FINANCIAL ACCOUNTING AND ANALYSIS

KMBN-103
UNIT 1

Meaning and Scope of Accounting : Overview of Accounting, Users of

Accounting, Accounting Concepts Conventions, Book keeping and
Accounting, Principles of Accounting, Basic Accounting terminologies,
Accounting Equation , Overview to Deprecation (straight line and
diminishing method) .
 Overview of Accounting

Accounting is a business language. We can use this language to communicate

financial transactions and their results. Accounting is a comprehensive system to
collect, analyze, and communicate financial information.

The origin of accounting is as old as money. In early days, the number of transactions
were very small, so every concerned person could keep the record of transactions
during a specific period of time. Twenty-three centuries ago, an Indian scholar
named Kautilya alias Chanakya introduced the accounting concepts in his
book Arthashastra. In his book, he described the art of proper account keeping and
methods of checking accounts. Gradually, the field of accounting has undergone
remarkable changes in compliance with the changes happening in the business
scenario of the world.

A book-keeper may record financial transactions according to certain accounting

principles and standards and as prescribed by an accountant depending upon the size,
nature, volume, and other constraints of a particular organization.

With the help of accounting process, we can determine the profit or loss of the
business on a specific date. It also helps us analyze the past performance and plan the
future courses of action.

Definitions of Accounting
Thus, accounting can be defined as the process of identifying, measuring, recording
and communicating the economic events of an organization to the interested users of
the information.

Smith and Ashburn: “Accounting is a means of measuring and reporting the results of
economic activities.”

R.N. Anthony: “Accounting system is a means of collecting summarizing, analyzing

and reporting in monetary terms, the information about the business.

American Institute of Certified Public Accountants (AICPA): “The art of recording,

classifying and summarizing 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.”

Thus, accounting is an art of identifying, recording, summarizing and interpreting

business transactions of financial nature. Hence accounting is the Language of
Business.

Objectives and Scope of Accounting

Let us go through the main objectives of Accounting:

 To keep systematic records - Accounting is done to keep systematic record of

financial transactions. The primary objective of accounting is to help us collect
financial data and to record it systematically to derive correct and useful results
of financial statements.

 To ascertain profitability - With the help of accounting, we can evaluate the

profits and losses incurred during a specific accounting period. With the help of
a Trading and Profit & Loss Account, we can easily determine the profit or loss
of a firm.

 To ascertain the financial position of the business - A balance sheet or a

statement of affairs indicates the financial position of a company as on a
particular date. A properly drawn balance sheet gives us an indication of the
class and value of assets, the nature and value of liability, and also the capital
position of the firm. With the help of that, we can easily ascertain the soundness
of any business entity.

 To assist in decision-making - To take decisions for the future, one requires

accurate financial statements. One of the main objectives of accounting is to
take right decisions at right time. Thus, accounting gives you the platform to plan
for the future with the help of past records.

To fulfill compliance of Law - Business entities such as companies, trusts, and

societies are being run and governed according to different legislative acts.
Similarly, different taxation laws (direct indirect tax) are also applicable to every
business house. Everyone has to keep and maintain different types of accounts and
records as prescribed by corresponding laws of the land. Accounting helps in
running a business in compliance with the law.

Branches of Accounting

The important branches of accounting are:

1. Financial Accounting: The purpose of Accounting is to ascertain the financial
results i.e. profit or loss in the operations during a specific period. It is also
aimed at knowing the financial position, i.e. assets, liabilities and equity position
at the end of the period. It also provides other relevant information to the
management as a basic for decision-making for planning and controlling the
operations of the business.
2. Cost Accounting: The purpose of this branch of accounting is to ascertain
the cost of a product / operation / project and the costs incurred for carrying out
various activities. It also assist the management in controlling the costs. The
necessary data and information are gatherr4ed form financial and other
sources.
3. Management Accounting : Its aim to assist the management in taking correct
policy decision and to evaluate the impact of its decisions and actions. The data
required for this purpose are drawn accounting and cost-accounting.
4. Inflation Accounting : It is concerned with the adjustment in the values of
asset and of profit in light of changes in the price level. In a way it is concerned
with the overcoming of limitations that arise in financial statements on account
of the cost assumption (i.e. recording of the assets at their historical or original
cost) and the assumption of stable monetary unit.
5. Human Resource Accounting: It is a branch of accounting which seeks to
report and emphasize the importance of human resources in a company’s
earning process and total assets. It is concerned with the process of identifying
and measuring data about human resources and communicating this
information to interested parties. In simple words, it is accounting for people as
organizational resources.
 Users of Accounting

Different categories of users need different kinds of information for making

decisions. The users of accounting can be divided in two board groups

(1). Internal users and

(2) External users.

