Chapter - 1

Basics of Financial Accounting

Sr.
Course outline – Topics
No
1 Definition of Accounting & Financial Information
2 Sources of Financial Information
3 Money Measurement & Financial Position
4 Functions of Financial Accounting
5 Elements of Financial Statements
6 Entity and Separate Entity Concept
7 User of Financial Information
8 Underlying Assumption – Going Concern
9 Recognition of the elements of financial statements
10 Measurement of the elements of financial statements
11 Qualitative characteristics of useful financial information

Video number 1-11 are mandatory part of this module.

Definition of Accounting
Accounting is a language that is used to communicate and understand the financial ideas, financial
expressions, financial thoughts and financial information.
Language
Language is a medium that is used to communicate and understand some ideas, feelings, expressions or information.
Financial information
Any information that is measurable in terms of money and causes a change in financial position of an entity is known as
financial information.
Sources of Financial Information
There are three sources of financial information, which are also known as accounting phenomena.
i) Transactions
Transactions are the outcome of dealings made.
ii) Events
Events are the outcome of incidents happened.
iii) Conditions
Conditions are the adjustments in recorded information.
Transaction (source of financial information)
Transaction occurs when two persons deal with each other.

Social motives dealings Social transaction

For example; a person receiving birthday gift from his friend is a social transaction.

Economic benefits dealing Accounting transaction

Accounting transaction is a monetary dealing between the entity (business / non business) and other person. An
accounting transaction causes change in financial position (financial status) of the entity.

Dealing between entity and other person includes:

1. Dealing of entity (first party) with owner/s (Second party)

2. Dealing of entity (first party) with any person other than the
owner/s (third parties).

From this details we can extract two criteria to identify accounting transaction:
1. Measurability in terms of money, and

2. Dealing of the entity with other person.

Practice 1.1
Keeping in view the criteria, identify which of the following information is accounting transaction:
1. Payment of staff salaries made by cheque.
2. Appointing a production manager on contract.
3. Having a conversation with foreign supplier for import of raw material.
4. Placing an order for purchase of production machine.
5. Purchasing motor vehicle and paying cash for the price.

Answer: (1, 5)
Explanation;
1. This is a dealing between entity and employee that is measurable in money.
2. Activity has no effect on financial position – there is no money measurement.
3. Activity has no effect on financial position – there is no money measurement.
4. Activity has no effect on financial position – there is no money measurement.
5. This is a dealing between entity and car showroom that is measurable in money.
Practice 1.2

Identify accounting transactions:

1. Up-keeping expenses of building paid by cheque.
2. Collection of dues from customers.
3. Negotiating with bank for taking loan.
4. Receiving cash against loan from bank.
5. Payment of personal expenses of the owner in cash.

Answer: (1, 2, 4, 5)

Explanation:
1. This is a dealing between entity and repairer that is measurable in money.
2. This is a dealing between entity and customer that is measurable in money.
3. Activity has no effect on financial position – there is no money measurement.
4. This is a dealing between entity and bank that is measurable in money
5. This is a dealing between entity and owner that is measurable in money
Event (source of financial information)
Event means anything that happens. There are two types of events, Monetary and Non-Monetary events.

Monetary Event
It is an outcome of happening or occurrence of incident that can be measured in terms of money and can cause a
change in financial position (financial status) of an entity.

Examples include:
Loss by fire.

Loss by accident.

Foreign exchange (gain/loss)

Non-Monetary Event
It is an outcome of happening or occurrence of incident that cannot be measured in terms of money and cannot cause a
change in financial position (status) of an entity.

Examples include:
Winning or losing a game that does not carry financial impacts
Condition (source of financial information)
Condition is the third source of financial information. It requires certain adjustments to be made in
already recorded transactions and events.

Examples include:
 Fixed Assets to be depreciated according to their expected useful life
 Provision to be created against expected doubtful recovery from customer
Practice 1.3

Which of the the following information is Transaction, Event or Condition.

