Module II - Financial Accounting

Meaning, need objective, concepts, conventions & assumptions. Branches of accounting, Internal
& external use of accounting. Advantage & limitations of financial accounting.

INTRODUCTION
Accounting is a system meant for measuring business activities, processing of information into
reports and making the findings available to decision-makers. The documents, which
communicate these findings about the performance of an organisation in monetary terms, are
called financial statements.
Usually, accounting is understood as the Language of Business. However, a business may have a
lot of aspects which may not be of financial nature. As such, a better way to understand
accounting could be to call it The Language of Financial Decisions. The better the understanding
of the language, the better is the management of financial aspects of living. Many aspects of our
lives are based on accounting, personal financial planning, investments, income-tax, loans, etc.
We have different roles to perform in life-the role of a student, of a family head, of a manager, of
an investor, etc. The knowledge of accounting is an added advantage in performing different
roles. However, we shall limit our scope of discussion to a business organisation and the various
financial aspects of such an organisation.
When we focus our thoughts on a business organisation, many questions (is our business
profitable, should a new product line be introduced, are the sales sufficient, etc.) strike our mind.
To answer questions of such nature, we need to have information generated through the
accounting process. The people who take policy decisions and frame business plans use such
information.
All business organisations work in an ever-changing dynamic environment. Any new programme
of the organisation or of its competitor will affect the business. Accounting serves as an effective
tool for measuring the financial pulse rate of the company. It is a continuous cycle of
measurement of results and reporting of results to decision makers.
Just like arithmetic is a procedural element of mathematics, book keeping is the procedural
element of accounting. When we talk about financial accounting, it is a specialized branch of
accounting that keeps track of a company's financial transactions. Using standardized guidelines,
the transactions are recorded, summarized, and presented in a financial report or financial
statement such as an income statement or a balance sheet.

MEANING AND DEFINITION OF ACCOUNTING

Accounting has been defined in different ways by different authorities on the subject.
Accounting is a comprehensive discipline and it is difficult to explain satisfactorily through any
single definition. However, two definitions to define accounting are given below:
According to “American Institute of Certified Public Accountants (AICPA),”
“Accounting is 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.”
In 1966, the “American Accounting Association (AAA)” defined accounting as,
“Accounting is the process of identifying, measuring and communicating economic
information to permit informed judgments and decisions by users of the information.”
Basic Accounting Terms:
1. Business Entity: It means a specifically identifiable business enterprise like Super Bazar, ITC
Limited, Hira & Co. etc.
2. Transactions: An event involving some value between two or more entities.
3. Assets: These are properties or economic resources of an enterprise which can be expressed
in monetary terms it can be divided in two parts
a) Fixed assets (more than 1 year period) b) Current assets (less than 1 year period)
4. Liabilities: These are certain obligations or dues which firm has to pay.
a) Long term (more than 1 year period) b) Short term (less than 1 year period)
5. Capital: It is an essential investment for commencement of every business.
6. Sales: It can be credit or cash, in which goods are delivered to customers.
7. Revenues: It is the amount which is earned by selling of products.
8. Expenses: It is known as cost of assets consumed or services which used.
9. Expenditure: It means spending money for some benefit.
10. Profit: Excess of revenues over expenses is called profit.
11. Gain: It generates from incidental transaction such as sales of fixed asset, winning of court
case.
12. Loss: Excess of expenses over income is termed as loss.
13. Discount: It is defined as concession or deduction in price of goods sold.
14. Voucher: It is known as evidence in support of a transaction.
15. Goods: It refers all the tangible goods (Raw material, work in progress, finished goods.)
16. Drawings: Amount of goods or cash which is withdrawn from business for personal use.
17. Purchases: It means of procurement of goods on credit or cash.
18. Stock: It is a part of unsold goods. It can be divided into two categories.
a) Opening stock b) Closing stock.
19. Debtors: There are persons who owe to an enterprise an amount for buying goods and
services on credit.
20. Creditors: These are persons who have to be paid by an enterprise an amount for providing
the enterprise goods and services on credit.
Accounting is not just a subject but a process that is used by the management to draw some
meaningful conclusion out the otherwise fragmented numerical facts. An accountant weaves the
thread of accounting in a logical and systematic manner and it involves a series of steps which is
also known as the process of Accounting. The process is depicted aptly in the following figure:

Following are the FUNCTIONS/SCOPE or CHARACTERISTICS or ATTRIBUTES of

accounting:
1. RECORDING: This is the basic function of accounting. It is essentially concerned with
not only ensuring that all business transactions of financial character are in fact recorded
but also that they are recorded in orderly manner.

