases Return or Returns Outward
When goods are returned to the suppliers due to defective quality or not as per
the terms of purchase, it is called as purchases return. To find net purchases,
purchases return is deducted from the total purchases.
Cost of Goods Sold
In manufacturing operations, it includes the following:
Cost of materials
Labour
Overheads

Expenditure
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Profit
Expenditure includes incurring a liability, disbursement of cash or transfer of
property for the purpose of obtaining assets, goods or services.
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Profit is a general term for the excess of revenue over related cost. When the
result of this computation is negative, it is referred to as loss.

Profit and Loss Statement

Profit and loss statement is a financial statement which presents the revenue
and expenses of an enterprise for an accounting period and shows the excess
of revenue over expenses (or vice versa). It is also known as profit and loss
account.
Balance Sheet
Balance sheet is a statement of financial position of an enterprise at a given
date. It exhibits a company’s assets, liabilities, capital, reserves and other
account balances at their respective book value.

GAAP & ACCOUNTING CONVENTIONS

In order to maintain uniformity and consistency in preparing and maintaining books of
accounts, certain rules or principles have been evolved. These rules/principles are classified
as concepts and conventions. These are foundations of preparing and maintaining accounting
records. Accounting concept refers to the basic assumptions, rules and principles which work
as the basis for recording of business transactions and preparing accounts. These concepts
constitute the very basis of accounting. All the concepts have been developed over the years
from experience and thus they are universally accepted rules.

Accounting Concepts

1. Business entity concept

2. Money measurement concept

3. Going concern concept

4. Accounting period concept

5. Accounting cost concept

6. Duality aspect concept

7. Realization concept
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8. Accrual concept

9. Matching concept
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Accounting Conventions

To make the accounting information useful to various interested parties, the basic
assumptions and concepts discussed earlier have been modified. These are called as
convention, they are as under:

1. Cost Benefit
2. Materiality
3. Consistency
4. Prudence
5. Full Disclosure

ACCOUNTING CONVENTIONS

 BUSINESS ENTITY CONCEPT

This concept assumes that, for accounting purposes, the business enterprise and
its owners are two separate independent entities. Thus, the business and personal
transactions of its owner are separate.
For example, when the owner invests money in the business, it is recorded as
liability of the business to the owner. Similarly, when the owner takes away from
the business cash/goods for his/her personal use, it is not treated as business
expense. Thus, the accounting records are made in the books of accounts from the
point of view of the business unit and not the person owning the business. This
concept is the very basis of accounting.

SIGNIFICANCE

This concept helps in ascertaining the profit of the business as only the business
expenses and revenues are recorded and all the private and personal expenses are
ignored. This concept restraints accountant from recording of owners
private/personal transactions. It also facilitates the recording and reporting of
business transactions from the business point of view

 MONEY MEASUREMENT CONCEPT

This concept assumes that all business transactions must be in terms of money
that is in the currency of a country. In our country such transactions are in terms
of rupees. Thus, as per the money measurement concept, transactions which can
be expressed in terms of money are recorded in the books of accounts. For
example, sale of goods worth Rs.200000, purchase of raw materials Rs.100000,
Rent Paid Rs.8000 etc. are expressed in terms of money, and so they are recorded
FA Notes – M1
in the books of accounts. The transactions which cannot be expressed in monetary
terms are not recorded in the books of accounts. For example, sincerity, loyalty,
honesty of employees are not recorded in books of accounts because these cannot
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be measured in terms of money although they do affect the profits and losses of
the business concern.

SIGNIFICANCE
This concept guides accountants what to record and what not to record. It helps in
recording business transactions uniformly. If all the business transactions are
expressed in monetary terms, it will be easy to understand the accounts prepared
by the business enterprise. It facilitates comparison of business performance of
two different periods of the same firm or of the two different firms for the same
period.

 GOING CONCERN CONCEPT

This concept states that a business firm will continue to carry on its activities for
an indefinite period of time. Simply stated, it means that every business entity has
continuity of life. Thus, it will not be dissolved in the near future. It should be
noted that ‘going concern concept’ does not imply permanent continuance of the
enterprise. It rather presumes that the enterprise will continue in operation long
enough to charge against income, cost, and liabilities and to meet the contractual
commitments.

SIGNIFICANCE

This concept facilitates preparation of financial statements. On the basis of this

concept, depreciation is charged on the fixed asset. It is of great help to the
investors, because, it assures them that they will continue to get income on their
investments. In the absence of this concept, the cost of a fixed asset will be
treated as an expense in the year of its purchase. A business is judged for its
capacity to earn profits in future.