1. Stock in godown lost by fire
2. Giving away gifts to employees of the entity
3. Training to employees through external trainers
4. Organizing a dinner for entity’s valued customers
5. Recognizing depreciation of machinery
6. Insurance claim recovered from insurance company against stock lost by fire
7. Cash paid as charity to a hospital

Answer: 1. Event – 2. Transaction – 3. Transaction – 4. Transaction – 5. Condition – 6. Transaction – 7. Transaction

Explanation:
1. Fire accident is not a dealing between two persons, value of loss of stock due to fire is an
outcome of fire accident that is measurable in terms of money. Therefore it is an event.
2. It’s a dealing between entity and employees and also measurable in terms of money.
Therefore, it is a transaction.
3. It’s a monetary dealing between entity and external trainers. Therefore, it is transaction
4. It’s a dealing between entity and restaurant that is measurable in terms of money.
Therefore, it is a transaction.
5. It is an adjustment in the value of already purchased machinery in order to show money
measurement of the benefits obtained from that machinery during the reporting period.
Therefore, it is termed as condition.
6. It’s a dealing between entity and insurance company. It is measurable in terms of money.
Therefore, it is a transaction.
7. It’s a dealing between entity and charitable institute. It is measurable in terms of money.
Therefore, it is a transaction.
Money measurement
Money measurement is often misunderstood as receipt or payment of cash. Whereas, money measurement means to
assign a value in reporting currency to the information, regardless the cash is still payable or receivable.

To better understand the concept of money measurement let us understand the idea of other measurements.

In order to measure a table; different parameters may be used for its measurement such as:
Measuring its weight 10.0 Kg
Measuring its length 3.0 Feet
Measuring its width 1.5 Feet
Measuring its height 2.0 Feet

Whereas, money value assigned to this table, Rs. 15,000 will be its money measurement.
Practice 1.4

Which of the following information is carrying money measurement?

1. Bought 30 numbers of computers.
2. Bought 10 fans @ Rs. 1,500 each, cash paid immediately.
3. Scrap dumped, weighted 150 Kg.
4. 5 workers are working on the plant in double shift.
5. Bought raw material worth Rs. 50,000, cash is not yet paid.

Answers: (2 & 5)
Explanation:
1. Only quantity is given, no currency value is known.
2. Quantity and currency value are given. Money value is measurable (10 fans x Rs.1,500 = Rs. 15,000)
3. Only quantity is given, no currency value is known.
4. Only quantity is given, no currency value is known.
5. Money value of raw material is available in the information.
Financial position
Financial position means; an entity’s status of Resources & Sources. Resources are the assets that an entity holds in its
control and Sources are the means of finances through which the entity makes such assets. Means of finances include;
liability and owners’ equity.
Concept of Asset, Liability and Owners’ Equity will be discussed in detail in the upcoming topics.

ASSETS Rs. LIABILITIES Rs.

Furniture 80,000 Bank loan 35,000
Computers 10,000 Other payable 15,000

EQUITY
Owner’s Capital 40,000

TOTAL 90,000 TOTAL 90,000

Functions of financial accounting (Accounting cycle)
Financial accounting is a subject that is about financial information. It is said that where-ever there is financial
information; there would be a need of financial accounting.
Financial accounting is used to:
1. Classify,
2. Record,
3. Summarize,
4. Report, and
5. Analyze

the financial information of an entity by using different accounting tools.

So, there are five functions of Financial Accounting.

1. Classifying. All types of financial information are classified into five main heads:
i. Assets
ii. Liabilities
iii. Incomes
iv. Expenses
v. Owners Equity.
These main heads are further sub-classified into accounting heads, which are then used for recording accounting
transactions in the books of accounts.

Main Assets Expenses Owners’ Liabilities Incomes

Heads Equity
Land Purchases Capital Bank loan Sales
Building Salaries Drawings Bank overdraft ServiceFee
Machinery Electricity Profits Creditors Commission
Accounting Heads

Furniture Repair etc. Payable etc.

Motor Van Advertisement etc.
Computer Telephone
Stocks Traveling
Receivables Freight
Cash Balance Rent
Bank Balance Stationery
etc. etc.
2. Recording. Financial information are recorded in the books of accounts according to the prescribed rules
3. Summarizing. Recorded financial information is summarized in another book of account. These summaries are
prepared for each accounting head that are named as ledger accounts
4. Reporting. The results of summaries of each accounting head are reported to the users of financial information
by preparing financial statements
5. Analyzing. Finally the facts reported are analyzed for certain decision making purposes
Elements of Financial Statements
All financial information of a business entity are divided into five main heads of accounts. These are also known as
elements of financial statements, according to the conceptual framework of financial reporting
by IFRS.
Assets:
Assets are the resources in control of entity as a result
of past event for which there is a probability that there
will be an inflow of economic benefits to the entity in
future.

