Financial Accounting

Prof. Trupti Naik

Inception of Business

Factors affecting selection of the form of business firm/ Organization:

- Risk appetite of the owner

- Scale of operation

- Amount of capital

- Owner’s desire for control

Types of Business Entity It carries out some economic activity for profit- making

purpose.

Economic Activity – Money Centered, Done with money and done for money to earn money.

Different Activities :

- Trading,

- Manufacturing, and

- Service (Banking, Insurance, Transportation etc.)

Sole EnterpriseManaged by a single owner

One person contributes towards the capital.

Bears the risk of running the business and reaps out the profit

No need for any specific documentation

Unlimited liability – if business property is not sufficient to repay the external liabilities of business , the personal property can be utilized to pay off the business liabilities.

PartnershipTwo or more owners(Maximum 10/20 partners).

Capital contribution is not the precondition to become a partner.

Agreement of doing business between partners

Registration not obligatory but optional.

Partners share the profit/loss as per the agreement executed by them.

Unlimited Liability.

Limited Liability CompanyA large number of contributors who contribute towards the

capital for business purpose.

The capital contribution is in the form of shares.

Subject to the provision of Companies Act

Separation of Ownership and Management

The owners/shareholders are not involved directly in the management of a company

Appoint a board of directors – responsible for management of the company.

Private Limited Company• Promoted by 2 promoters

• Can not have more than 50 shareholders

• Can not issue shares/ debentures through public issue

• Can raise the capital by issuing the shares/ debentures through private placements or rights issues only

• These shares are not freely transferable

Public Limited CompanyPromoted by seven promoters

Can raise the capital by issuing securities – shares and debentures through public issue.

Share is the smallest unit in which the total capital of a company is divided into.

Can commence business only after obtaining a Letter of Commencement of business from ROC

Form of Democracy- Separation of Ownership and Management

Executive Level (Managers/ Executives/ supervisors)

Middle level Management(Zonal managers/ Area managers)

President/ Vice President/ General Manager

Chairman/Managing Director

Board of Directors

Equity Shareholders

Corporate Financial ReportingSeparation of Ownership and management

Necessity of apprising the owners about the financial performance of company.

It is mandatory to publish financial statements in the form of annual report every year.

Annual Report – To communicate the financial performance as well as policies and strategies of the company.

Annual Report discloses a host of information about the company, which includes the following:

- Company’s Vision Statement - Chairman’s Speech and Report - Auditors’ Report- Directors’ Report- Management Discussion and Analysis- Abstract of Audited Financial Statements- Standalone as well as Consolidated Financial Statements- Accounting Policies- Corporate Governance Report- Segment Reporting

Objective of Corporate Financial Reporting Annual report is considered to be a multi utility document

- Equity shareholders get apprised about the profitability position

- Lenders/ Debenture holders come to know about the long term solvency of the business entity

- Short term creditors/ suppliers understand about the liquidity position of the business

- Employees also get an idea about the financial health and policies as well as the future course of action of the company.

Structure and Components of Financial Statements

According to Indian Accounting Standard , Complete set of Financial statements should include:

- A Balance Sheet as at the end of the period- A Statement of Profit and Loss for the period- A Statement of Cash Flows for the period- Notes comprising of significant accounting policies- A balance sheet as at the beginning of the year.

Introduction to Accounting

Financial accounting – Business Language

Recording financial information

Providing financial information to a wide range of users

Based on some accepted principles, rules and guidelines.

Consists of a series of activities such as identification, recording, classification, summarization, presentation, analysis and interpretation of monetary transaction.

It is an information system that measures, processes and communicates financial information

Necessity of Accounting:

Assess the present position or the results of business i.e. profit or loss.

Represent the financial stability of the business – stating the position of its assets and liabilities.

Prepare a comparative analysis of the financial results.

To take decision about declaring dividends, capital structure etc.

To estimate or asses the amount of Income Tax and Sales Tax.

The users of accounting Information

Decision Makers

Management:Finance

ProductionMarketing

Human ResourceInformation

System

Those who have Direct Financial

Interest:InvestorsCreditors

Those who have Indirect Financial

Interest:Tax Authorities

GovernmentUnions

CustomersEconomic Planners

Branches of Accounting

Financial Accounting: Generates reports and communicates them to decision

makers.