 ACCOUNTING PERIOD CONCEPT

FA Notes – M1
All the transactions are recorded in the books of accounts on the assumption that
profits on these transactions are to be ascertained for a specified period. This is
known as accounting period concept. Thus, this concept requires that a balance
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sheet and profit and loss account should be prepared at regular intervals. This is
necessary for different purposes like, calculation of profit, financial position, tax
computation etc. Further, this concept assumes that, indefinite life of business is
divided into parts. These parts are known as Accounting Period. It may be of one
year, six months, three months, one month, etc.

SIGNIFICANCE

It helps in predicting the future prospects of the business. It helps in calculating

tax on business income calculated for a particular time period. It also helps banks,
financial institutions, creditors, etc to assess and analyse the performance of
business for a particular period. It also helps the business firms to distribute their
income at regular intervals as dividends

 ACCOUNTING COST CONCEPT

Accounting cost concept states that all assets are recorded in the books of
accounts at their purchase price, which includes cost of acquisition, transportation
and installation and not at its market price. It means that fixed assets like
building, plant and machinery, furniture, etc are recorded in the books of accounts
at a price paid for them. For example, a machine was purchased by XYZ Limited
for Rs.500000, for manufacturing shoes. In addition, Rs.2000 were spent on its
installation. The total amount at which the machine will be recorded in the books
of accounts would be the sum of all these items i.e. Rs.502000. This cost is also
known as historical cost.
SIGNIFICANCE
This concept requires asset to be shown at the price it has been acquired, which
can be verified from the supporting documents. It helps in calculating
depreciation on fixed assets. The effect of cost concept is that if the business
entity does not pay anything for an asset, this item will not be shown in the books
of accounts.

 DUALITY ASPECT CONCEPT

Dual aspect is the foundation or basic principle of accounting. It provides the very
basis of recording business transactions in the books of accounts. This concept
assumes that every transaction has a dual effect, i.e. it affects two accounts in
their respective opposite sides. Therefore, the transaction should be recorded at
two places. It means, both the aspects of the transaction must be recorded in the
books of accounts. For example, goods purchased for cash has two aspects which
are (i) Giving of cash (ii) Receiving of goods. These two aspects are to be
recorded.
SIGNIFICANCE
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This concept helps accountant in detecting error. It encourages the accountant to
post each entry in opposite sides of two affected accounts.

 REALIZATION CONCEPT
This concept states that revenue from any business transaction should be included
in the accounting records only when it is realised. For example: ‘A’ places order
with ‘B’ for supply of certain goods yet to be manufactured. On receipt of order,
‘B’ purchases raw materials, employs workers, produces the goods and delivers
them to ‘A’. ‘A’ makes payment on receipt of goods. In this case the sale will be
presumed to have been made not at the time of receipt of order for the goods but
at the time when goods are delivered to ‘A’. The term realisation means creation
of legal right to receive money. Selling goods is realisation, receiving order is not.

SIGNIFICANCE

It helps in making the accounting information more objective. It provides that the
transactions should be recorded only when goods are delivered to the buyer.

 ACCRUAL CONCEPT

The meaning of accrual is something that becomes due especially an amount of

money that is yet to be paid or received at the end of the accounting period. It
means that revenues are recognised when they become receivable though cash is
received or not received and the expenses are recognised when they become
payable though cash is paid or not paid. Both transactions will be recorded in the
accounting period to which they relate. Therefore, the accrual concept makes a
distinction between the accrual receipt of cash and the right to receive cash as
regards revenue and actual payment of cash and obligation to pay cash as regards
expenses.

SIGNIFICANCE

It guides how the expenses should be matched with revenue for determining exact
profit or loss for a particular period. It is very helpful for the
investors/shareholders to know the exact amount of profit or loss of the business.

 MATCHING CONCEPT
FA Notes – M1
This is based on the Accounting Period Concept. The paramount objective of
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running a business is to earn profit. In order to ascertain the profit made by the
business during a period, it is necessary that ‘revenues’ of the period should be
matched with ‘expenses’ of the period. The matching concept states that the
expenses incurred to earn the revenues must belong to the same accounting
period. So once the revenue is realised, the next step is to allocate it to the
relevant accounting period. This can be done with the help of accrual concept.