Liabilities:
Liabilities are the present obligations of entity arising from past events for
which there is a probability that there will be outflow of resources
embodying economic benefits for the entity in future.

Income:
Incomes are earnings of the entity through Revenue or Gains. Income simultaneously
causes increase in economic benefits during the reporting period in the form of
inflows or enhancements of assets or decrease of liabilities that result in increase in
equity, other than those relating to contributions from equity participants.
Sources of revenue are; sales of goods or services and return on investments.
Sources of gains are; profit on disposal of assets and discounts on settlement of liabilities.

Expense:
Expenses are the costs that expire during the reporting period of entity. Expenses
simultaneously cause decrease in economic benefits during the reporting period in
the form of outflows or depletions of assets or incurrence of liabilities that result in
decrease in equity, other than those relating to distributions to equity participants.
These must match with current year’s revenue. It includes losses sustained
during the reporting period.

Owners’ Equity:
Owners’ equity is the source of finance that represents
owners' stake in the entity. Equity is the residual interest in
the assets of the entity after deducting all its liabilities.
Components of owners’ equity are; introduction of resources
by owner into the business (capital); profits generated by the
entity (net profit); distributions of profits to the owners for
personal use (drawings/dividends).
Entity
It is an activity that is undertaken by individuals or group of people for some purpose (profit or non profit).

Purpose

Profit motive Non profit motive

Business Welfare Society

It is an economic activity, which It is a welfare organization, which is
is undertaken to earn profits. It is undertaken by some volunteers and
initially financed by owners and its motive is to help the other beings.
all of its risks and rewards also
belong to its owners.

Financial information is involved in both profit motive and non profit motive entities. Therefore, financial
accounting is a need for a business as well as a welfare society.

Profit motive Non-profit motive

Separate Entity Concept
A business entity and its owner are two different persons. For accounting purposes, business has
separate entity/identity apart from its owner.
As a student of accounting, while analysing the transactions, you must focus on the accounting
information considering yourself as an accountant of the business for which you are analysing the
transactions. Do not consider yourself as an owner of that business.
Owner’s personal expenses like food, medicines, clothing, house rent etc., which are paid by the
owner from his/her owned resources are not financial information belonging to the business unless
those are paid from business cash resources on behalf of the owner.

Practice 1.5
Based on the business entity concept, which of the following information would be accounted for in the accounting
books of an entity/business?
1. Cash invested as capital of the business by the owner.
2. Owner bought motor car for his personal use out of his personal bank account.
3. Owner used a part of his residential building for the business godown for which he was paid rent out
of business bank account.
4. Owner took loan for his daughters’ marriage from a friend.
5. Goods bought by business for trading were consumed by the owner for his personal consumption.

Answers (1, 3, 5)
Explanation:
1. It will affect cash asset and owner equity of the business.
2. There will be no effect of this transaction on business.
3. It will affect the business bank account.
4. There will be no effect of this transaction on business.
5. This transaction will decrease the stock balance of the business.
Users of Financial Information
According to the Conceptual Framework for Financial Reporting, “The objective of financial statements is to provide
information about the financial position, financial performance and changes in financial position of an entity that is
useful to a wide range of users in making accounting decisions.”
A business must report its financial information because there are various groups of people who want or need to know
it. Following groups are likely to be interested in financial information of an entity.

(a) Investor/Shareholders/owners
To assess how well the management is performing. How profitable are
the operations? How much profit they can easily withdraw from the
business for their own use.

(b) Trade contacts

Suppliers and customers are two main trade contacts. Suppliers
want to know about the entity’s ability to pay its debts against
supplies on credit terms, customers need to know that the entity
is a secured source of supply and is in no danger of having to
close down.

(c) Lenders
Providers of finance are lenders to entity might include a bank. The bank
wants to ensure that the entity is able to keep up interest payments, and
eventually to repay the amounts advanced.

(d) Taxation authorities

Interested to know about profits in order to assess the tax
payable by the entity, including sales taxes etc.