1 Internal User:

Managers: These are the persons who manage the business, i.e.

management at the top, middle and lower levels. Their requirements of

information are different because they make different types of decisions.

Accounting reports are important to managers for evaluating the results of their

decisions. In additions to external financial statements, managers need detailed

internal reports either branch division or department or product-wise.

Accounting reports for managers are prepared much more frequently than

external reports.

Accounting information also helps the managers in appraising the performance

of subordinates. As such Accounting is termed as “the eyes and ears of

management.”

2 External Users:

1. Investors: Those who are interested in buying the shares of company are

naturally interested in the financial statements to know how safe the investment

already made is and how safe the proposed investments will be.
2. Creditors: Lenders are interested to know whether their load, principal and

interest, will be paid when due. Suppliers and other creditors are also interested

to know the ability of the firm to pay their dues in time.

3. Workers : In our country, workers are entitled to payment of bonus which

depends on the size of profit earned. Hence, they would like to be satisfied that

he bonus being paid to them is correct. This knowledge also helps them in

conducting negotiations for wages.

4. Customers: They are also concerned with the stability and profitability of

the enterprise. They may be interested in knowing the financial strength of the

company to rent it for further decisions relating to purchase of goods.

5. Government: Governments all over the world are using financial

statements for compiling statistics concerning business which, in turn, helps in

compiling national accounts. The financial statements are useful for tax

authorities for calculating taxes.

6. Public : The public at large interested in the functioning of the enterprises

because it may make a substantial contribution to the local economy in many

ways including the number of people employed and their patronage to local

suppliers.

7. Researchers: The financial statement, being a mirror of business

conditions, is of great interest to scholars undertaking research in accounting

theory as well as business affairs and practices.

 ADVANTAGES FROM ACCOUNTING

The role of accounting has changed from that of a mere record keeping during the 1 st

decade of 20th century of the present stage, which it is accepted as information system

and decision making activity. The following are the advantages of accounting.

1. Provides for systematic records: Since all the financial transactions are
recorded in the books, one need not rely on memory. Any information required is
readily available from these records.
2. Facilitates the preparation of financial statements: Profit and loss accountant
and balance sheet can be easily prepared with the help of the information in the
records. This enables the trader to know the net result of business operations (i.e.
profit / loss) during the accounting period and the financial position of the business
at the end of the accounting period.
3. Provides control over assets: Book-keeping provides information regarding
cash in had, cash at bank, stock of goods, accounts receivables from various
parties and the amounts invested in various other assets. As the trader knows the
values of the assets he will have control over them.
4. Provides the required information: Interested parties such as owners, lenders,
creditors etc., get necessary information at frequent intervals.
5. Comparative study: One can compare the present performance of the
organization with that of its past. This enables the managers to draw useful
conclusion and make proper decisions.
6. Less Scope for fraud or theft: It is difficult to conceal fraud or theft etc., because
of the balancing of the books of accounts periodically. As the work is divided
among many persons, there will be check and counter check.
7. Tax matters: Properly maintained book-keeping records will help in the
settlement of all tax matters with the tax authorities.
8. Ascertaining Value of Business: The accounting records will help in ascertaining
the correct value of the business. This helps in the event of sale or purchase of a
business.
9. Documentary evidence: Accounting records can also be used as an evidence in
the court to substantiate the claim of the business. These records are based on
documentary proof. Every entry is supported by authentic vouchers. As such,
Courts accept these records as evidence.
10. Helpful to management: Accounting is useful to the management in various
ways. It enables the management to assess the achievement of its performance.
The weakness of the business can be identified and corrective measures can be
applied to remove them with the helps accounting.