Management Accounting:The methods/system which help the management to

predict the future and in formulating future policies.

It ensures evaluation and analytical interpretation of accounting data.

Cost Accounting: It is the process of determining and accumulating the

cost of product or activity.

It is a process of accounting for the incurrence and the control of cost.

It also covers classification, analysis, and interpretation of cost.

Bases of Accounting:Cash system of accounting.

Mercantile or Accrual system of accounting.

Hybrid System of Accounting.

Accrual System of Accounting Accrual system of accounting focuses on both the cash

transaction and credit transaction, including accruals.

Entering the monetary transaction in the elementary books of accounts.

Both cash and credit transactions are recorded in the elementary books of accounts.

Posting from elementary books of accounts to the appropriate accounts in ledger.

Preparation of Trial Balance to check the mathematical accuracy of the ledger accounts.

Making adjustments for accruals at the end of the year.

Passing the closing entries for Nominal accounts which help in preparing Trading and Profit and Loss account.

Real and Personal accounts are balanced so as to have a projection of assets and liabilities in the balance sheet.

Difference between Accrual System and Cash System

Point of Difference Cash system Accrual System

1. Type of transaction Only cash transactions are recorded in the books of accounts

Both cash and credit transactions are recorded in the books of accounts.

2. Completeness of Records

Does not show all the monetary transactions.

Shows all the monetary transactions.

3. Suitability Does not suit in all type of business organizations.

Suits in every type of business organizations.

Concept of Accounting Year Shareholders are interested to know about the financial

performance of the organization at a regular interval.

Every business enterprise finalizes its books of accounts at a regular interval of twelve months..

Common accounting period from April 1 to March 31.

This period of twelve months is called accounting year/ financial year/fiscal year.

Finalization of accounts - closing the books of accounts so as to work out the profit/loss incurred for the year.

Accounting Concepts and Conventions

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 Concepts

Business Entity, Money Measurement, Going Concern, Accounting Period, Cost Concept, Duality Aspect concept, Realization Concept,Accrual Concept and Matching Concept.

Business Entity The owner of the business is always separated from business/

enterprise

Business is treated as a separate entity

All business records reports are developed separately and must be apart from their owner.

Shareholders are not liable for the enterprise’s debt beyond the capital.

Shareholders may transfer their shares without dissolving the business.

Money MeasurementAll transactions happening during an accounting period

Change in financial position of a company

Measurable in terms of money

E.g. accident of a general manager, sincerity, loyalty, honesty of employees are not recorded

These cannot be measured in terms of money ,they do affect the profits and losses of the business concern.

Going ConcernA business firm will continue to carry on its activities for an

indefinite period of time.

A firm is said to be going concern when there is neither the intention nor necessary to wind up its affairs.

Since business is to continue, fixed assets will be shown at cost less depreciation basis.

The going concern concept also implies that existing liabilities will be paid at maturity.

Cost ConceptAn asset will be recorded in the books at a cost i.e. a

price paid or to be paid for it.

The acquisition cost may be greater or less than the fair market price.

The assets are used in producing goods or services , its cost expires – Depreciation.

The cost of an asset is therefore allocated over the estimated economic life of the asset.

Dual Aspect Concept“For every debit, there is a credit".

Every transaction should have two sided effect to the extent of same amount.

For example, if A starts a business with a capital of `10,000.

On the one hand the business has assets of ` 10,000 while on the other hand the business has to pay to the proprietor a sum of ` 10,000 which is taken as proprietor's capital.

Realization Concept Emphasizes that profit should be considered only when

realized.

At what stage profit should be deemed to have accrued? - at the time of receiving the order or - at the time of execution of the order or - at the time of receiving the cash?

The revenue is earned only when the goods are transferred.

It means that profit is deemed to have accrued when possession of goods passes to the buyer, viz., when sales are made.

Accrual Concept

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.

Revenues are recognized when they become receivable though cash is received or not received

The expenses are recognized when they become payable though cash is paid or not paid.

Matching ConceptThe aim of business is to earn profit.

It becomes necessary to evaluate the performance periodically.

The revenues and costs of same period are matched.

Income made by the business during a period can be measured only when the revenue earned is compared with the expenditure incurred for earning that revenue.

The question when the payment was received or made is irrelevant.

Convention of Disclosure:The disclosure of all significant information to the reader.