(e) Manager and Employees

Need information about the entity’s financial situation,
because their future careers and the size of their wages
and salaries depend on it. To enable them to manage
the business efficiently and to make effective decisions

(f) Financial consultants and advisers

Need information for their clients or audience.
For example, stockbrokers need information to advise investors, credit agencies
want information to advise potential suppliers of goods to the concern; and
journalists need information for their reading public.

(g) Government
Interested in the allocation of resources. They also require
information in order to provide a basis for national
statistics.

(h) Public
Entity affects members of the public in a variety of ways. For example, entity may
make a substantial contribution to a local economy by providing employment
and using local suppliers. Another important factor is the effect of an entity on
environment, for example, as regards pollution.
Practice 1.6

State following statements are true or false:

1. Debt burden of the company is the information mostly require by income tax authorities.
2. Dividend declaration is the information needed by shareholders.
3. Financial ratios are most likely require by financial consultants
4. Bonus to employee’s is the information that is needed by Government.
5. Cost of sales information is usable for managers.
6. Welfare society is always interested in green policies cost of company.

Answers: (1-false 2-true 3-true 4-False 5-true 6-True)

Explanation:
1. This information is required by lenders, investors and shareholders
2. True
3. True
4. Such information is required by income tax authorities and managers
5. True
6. True
Underlying Assumption

Going concern
Assumption that a business unit will remain in existence for the foreseeable future
The IFRS Conceptual Framework states that the going concern assumption is an underlying assumption, it is assumed
that the entity will realize its assets and settle its obligations in the normal course of the business. Thus, the financial
statements presume that an entity will continue in operation indefinitely or, if that presumption is not valid, disclosure
and a different basis of reporting are required.

Examples include:
 Significant trading losses being incurred for several years. Profitability of a company is essential for its survival
in the long term.

 Deteriorating liquidity position of a company not backed by sufficient financing arrangements.

 High financial risk arising from increased debts level causing the company to delays in payment of interest and
loan.

 Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.

 Increasing level of short term borrowing and overdraft not supported by increase in business.

 Serious litigations faced by a company which does not have the financial strength to pay the possible
settlement.

 Inability of a company to develop a new range of commercially successful products.

 Bankruptcy of a major customer of the company.

Recognition of the elements of financial statements

Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition
of an element and satisfies the following criteria for recognition:

 It is probable that any future economic benefit associated with the item will flow to or from the entity; and
 The item's cost or value can be measured with reliability.

Based on these general criteria:

 An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to
the entity and the asset has a cost or value that can be measured reliably.
 A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying
economic benefits will result from the settlement of a present obligation and the amount at which the
settlement will take place can be measured reliably.
 Income is recognised in the income statement when an increase in future economic benefits related to an
increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect,
that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in
liabilities (for example, the net increase in assets arising on a sale of goods or services or the decrease in
liabilities arising from the waiver of a debt payable).
 Expenses are recognised when a decrease in future economic benefits related to a decrease in an asset or an
increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of
expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for
example, the accrual of employee entitlements or the depreciation of equipment).
Measurement of the elements of financial statements

Measurement involves assigning monetary amounts at which the elements of the financial statements are to be
recognised and reported.

The IFRS Framework acknowledges that a variety of measurement bases are used today to different degrees and in
varying combinations in financial statements, including:
 Historical cost
 Current cost
 Fair Value ( reallizable value / settlement value)
 Present value (discounted cash flows)

Historical cost is the measurement basis most commonly used today, but it is usually combined with other
measurement bases. The IFRS Framework does not include concepts or principles for selecting which measurement
basis should be used for particular elements of financial statements or in particular circumstances. However, individual
standards and interpretations do provide this guidance.
Qualitative characteristics of useful financial information

Fundamental qualitative characteristics Fundamental Qualitative Characteristics

Relevance
Relevance refers to whether the information makes a difference Relevance Faithful
to the decision maker in order to make predictions about the • Confirmatory Value representation
• Predictive Value; or • Complete
outcome of past, present and future events or to confirm and • Both • Neutral
correct prior expectations, e.g., report of bank balance that is ity sp ec
ific
• Free from error
an e nt se d o n:
essential to determine how much to borrow. M ater
ia lit y is
of Re le va nc
e ba
as pe ct
e
•N atur de ; or
To be relevant, information must have confirmatory value, •M ag ni
tu
•Bo th
predictive value or both.
Confirmatory value is the exchange value, i.e., the value of one
thing in terms of another at any place or time, e.g., the expected selling price of a non-current asset less costs to sell.
Predictive value is the ability of accounting numbers to provide information that is useful in predicting future accounting
numbers, e.g., present value of expected future cash flows (known as value in use).
The confirmatory value and predictive value of financial information are interrelated. Information that has predictive
value often also has confirmatory value.