Only those transactions and events are recorded in accounting which is of a financial
character. There are so many transactions which are very important for business but
which cannot be measured and expressed in terms of money and hence such transactions
are not recorded. E.g. A quarrel between Production Manager & Sales Manager,
resignation by an experienced employee, strike of workers etc.
 Recording is done in the book “JOURNAL”. But in some big businesses where the
numbers of transactions are quite large, journal is further subdivided into various
subsidiary books such as:
 „Cash Book‟ for recording cash transactions

 „Purchases Book‟ for recording credit purchases of goods

 „Sales Book‟ for recording credit sales of goods

 „Purchase Return Book‟ for recording the return of credit purchases

 „Sales Return Book‟ for recording the return of credit sales

2. CLASSIFYING: After recording the transactions in journal or subsidiary books, the
transactions are classified. Classification is the process of grouping the transactions of
one nature at one place, in a separate account. The book in which various accounts are
open is called “LEDGER”.

Separate accounts are opened in the ledger in the name of each person, whether
customer or supplier. Likewise, separate accounts are opened for purchases, sales, assets
etc. Similarly, expenses and incomes are again classified under separate heads in the
ledger.
3. SUMMARISING: It is the art of presenting the classified data in a manner which is
understandable and useful to management and other users of such data. This involves
the balancing of ledger accounts and the preparation of “TRIAL BALANCE” with the
help of such balances. Final accounts are prepared with the help of Trial Balance which
include “Trading and Profit & Loss Account” and a “Balance Sheet”.

The above mentioned Characteristics of Accounting are also termed as “PROCESS

OF ACCOUNTING” or “ACCOUNTING CYCLE”.
ACCOUNTING CYCLE
Transaction

Trading, Profit &

Loss Account Journal

Trial Balance Ledger

 4. ANALYZING AND INTERPRETING: This is the final function of accounting. The
recorded financial data is analyzed and interpreted in such a manner that the end users
can make a meaningful judgment about the financial condition and profitability of
business operations.

5. COMMUNICATING: The accounting information after being meaningfully analyzed

and interpreted has to be communicated in a proper form and manner to the proper
person. This is done through preparation and distribution of accounting reports.

Objective of Accounting
Objective of accounting may differ from business to business depending upon their specific
requirements. However, the following are the general objectives of accounting.

i) To keeping systematic record: It is very difficult to remember all the business

transactions that take place. Accounting serves this purpose of record keeping by promptly
recording all the business transactions in the books of account.

ii) To ascertain the results of the operation: Accounting helps in ascertaining result i.e.,
profit earned or loss suffered in business during a particular period. For this purpose, a business
entity prepares either a Trading and Profit and Loss account or an Income and Expenditure
account which shows the profit or loss of the business by matching the items of revenue and
expenditure of the same period.

iii) To ascertain the financial position of the business: In addition to profit, a businessman
must know his financial position i.e., availability of cash, position of assets and liabilities etc.
This helps the businessman to know his financial strength. Financial statements are
barometers of health of a business entity.

iv) To portray the liquidity position: Financial reporting should provide information about
how an enterprise obtains and spends cash, about its borrowing and repayment of
borrowing, about its capital transactions, cash dividends and other distributions of resources by
the enterprise to owners and about other factors that may affect an enterprise‟s liquidity and
solvency.

v) To protect business properties: Accounting provides up to date information about the

various assets that the firm possesses and the liabilities the firm owes so that nobody can claim
a payment which is not due to him.

vi) To facilitate rational decision – making: Accounting records and financial statements
provide financial information which help the business in making rational decisions about the
steps to be taken in respect of various aspects of business.
 vii) To satisfy the requirements of law: Entities such as companies, societies, public trusts
are compulsorily required to maintain accounts as per the law governing their operations such
as the Companies Act, Societies Act, and Public Trust Act etc. Maintenance of accounts is also
compulsory under the Sales Tax Act and Income Tax Act.

Importance of Accounting

i) Owners: The owners provide funds or capital for the organization. They possess curiosity in
knowing whether the business is being conducted on sound lines or not and whether the
capital is being employed properly or not. Owners, being businessmen, always keep an eye on
the returns from the investment. Comparing the accounts of various years helps in getting good
pieces of information.

ii) Management: The management of the business is greatly interested in knowing the position of
the firm. The accounts are the basis; the management can study the merits and demerits of
the business activity. Thus, the management is interested in financial accounting to find whether
the business carried on is profitable or not. The financial accounting is the “eyes and ears of
management and facilitates in drawing future course of action, further expansion etc.”

iii) Creditors: Creditors are the persons who supply goods on credit or bankers or lenders of money.
It is usual that these groups are interested to know the financial soundness before granting credit.
The progress and prosperity of the firm, two which credits are extended, are largely
watched by creditors from the point of view of security and further credit. Profit and Loss
Account and Balance Sheet are nerve centers to know the soundness of the firm.

iv) Employees: Payment of bonus depends upon the size of profit earned by the firm. The more
important point is that the workers expect regular income for the bread. The demand for wage
rise, bonus, better working conditions etc. depend upon the profitability of the firm and in
turn depends upon financial position. For these reasons, this group is interested in accounting.

v) Investors: The prospective investors, who want to invest their money in a firm, of course, wish
to see the progress and prosperity of the firm, before investing their amount, by going through
the financial statements of the firm. This is to safeguard the investment. For this, this group is
eager to go through the accounting which enables them to know the safety of investment.

vi) Government: Government keeps a close watch on the firms which yield good amount of profits.
The state and central Governments are interested in the financial statements to know the
earnings for the purpose of taxation. To compile national accounting is essential.

vii) Consumers: These groups are interested in getting the goods at reduced price. Therefore, they
wish to know the establishment of a proper accounting control, which in turn will reduce to
 cost of production, in turn, fewer prices to be paid by the consumers. Researchers are also
interested in accounting for interpretation.

viii) Research Scholars: Accounting information, being a mirror of the financial performance of a
business organization, is of immense value to the research scholar who wants to make a study
into the financial operations of a particular firm. To make a study into the financial
operations of a particular firm, the research scholar needs detailed accounting information
relating to purchases, sales, expenses, cost of materials used, current assets, current liabilities,
fixed assets, long-term liabilities and share-holders funds which is available in the accounting
record maintained by the firm.

Book-keeping
Bookkeeping is the systematic recording and organising of financial transactions in a company.
Bookkeeping involves the recording, on a day-to-day basis, of the financial transactions and
information pertaining to a business. It ensures that records of the individual financial
transactions are correct, up-to-date and comprehensive. Accuracy is therefore vital to the
process.
Essentially, bookkeeping means recording and tracking the numbers involved in the financial
side of the business in an organised way. It is essential for businesses but is also useful for
individuals and non-profit organisations.
Bookkeeping and accounting are often heard being used interchangeably, however, accounting is
the overall practice of managing finances of a business or individual, while bookkeeping refers
more specifically to the tasks and practices involved in recording the financial activities.
The difference can better be understood by the following comparative chart:
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
GAAP are the guidelines issued by authoritative bodies for processing accounting
information. Accounting principles may be defined as those rules of action or conduct which are
adopted by the accountants universally while recording the accounting transactions. These
principles can be classified into two categories:
1. Accounting Concepts or Assumptions

2. Accounting Conventions

Accounting concepts:
The term „concept‟ is used to denote accounting postulates, i.e., basic assumptions or
conditions upon which science of accounting is based. No enterprise can prepare its financial
statements without considering these basic concepts or assumptions. The following are the
common accounting concepts adopted by many business concerns.

i). Business Entity Concept

ii). Money Measurement Concept
iii). Going Concern Concept
iv). Dual Aspect Concept
v). Periodicity Concept
vi). Historical Cost Concept
vii). Matching Concept
viii). Realisation Concept
ix). Accrual Concept
x). Objective Evidence Concept

i) Business Entity Concept:

This is also known as „Separate Entity Concept‟. A business unit is an organization of persons
established to accomplish an economic goal. Business entity concept implies that the business
unit is separate and distinct from the persons who provide the required capital to it. This
concept can be expressed through an accounting equation, viz., Assets = Liabilities + Capital.
The equation clearly shows that the business itself owns the assets and in turn owes to various
claimants. It is worth mentioning here that the business entity concept as applied in accounting
for sole trading units is different from the legal concept. The expenses, income, assets, and
liabilities not related to the sole proprietorship business are excluded from accounting. However,
a sole proprietor is personally liable and required to utilize non-business assets or private assets
also to settle the business creditors as per law. Thus, in the case of sole proprietorship, business
and non-business assets and liabilities are treated alike in the eyes of law. In the case of a
partnership, firm, for paying the business liabilities the business assets are used first and it any
surplus remains thereafter, it can be used for paying off the private liabilities of each partner.
Similarly, the private assets are first used to pay off the private liabilities of partners and if any
surplus remains, it is treated as part of the firm‟s property and is used for paying the firm‟s
liabilities. In the case of a company, its existence does not depend on the life span of any
shareholder.

ii) Money Measurement Concept:

In accounting, all events and transactions are recorded in terms of money. Money is
considered as a common denominator, by means of which various facts, events, and transactions
about a business can be expressed in terms of numbers. In other words, facts, events, and
transactions which cannot be expressed in monetary terms are not recorded in accounting.
Hence, the accounting does not give a complete picture of all the transactions of a business unit.
This concept does not also take care of the effects of inflation because it assumes a stable
value for measuring.

iii) Going Concern Concept:

Under this concept, the transactions are recorded assuming that the business will exist for a
longer period of time, i.e., a business unit is considered to be a going concern and not a
liquidated one. It is assumed the coming and going of persons will not affect the working of the
business, it will go on working even if the owners cease to exist. Keeping this in view, the
suppliers and other companies enter into business transactions with the business unit. This
assumption supports the concept of valuing the assets at historical cost or replacement cost. This
concept also supports the treatment of prepaid expenses as assets, although they may be
practically unsalable.

iv) Dual Aspect Concept:

According to this basic concept of accounting, every transaction has a two-fold aspect, Viz.,
1. Giving certain benefits and 2. Receiving certain benefits. The basic principle of double
entry system is that every debit has a corresponding and equal amount of credit. This is the
underlying assumption of this concept. The accounting equation viz., Assets = Capital +
Liabilities or Capital = Assets – Liabilities, will further clarify this concept, i.e., at any point of
time, the total assets of the business unit are equal to its total liabilities. Liabilities here relate
both to the outsiders and the owners. Liabilities to the owners are considered as capital.

v) Periodicity Concept:

Under this concept, the life of the business is segmented into different periods and accordingly
the result of each period is ascertained. Though the business is assumed to be continuing in
future, the measurement of income and studying the financial position of the business for a
shorter and definite period will help in taking corrective steps at the appropriate time. Each
segmented period is called “accounting period” and the same is normally a year. The
businessman has to analyse and evaluate the results ascertained periodically. At the end of an
accounting period, an Income Statement is prepared to ascertain the profit or loss made
during that accounting period and Balance Sheet is prepared which depicts the financial
position of the business as on the last day of that period. During the course of preparation of
these statements capital and revenue, items are to be necessarily distinguished.

vi) Historical Cost Concept:

According to this concept, the transactions are recorded in the books of account with the
respective amounts involved. For example, if an asset is purchases, it is entered in the
accounting record at the price paid to acquire the same and that cost is considered to be the
base for all future accounting. It means that the asset is recorded at cost at the time of
purchase but it may be methodically reduced in its value by way of charging depreciation.
However, in the light of inflationary conditions, the application of this concept is considered
highly irrelevant for judging the financial position of the business.

vii) Matching Concept:

The essence of the matching concept lies in the view that all costs which are associated to a
particular period should be compared with the revenues associated to the same period to
obtain the net income of the business. Under this concept, the accounting period concept is
relevant and it is this concept (matching concept) which necessitated the provisions of different
adjustments for recording outstanding expenses, prepaid expenses, outstanding incomes, incomes
received in advance, etc., during the course of preparing the financial statements at the end of the
accounting period.

viii) Realisation Concept:

This concept assumes or recognizes revenue when a sale is made. Sale is considered to be
complete when the ownership and property are transferred from the seller to the buyer and
the consideration is paid in full. However, there are two exceptions to this concept, viz.,
1. Hire purchase system where the ownership is transferred to the buyer when the last installment
is paid and
2. Contract accounts, in which the contractor is liable to pay only when the whole contract is
completed, the profit is calculated on the basis of work certified each year.

ix) Accrual Concept:

According to this concept, the revenue is recognized on its realization and not on its actual
receipt. Similarly, the costs are recognized when they are incurred and not when payment is
made. This assumption makes it necessary to give certain adjustments in the preparation of
income statement regarding revenues and costs. But under cash accounting system, the
revenues and costs are recognized only when they are actually received or paid. Hence, the
combination of both cash and accrual system is preferable to get rid of the limitations of each
system.

x) Objective Evidence Concept:

This concept ensures that all accounting must be based on objective evidence, i.e., every
transaction recorded in the books of account must have a verifiable document in support of
 its, existence. Only then, the transactions can be verified by the auditors and declared as true or
otherwise. The verifiable evidence for the transactions should be free from the personal bias,

Accounting Conventions:

The term „conventions‟ includes those customs or traditions which guide the accountants
while preparing accounting statements. The following conventions are to be followed to have a
clear and meaningful information and data in accounting:

i) Consistency: The convention of consistency refers to the state of accounting rules, concepts,
principles, practices, and conventions being observed and applied constantly, i.e., from one
year to another there should not be any change. If consistency is there, the results and
performance of one period can be compared easily and meaningfully with the other. It also
prevents personal bias as the persons involved have to follow the consistent rules, principles,
concepts, and conventions. This convention, however, does not completely ignore changes. It
admits changes wherever indispensable and adds to the improved and modern techniques of
accounting.

ii) Disclosure: The convention of disclosure stresses the importance of providing accurate, full
and reliable information and data in the financial statements which is of material interest to
the users and readers of such statements. This convention is given due legal emphasis by the
Companies Act, 1956 by prescribing formats for the preparation of financial statements.
However, the term disclosure does not mean all information that one desires to get should be
included in accounting statements. It is enough if sufficient information, which is of material
interest to the users, is included.

iii) Conservatism: In the prevailing present day uncertainties, the convention of conservatism has
its own importance. This convention follows the policy of caution or playing safe. It takes into
account all possible losses but not the possible profits or gains. A view opposed to this
convention is that there is the possibility of creation of secret reserves when conservatism is
excessively applied, which is directly opposed to the convention of full disclosure. Thus, the
convention of conservatism should be applied very cautiously.

BRANCHES OF ACCOUNTING
The changing business scenario over the centuries gave rise to specialized branches of
accounting which could cater to the changing requirements. The branches of accounting are;

i) Financial accounting;

ii) Cost accounting; and

iii) Management accounting.

Now, let us understand these terms.

Financial Accounting

The accounting system concerned only with the financial state of affairs and financial
results of operations is known as Financial Accounting. It is the original form of accounting.
It is mainly concerned with the preparation of financial statements for the use of outsiders
like creditors, debenture holders, investors and financial institutions. The financial statements
i.e., the profit and loss account and the balance sheet, show them the manner in which operations
of the business have been conducted during a specified period.