SIGNIFICANCE

It guides how the expenses should be matched with revenue for determining exact
profit or loss for a particular period. It is very helpful for the
investors/shareholders to know the exact amount of profit or loss of the business.

ACCOUNTING CONVENTIONS

 Cost Benefit conventions

This convention states that the cost of applying a principle should not be more
than the benefit derived from it. If the cost is more than the benefit then that
principle should be modified.

 Materiality conventions

The materiality convention requires all relatively relevant information should be

disclosed in the financial statements. Unimportant and immaterial information are
either left out or merged with other items.

 Consistency conventions

The aim of consistency principle is to preserve the comparability of financial

statements. The rules, practices, concepts and principles used in accounting
should be continuously observed and applied year after year. Comparisons of
financial results of the business among different accounting period can be
significant and meaningful only when consistent practices were followed in
ascertaining them. For example, depreciation of assets can be provided under
different methods, whichever method is followed, it should be followed regularly.

 Prudence (Conservatism) conventions

Prudence principle takes into consideration all prospective losses but leaves all
prospective profits. The essence of this principle is ‘anticipate no profit and
provide for all possible losses’. For example, while valuing stock in trade, market
price or cost price whichever is less is considered.
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 Full Disclosure
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According to this convention accounting reports should disclose fully and fairly
the information they represent. They should be honestly prepared and sufficiently
disclose information which is of material interest to proprietors, present and
potential investors and creditors.

SYSTEM OF ACCOUNTING
BASIC ACCOUNTING MECHANICS: RULES OF DEBIT & CREDIT

DOUBLE ENTRY SYSTEM OF BOOK KEEPING

DEFINITION: Every 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, this
recording of the two fold effect of every transaction is termed as Double Entry System.

 There are numerous transactions in a business concern. Each transaction, when

closely analysed, reveals two aspects.

 One aspect is ‘receiving aspect’ or ‘incoming aspect’ or ‘expenses/loss aspect’. This

is termed as the ‘Debit aspect’.

 The other aspect is ‘giving aspect’ or ‘outgoing aspect’ or ‘income/gain aspect’. This
is termed as the ‘Credit aspect’.

 These two aspects namely “Debit aspect” and “Credit aspect’ form the basis of
Double Entry System.

 The double entry system is so named since it records both the aspects of a transaction.

 In short, the basic principle of this system is, for every debit, there must be a
corresponding credit of equal amount and for every credit, there must be a
corresponding debit of equal amount.
FA Notes – M1
Transactions can be divided into three categories:

a. Transactions relating to individuals and firms

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b. Transactions relating to properties, goods or cash
c. Transactions relating to expenses or losses and incomes or gains.
On this basis, it becomes necessary for the business to keep an account of:

a. Each person with whom it deals

b. Each property or asset which the business owns

c. Each item of income or expenses

Therefore, accounts can also be classified into PERSONAL, REAL & NOMINAL.

TYPES OF ACCOUNTS

Persona
Real Nominal
l
Expenses
Natural Tangible
and Losses

Incomes and
Artificial Intangible
Gains

Representative

 PERSONAL ACCOUNTS
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i. Natural Persons: Accounts which relate to individuals. For example, Mohan’s
A/c, Shyam’s A/c etc.

ii. Artificial Persons: Accounts which relate to a corporate bodies, firms or

institutions. For example, HMT Ltd., Indian Overseas Bank, Life Insurance
Corporation of India, Cosmopolitan club etc.

iii. Representative Persons: Accounts which represent a particular person or

group of persons. For example, outstanding salary account, prepaid insurance
account, etc.

The business concern may keep business relations with all the above personal accounts,
because of buying goods from them or selling goods to them or borrowing from them or
lending to them. Thus they become either Debtors or Creditors. The proprietor being an
individual his capital account and his drawings account are also personal accounts.

The rule for this account is:

Debit the Receiver, Credit the Giver

 REAL ACCOUNTS
Accounts relating to properties and assets which are owned by the business
concern. Real accounts include tangible and intangible accounts. For example,
Land, Building, Goodwill, Purchases, etc.
The rule for this account is:
Debit What Comes In, Credit What Goes Out

 NOMINAL ACCOUNTS
These accounts do not have any existence, form or shape. They relate to incomes
and expenses and gains and losses of a business concern. For example, Salary
Account, Dividend Account, etc.

The rule for this account is:

Debit All Expenses & Losses, Credit All Incomes & Gains
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