Materiality (entity specific aspect of relevance)

Materiality is the basis for recognising a transaction in the financial reporting process. It is the extent to which financial
information is material. In other words, materiality is an entity-specific aspect of relevance based on the nature or
magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.
Therefore, information is considered material if its omission could influence the decision making of the users.
Faithful representation
Faithful representation is the correspondence between accounting figures and descriptions and the resources or events
that these figures and descriptions represent. Information must faithfully represent the effects of transactions and
other events.
To be a perfectly faithful representation, a depiction would have the following three characteristics:
 Complete A complete depiction includes all information necessary for a user to understand the phenomenon being
depicted, including all necessary descriptions and explanations.
 Neutral A neutral depiction is without bias in the selection or presentation of financial information, which does not
mean information with no purpose or no influence on behavior.
 Free from error It means there are no errors or omissions in the description of the phenomenon, and the process used
to produce the reported information has been selected and applied with no errors in the process.
A faithful representation, by itself does not necessarily result in useful information, e.g., reporting an asset acquired
through a government grant at nominal value.

Example – Getting prepared for facing loss because of doubtful recovery from customers (economic phenomena)
The information about this economic phenomenon should be useful (relevant & faithful) (comparable, verifiable,
timely & understandable)
Enhancing qualitative characteristics Enhancing Qualitative Characteristics

The qualitative characteristics that enhance the usefulness of

information that is relevant and faithfully represented are: Comparability • Consistency

Comparability • Direct
Verifiability • Indirect
It requires consistent accounting treatments of items in the
financial statements of different entities at the same point of Timeliness
• Timely Report
• Reliable Information
time so as to enable valid comparison. Two sets of financial
statements would have comparability if they had been prepared • Reasonable Knowledge
Understandability
on the same basis and include similar type of value. • Disclosures

Verifiability
It means that the measurement made by one measurer will be confirmed by another. It exists when there is a high
degree of consensus among independent measurers, i.e., independent accountants using the same measurement
process arrived substantially at same results. Verification can be:
 direct (verifying an amount or other representation through direct observation; (e.g., by counting cash); or
 indirect (checking the inputs to a model, formula or other technique and recalculating the outputs using the same
methodology, (e.g., using FIFO method)
Timeliness
It is necessary to balance the relative merits of timely reporting, and the provision of reliable information. If reporting is
delayed until all aspects are known, the information may be reliable, but of little use to those who have had to make
decisions in the interim.
Understandability
Information should be presented in a way that is readily understandable by users who have a reasonable knowledge of
business, economic activities and accounting and who are willing to study the information diligently. Disclosures make
the information understandable.
Assignment Questions
Q. 1
The underlying assumption in preparing financial statements is ‘Going Concern’. State which ONE of the following best
explains this concept.
a) An entity has no intention to liquidate but can curtail major operations if management decides
b) The financial statements of an entity should be user friendly
c) An entity should continue in operation for the foreseeable future
d) Transactions and events of an entity should be recorded for the foreseeable future

Q. 2
Which of the following is the best description of fair presentation in accordance with IAS 1 Presentation of Financial
Statements?
a) The financial statements are accurate
b) The financial statements are as accurate as possible given the accounting systems of the organization
c) The directors of the company have stated that the financial statements are accurate and correctly prepared
d) The financial statements are reliable in that they reflect the effects of transactions, other events and
conditions

Q. 3
For the purpose of fair presentation, the requirement of IAS 1 can be stated as which of the following?
i. Selection and application of accounting policies
ii. Presentation of information in a manner which provides relevant, reliable, comparable and understandable
information
iii. Additional disclosures where required
a) (i) and (ii) only
b) (ii) and (iii) only
c) (i) and (iii) only
d) (i), (ii) and (iii)
Examination Questions
Q. 1
Briefly describe the fundamental and enhancing characteristics of useful financial information (marks 3)
Q. 2
Enumerate different users of financial statements (marks 3)
Q. 3
What are the two recognition criteria for Assets? (marks 2)