LIMITATIONS OF ACCOUNTING

The following are the limitations of accounting.

1. Does not record all events: Only the transactions of a financial character will
be recorded under book-keeping. So it does not reveal a complete picture about
the quality of human resources, locational advantage, business contacts etc.
2. Does not reflect current values: The data available under book-keeping is
historical in nature. So they do not reflect current values. For instance, we record
the value of stock at cost price or market price, which ever is less. In case of,
building, machinery etc., we adopt historical cost as the basis. In fact, the current
values of buildings, plant and machinery may be much more than what is
recorded in the balance sheet.
3. Estimates based on Personal Judgment: The estimate used for determining
the values of various items may not be correct. For example, debtor are
estimated in terms of collectability, inventories are based on marketability, and
fixed assets are based on useful working life. These estimates are based on
personal judgment and hence sometimes may not be correct.
4. Inadequate information on costs and Profits: Book-keeping only provides
information about the overall profitability of the business. No information is given
about the cost and profitability of different activities of products or divisions
 ACCOUNTING PRINCIPLES
Accounting principles can be subdivided into two categories:

·        Accounting Concepts; and

·        Accounting Conventions

Accounting Concepts: The term ‘concept’ is used to connote accounting postulates,

that is necessary assumptions and conditions upon which accounting is based.

Accounting Concepts

1. Business Entity Concept

2. Money Measurement Concept

3. Cost Concept

4. Going Concern Concept

5. Dual Aspect Concept

6. Realization Concept

Accounting Conventions

7. Convention of Consistency

8. Convention of Disclosure

9. Convention of Conservative

1.Business Entity Concept

Business is treated as a separate entity or unit apart from its owner and others. All the
transactions of the business are recorded in the books of business from the point of
view of the business as an entity and even the owner is treated as a creditor to the
extent of his/her capital.

2.Money Measurement Concept

In accounting, we record only those transactions which are expressed in terms of

money. In other words, a fact which can not be expressed in monetary terms, is not
recorded in the books of accounts.
3.Going Concern Concept

It is persuaded that the business will exists for a long time and transactions are
recorded from this point of view.

4.Dual Aspect Concept

For example, the proprietor of a business starts his business with Cash Rs.1,00,000/-,
Machinery of Rs.50,000/- and Building of Rs.30,000/-, then this fact is recorded at two
places. That is Assets account (Cash, Machinery & Building) and Capital accounts. The
capital of the business is equal to the assets of the business.

Thus, the dual aspect can be expressed as under

Capital + Liabilities = Assets

or

Capital = Assets – Liabilities

5.Realization Concept

Accounting is a historical record of transactions. It records what has happened. It does

not anticipate events. This is of great important in preventing business firms from
inflating their profits by recording sales and income that are likely to accrue.

6.Accounting Period Concept

The net income can be measured by comparing the assets of the business existing at
the time of its liquidation. But as the life of the business is assumed to be infinite, the
measurement of income according to the above concept is not possible. So a twelve
month period is normally adopted for this purpose. This time interval is called
accounting period.

Accounting Conventions: The term ‘convention’ is used to signify customs and

traditions as a guide to the presentation of accounting statements.

7. Convention of Consistency

In order to enable the management to draw important conclusions regarding the

working of the company over a few years, it is essential that accounting practices and
methods remain unchanged from one accounting period to another. The comparison of
one accounting period with that of another is possible only when the convention of
consistency is followed
8. Convention of Disclosure

This principle implies that accounts must be honestly prepared and all material
information must be disclosed therein. The contents of Balance Sheet and Profit and
Loss Account are prescribed by law. These are designed to make disclosure of all
material facts compulsory.

9. Convention of Conservation

Financial statements are always drawn up on rather a conservative basis. That is,
showing a position better than what it is, not permitted. It is also not proper to show a
position worse than what it is. In other words, secret reserves are not permitted.

Book-Keeping and Accounting

Book – Keeping: Book – Keeping involves the chronological recording of financial

transactions in a set of books in a systematic manner.

Accounting: Accounting is concerned with the maintenance of accounts giving stress

to the design of the system of records, the preparation of reports based on the recorded
date and the interpretation of the reports.

According to G.A. Lee the accounting system has two stages.

1. The making of routine records in the prescribed from and according to set rules
of all events with affect the financial state of the organization; and
2. The summarization from time to time of the information contained in the records,
its presentation in a significant form to interested parties and its interpretation as
an aid to decision making by these parties.
 Basic Accounting Terminology
1. Accounts Receivable – The amount of money owed by your customers after goods
or services have been delivered and/or used.

2. Accounting – A systematic way of recording and reporting financial transactions.

3. Accounts Payable – The amount of money you owe creditors (suppliers, etc.) in
return for good and/or services they have delivered.

4. Assets (Fixed and Current) – Current assets are those that will be used within one
year. Typically this could be cash, inventory or accounts receivable. Fixed assets (non
current) are more long-term and will likely provide benefits to a company for more than
one year, such as a building, land or machinery. 

5. Balance Sheet – A financial report that summarizes a company's assets (what it

owns), liabilities (what it owes) and owner’s equity at a given time.

6. Capital – A financial asset and its value, such as cash or goods. Working capital is

calculated by taking your current assets subtracted from current liabilities.

7. Cash Flow – The revenue or expense expected to be generated through business

activities (sales, manufacturing, etc.) over a period of time. Having a positive cash flow
is essential in order for businesses to survive in the long run.

8. Certified Public Accountant – A designation given to someone who has passed a
standardized CPA exam and met government-mandated work experience and
educational requirements to become a CPA.

9. Cost of Goods Sold – The direct expense related to producing the goods sold by a

company. This may include the cost of the raw materials (parts) and amount of
employee labor used in production.

10. Credit – An accounting entry that may either decrease assets or increase liabilities

and equity on the company's balance sheet, depending on the transaction. When using
the double-entry accounting method there will be two recorded entries for every
transaction: a credit and a debit.

11. Debit – An accounting entry where there is either an increase in assets or

a decrease in liabilities on a company's balance sheet.

12. Expenses (Fixed, Variable, Accrued, Operation) – The fixed, variable, accrued or

day-to-day costs that a business may incur through its operations. Examples of
expenses include payments to banks, suppliers, employees or equipment.
13. Generally Accepted Accounting Principles (GAAP) - A set of rules and
guidelines developed by the accounting industry for companies to follow when
reporting financial data. Following these rules is especially critical for all publicly traded
companies.

14. General Ledger – A complete record of the financial transactions over the life of a
company.

15. Liabilities (Current and Long-Term) –  A company's debts or financial obligations

it incurred during business operations. Current liabilities are those debts that are
payable within a year, such as a debt to suppliers. Long-term liabilities are typically
payable over a period of time greater than one year. An example of a long-term liability
would be a bank loan.

16. Net Income – A company's total earnings, also called net profit or the “bottom
line.” Net income is calculated by subtracting totally expenses from total revenues.

17. Owner's Equity –  An owner’s equity is typically explained in terms of the
percentage amount of stock a person has ownership interest in the company. The
owners of the stock are commonly referred to as the shareholders.

18. Present Value – The value of how much a future sum of money is worth today.
Present value helps us understand how receiving $100 now is worth more than
receiving $100 a year from now.

19. Profit and Loss Statement – P&L - A financial statement that is used to summarize
a company’s performance and financial position by reviewing revenues, costs and
expenses during a specific period of time; such a quarterly or annually.

20. Return on Investment – A measure used to evaluate the financial performance
relative to the amount of money that was invested. The ROI is calculated by dividing the
net profit by the cost of the investment. The result is often expressed as a percentage.

The Accounting Equation

ASSETS= LIABILITIES +CAPITAL

Or
CAPITAL = ASSETS – LIABILITIES
 Overview to Depreciation
Depreciation is the systematic reduction in the recorded cost of a fixed asset. Examples
of fixed assets that can be depreciated are buildings, furniture, leasehold improvements,
and office equipment. The only exception is land, which is not depreciated (since land is
not depleted over time, with the exception of natural resources). The reason for using
depreciation is to match a portion of the cost of a fixed asset to the revenue that it
generates; this is mandated under the matching principle, where you record revenues
with their associated expenses in the same reporting period in order to give a complete
picture of the results of a revenue-generating transaction. The net effect of depreciation
is a gradual decline in the reported carrying amount of fixed assets on the balance
sheet.

In straight line depreciation method, cost of a fixed asset is reduced uniformly over the
useful life of the asset. Since depreciation expense charged to income statement in
each period is the same, the carrying amount of the asset on balance sheet declines in
a straight line.
Due to its simplicity, straight line method of depreciation is the most commonly used
depreciation method. Accounting principles require companies to depreciate its fixed
assets using method that best reflects the pattern in which the assets are being used.
While the straight-line method is appropriate in many situations, some fixed assets lose
more value in initial years. In such situations other depreciation methods are more
appropriate.

Formula

Depreciation expense under straight line method is calculated by dividing the

depreciable amount of the fixed asset by the useful life of the asset.
Depreciable Amount
Depreciation Expense: Straight-line Method
=
Useful Life

Depreciable amount equals cost minus salvage value. Cost is the amount at which the
fixed asset is capitalized. Salvage value (also called residual value or scrap value) is the
estimated value of the fixed asset at the end of its useful life.
Since an amount equal to the salvage value can be recovered by selling the asset, only
the difference between the cost and the salvage value is depreciated.
Useful life of a fixed asset represents the number of accounting periods within which the
asset is expected to generate economic benefits.
Normally purchase of fixed assets does not coincide with the start of financial year. In
such situations, some companies elect to charge the whole year depreciation to income
statement in the year of purchase (and do not charge any depreciation in the year of
 disposal). Another more appropriate option is to charge proportionate depreciation for
partial year.
N
Depreciation Expense: Straight-line Method for a Partial Year = DE
×
12

Where

DE is the depreciation expense for a complete financial year.

N is the number of months during which the fixed asset was available for use.

Example

On 1 Jan 2011, Company A purchased a vehicle costing $20,000. The company

expects the vehicle to be operational for 4 years at the end of which it can be sold for
$5,000. Calculate depreciation expense for the year ended 31 Dec 2011, 2012, 2013
and 2014.

Solution:

Depreciable amount of the vehicle is $15,000 ($20,000 cost minus $5,000 salvage
value). Useful life is 4 years.
Depreciation expense for year ended 31 Dec 2011 = $15,000 ÷ 4 = $3,750 per year.
Depreciation expense shall remain the same over the useful life. Hence, an amount of
$3,750 shall be the depreciation expense for year ended 31 Dec 2012, 2013 and 2014.

This method of depreciation involves multiplying the asset carrying amount by

the depreciation rate to calculate the depreciation that can be claimed that year.

So what’s the carrying amount? The carrying amount is the value of the asset after any
depreciation to date has been deducted from the original cost.

Depreciation is calculated on a pro rata basis. If an asset is purchased part way

through the year, it is depreciated for only the portion of the year for which it was
owned. Each year the Reducing balance depreciation
Diminishing Value Method

same method of calculating depreciation must be used.

Example

Let’s look at a motor vehicle that has been depreciated for a couple of years.

Item: motor vehicle

Purchase date: 1/10/2008
Cost: $25,000
Depreciation method: reducing balance 40% p.a.

We need to calculate pro rata, how much depreciation can be claimed. The financial
year ends 30 June 2009, so we have owned the vehicle for nine months and can claim
nine months worth of depreciation.

Here’s our calculation:

Cost x depreciation rate / 12 months x months of ownership = depreciation

25000 x    40%             /       12     x              9              =     7500

Our asset cost 25000 and we can claim 7500 depreciation for the year ended 20th June
2009. The asset now has a carrying amount of 17500. The carrying amount is
calculated by subtracting the depreciation from the original cost.

Because we are using the reducing balance method, depreciation for the year ended
30th June 2010 is calculated as follows:

Original cost – depreciation to date = carrying amount

25000          –          7500             =       17500

Carrying amount x depreciation rate = depreciation expense

17500                x          40%          =       7000