Cost Accounting

In view of the limitations of financial accounting in respect of information relating to the cost
of individual products, cost accounting was developed. It is that branch of accounting which is
concerned with the accumulation and assignment of historical costs to units of product and
department, primarily for the purpose of valuation of stock and measurement of profits. Cost
accounting seeks to ascertain the cost of unit produced and sold or the services rendered by
the business unit with a view to exercising control over these costs to assess profitability and
efficiency of the enterprise. It generally relates to the future and involves an estimation of future
costs to be incurred. The process of cost accounting based on the data provided by the
financial accounting.

Management Accounting

It is an accounting for the management i.e., accounting which provides necessary information
to the management for discharging its functions. According to the Anglo-American Council on
productivity, “Management accounting is the presentation of accounting information is such
a way as to assist management in the creation of policy and the day-to-day operation of an
undertaking.” It covers all arrangements and combinations or adjustments of the orthodox
information to provide the Chief Executive with the information from which he can control the
business e.g. Information about funds, costs, profits etc. Management accounting is not only
confined to the area of cost accounting but also covers other areas (such as capital expenditure
decisions, capital structure decisions, and dividend decisions) as well.

Users of Accounting Information - Internal & External

Accounting information helps users to make better financial decisions. Users of financial
information may be both internal and external to the organization.
Internal users (Primary Users) of accounting information include the following:
(i) Management: for analyzing the organization's performance and position and taking
appropriate measures to improve the company results.
 (ii) Employees: for assessing company's profitability and its consequence on their future
remuneration and job security.
(iii) Owners: for analyzing the viability and profitability of their investment and
determining any future course of action.
Accounting information is presented to internal users usually in the form of management
accounts, budgets, forecasts and financial statements.

External users (Secondary Users) of accounting information include the following:

(i) Creditors: for determining the credit worthiness of the organization. Terms of credit
are set by creditors according to the assessment of their customers' financial health.
Creditors include suppliers as well as lenders of finance such as banks.
(ii) Tax Authorities: for determining the credibility of the tax returns filed on behalf of
the company.
(iii) Investors: for analyzing the feasibility of investing in the company. Investors want to
make sure they can earn a reasonable return on their investment before they commit
any financial resources to the company.
(iv) Customers: for assessing the financial position of its suppliers which is necessary for
them to maintain a stable source of supply in the long term.
(v) Regulatory Authorities: for ensuring that the company's disclosure of accounting
information is in accordance with the rules and regulations set in order to protect the
interests of the stakeholders who rely on such information in forming their decisions.

Advantages of Accounting

The following are the advantages of accounting to a business:

i) It helps in having complete record of business transactions.
ii) It gives information about the profit or loss made by the business at the close of a year and its
financial conditions. The basic function of accounting is to supply meaningful information about
the financial activities of the business to the owners and the managers.
iii) It provides useful information form making economic decisions,
iv) It facilitates comparative study of current year‟s profit, sales, expenses etc., with those of the
previous years.
v) It supplies information useful in judging the management‟s ability to utilise enterprise
resources effectively in achieving primary enterprise goals.
vi) It provides users with factual and interpretive information about transactions and other events
which are useful for predicting, comparing and evaluation the enterprise‟s earning power.
vii) It helps in complying with certain legal formalities like filing of income-tax and sales-tax
returns. If the accounts are properly maintained, the assessment of taxes is greatly facilitated.
Limitations of Accounting
(i) Accounting is historical in nature: It does not reflect the current financial position
or worth of a business.

(ii) Transactions of non-monetary nature do not find place in accounting:

Accounting is limited to monetary transactions only. It excludes qualitative elements
like management, reputation, employee morale, labour strike etc.

(iii) Facts recorded in financial statements are greatly influenced by accounting

conventions and personal judgments of the Accountant or Management. Valuation
of inventory, provision for doubtful debts and assumption about useful life of an asset
may, therefore, differ from one business house to another.

(iv) Accounting principles are not static or unchanging-alternative accounting

procedures are often equally acceptable. Therefore, accounting statements do not
always present comparable data

(v) Cost concept is found in accounting: Price changes are not considered. Money
value is bound to change often from time to time. This is a strong limitation of
accounting.