“disclosure” does not imply that all information that any one could desire is to be included in accounting statements.

Sufficient disclosure of information which is of material in trust to the .

The disclosures can be in the way of foot notes. Within the body of financial statements, in the minutes of meeting of directors etc.

Convention of Materiality: It refers to the relative importance of an item or event.

Events or items having a significant bearing are recorded .

Accounting will be not be unnecessarily over burden with minute details.

No formula in making a distinction between material and immaterial events.

It is a matter of judgment and it is left to the accountant for taking a decision.

Convention of Consistency:Accounting practices should remain uncharged from one

period to another.

E.g. if depreciation is charged on fixed assets as per reducing balance method, it is to be followed every year.

This is necessary for the purpose of comparison.

However, consistency does not mean inflexibility.

It does not forbid introduction of improved accounting techniques. If a change becomes necessary, the change and its effect should be stated clearly.

Convention of Conservatism:Uncertainties and risks inherent in business transactions

should be given a proper consideration.

The possibility of loss, consider at the earliest and a prospect of profit, ignored up to the time it doesn’t materialize.

Follow the rule 'anticipate no profit but provide for all possible losses'.

E.g. the inventory is valued 'at cost or market price whichever is less. In case market price has gone down then provide for the 'anticipated loss' but if the market price has gone up then ignore the 'anticipated profits.'

Process of Accounting

Recording chronological manner

Transactions measurable in terms of money

Preparation of business documents.

Systematically recording of transactions - Journal

Classification and summarization of transaction – Ledger

Preparation of Trial Balance

Preparation of Profit and Loss account and Balance Sheet.

Types of Accounts

Personal account - represents persons and organizations.

Natural person Account

Artificial Persons Account – Firm, Company, Club,

Institution

Representative Person Account – Capital Account,

Drawings Account ,Outstanding Rent Account etc.

Real Account - represent assets

Tangible Real account – the assets which can be touched

and felt.

E.g. Buildings, Machinery, Cash, Furniture

Intangible real account – assets which can not be

touched and felt.

E.g. Goodwill, Trademarks and Patents

Nominal Account - represent expenses, losses,

incomes, gains

Personal account – Debit the receiver

Credit the giver

Real account – Debit what comes inCredit what goes out

Nominal account – Debit all expenses and lossesCredit all incomes and gains

Transactions Accounts involved

Nature of account

Account to be debited

Account to be credited

Started business with cash

CashCapital

RealPersonal

Cash Capital

Purchased goods

Goods,Cash

RealReal

Goods Cash

Purchased furniture

FurnitureCash

RealReal

Furniture Cash

Sold goods in cash

GoodsCash

Real Real

Cash Goods

Sold goods to Mr. K

KGoods

PersonalReal

K Goods

Paid for advertisement

AdvertisementCash

NominalReal

advertisement Cash

Transactions Accounts involved

Nature of account

Account to be debited

Account to be credited

Salaries paid SalariesCash

NominalReal

Salaries Cash

Wages paid WagesCash

NominalReal

Wages Cash

Rent paid RentCash

NominalReal

Rent Cash

Purchased computer

Computer Cash

RealReal

Computer Cash

Proprietor’s house rent paid

Drawings Cash

PersonalReal

Drawings Cash

Carriage paid Carriage Cash

NominalReal

Carriage Cash

Machinery purchased from Mr. B

MachineryMr. B

RealPersonal

Machinery Mr. B

Journal

Book of original entry

Daily transactions are recorded

Chronologically

With a description – narration

Subdivision into number of sub journals

Types of JournalsCash book

Purchase Book

Sales Book

Purchase Return Book

Sales Return Book

Bills Receivable Book/ Debtors

Bills Payable Book/ Creditors

Format of Journal

Date Particulars L/F AmountDebitRs.

AmountCredit Rs.

1.1.11 Cash a/c Dr. To. Capital a/c(Being capital introduced )

1,00,0001,00,000

Ledger

Concept of Financial Statements

Contain financial information of the enterprise

Total summary of books of account

To convey the owners, creditors and the general public about the financial position of the company.

Basis for decisions for all those interested in the company.

Concept of Financial StatementsManagement: To review company’s progress and decide

the courses of action .

Creditors: choose to extend, maintain or restrict credit.

Shareholders: