Unit i

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  • 1. FINANCIAL ACCOUNTING Accounting is a business language which elucidates the various kinds of transactions duringthe given period of time. Accounting is referred as “The Language of Business”. The basic function of alanguage is to communicate others. Here, Accounting performs this function. It communicatesthe result of business operations to the various parties viz., the proprietor, creditors, investors,Government and other agencies.American Institute of Certified Public Accountants Association (AICPA) defines the termaccounting as "Accounting is the process of recording, classifying, summarizing in asignificant manner of transactions which are in financial character and finally results areinterpreted."An analysis of the definition brings out the following functions of accounting: 1. RECORDING: Recording is done in the book of journal. 2. CLASSIFYING: Classification is concerned with the systematic analysis of the recorded data, With a view to group transactions or entries of similar nature. The work of classification is done in the book termed as “LEDGER” 3. SUMMARIZING: After classifying the data, the process of summarizing leads to the preparation of the following statements:  Trail balance  Income statement  Balance sheet 4. DEALS WITH FINANCIAL TRANSACTIONS: Accounting records only those transactions and events in terms of money which are of a financial character. Transactions which are not of a financial character are not recorded in the books of account. 5. ANALYSIS AND INTERPRETS: The recorded financial data is analyzed and interpreted in a manner that the businessman can make a meaningful judgment about the financial position and profitability of the business operations. 6. COMMUNICATES: The accounting information are communicated by way of preparation and distribution of accounting reports, income statement, balance sheet, accounting ratios, graphs, diagrams and fund flow statement, etc. 1
  • 2. Accounting is a combination of various functions RECORDING CLASSIFYING SUMMARIZING DEALS WITH FINANCIAL TRANSACTIONS ANALYSIS & INTERPRETS COMMUNICATESQualities of Accounting:  In accounting, transactions which are non- financial in character cannot be recorded  Transactions are recorded either individually or collectively according to their groups.  Users should be able to make use of information.UTILITY OF THE FINANCIAL STATEMENTS The financial statements are found to be more useful to many people immediately afterpresentation only in order to study the financial status of the enterprise in the angle of their ownobjectives.  To Management  To Shareholders, Security Analysts and Investors  To Lenders  To Suppliers  To Customers  To Govt., and Regulatory Authorities  To Promote Research and Development 2
  • 3. To Management The financial statements are most inevitable (unavoidable) for the management to take rationaldecisions to maintain the sustainability in the business environment among the other competitors.To Shareholders, Security Analysts and Investors The information extracted from the financial statements are processed by the above mentionedpeople to identify not only the financial status but also to determine the qualities of getting appropriaterate of return out of the prospective investment.To Lenders The lenders do study about the business enterprise through the available information of itsfinancial statements normally before lending. The aim of the study is to analyze the status of the firm forthe worthiness of lending with reference to the payment of interest periodicals and the repayment of theprincipal.To Suppliers The suppliers are in need of information about the business fleeces before sale of goods on credit.The Suppliers are very cautious in supplying the goods to the business houses based on the variouscapacities of themselves. The most important capacity required as well as expected from the buyer firmsis that prompt repayment of dues of the credit purchase from the suppliers. This quality of promptpayment could be known through culling out the information from the balance sheet. It mainly playspivotal role in answering the status inquiries about the buyerTo Customers The legal relationship of the transferability of ownership of the products is obviously understoodthrough financial information available in the statements. The agreement of warranty and guarantee istested through the financial status of the enterprise.To Govt., and Regulatory Authorities The taxes to be paid to the central and state govts on the revenues only through presentation ofinformation.To Promote Research and Development For research and development, the amount of investment required is voluminous, which has to bemobilized from either internally or externally to the requirement of the future prospects of the enterprise.OBJECTIVES OF ACCOUNTING  To keep systematic records  To protect the business operations from the loss  To ascertain the operational profit or loss  To ascertain the financial position of the business 3
  • 4. ACCOUNTING PRINCIPLES The transactions of the business enterprise are recorded in the business language, which routedthrough accounting. The entire accounting system is governed by the practice of accountancy. Theaccountancy is being practiced through the universal principles which are wholly led by the concepts andconventions. The entire principles of accounting are on the constructive accounting concepts and conventions Accounting Concepts Accounting Conventions Accounting PrinciplesACCOUNTING CONCEPTS The following are the most important concepts of accounting:  Money Measurement concept  Business Entity concept  Going Concern concept  Matching concept  Accounting Period concept  Duality or Double Entry concept  Cost conceptMoney Measurement Concept This is the concept tunes the system of accounting as fruitful in recording the transactions andevents of the enterprise only in terms of money. The money is used as well as expressed as a denominatorof the business events and transactions. The transactions which are not in the expression of monetaryterms cannot be registered in the book of accounts as transactions.  Recording of transactions are only in terms of money in the processBusiness Entity Concept This concept treats the owner as totally a different entity from the business. To put in to nutshell"Owner is different and Business is different". The capital which is brought inside the firm by the owner,at the commencement of the firm is known as capital. The amount of the capital, which was initiallyinvested, should be returned to the owner considered as due to the owner; who was nothing but thecontributory of the capital.  Owner and business organizations are two separate entities 4
  • 5. Going Concern Concept The concept deals with the quality of long lasting status of the business enterprise irrespective of theowners status, whether he is alive or not. This concept is known as concept of long-term assets. The fixedassets are bought in the intention to earn profits during the season of the business. The assets which areidle during the slack season of the business retained for future usage, in spite of that those assets arefrequently sold out by the firm immediately after the utility leads to mean that those assets are not fixedassets but tradable assets. The fixed assets are retained by the firm even after the usage is only due to theprinciple of long lastingness of the business enterprise. If the business disposes the assets immediatelyafter the current usage by not considering the future utility of the assets in the firm which will notdistinguish in between the long-term assets and short-term assets known as tradable in categories.  Accounting concept for long lastingness of the business enterpriseMatching Concept This concept only makes the entire accounting system as meaningful to determine the volume ofearnings or losses of the firm at every level of transaction; which is an outcome of matching in betweenthe revenues and expenses. The worth of the transaction is identified through matching of revenues whichare mainly generated from the sales volume and the expenses of the firm at every level.  Concept of fusion in between the expenses and revenuesAccounting Period ConceptThough the life period of the business is longer in span, which is classified into the operating periodswhich are smaller in duration. The accounting period may be either calendar year of Jan-Dec or fiscalyear of April-Mar. The operating periods are not equivalent among the trading firms, which means thatthe operating period of one firm may be shorter than the other one. The ultimate aim of the concept is tonullify the deviations of the operating periods of various traders in the trading practice. According to the Companies Act, 1956, the accounting period should not exceed more than 15months.  Concept of uniform accounting horizon among the firms to evade deviationsDuality or Double entry accounting concept It is the only concept which portrays the two sides of a single transaction. The law of entirebusiness revolves around only on mutual agreement sharing policy among the players.  Concept of mutual agreement and sharing of benefitsCost Concept It is the concept closely relevant with the going concern concept. Under this concept, thetransactions are recorded only in terms of cost rather than in market value. Fixed assets are only enteredin terms of the purchase price which is a original cost of the asset at the moment of purchase. Thedepreciation is deducted from the original value which is the initial purchase price of the asset willhighlight the book value of the asset at the end of the accounting period. 5
  • 6. ACCOUNTING CONVENTIONS Accounting conventions are bearing the practical considerations in recording the transactions of thebusiness enterprise in systematic manner. Convention of consistency Convention of conservatism Convention of disclosureConvention of consistency The nature of recording the transactions should not be changed at any cause or moment. It shouldbe maintained throughout the life period of the firm. If a firm follows the straight line method of chargingthe depreciation since its inception should be followed without any change. The firm should not alter themethod of charging the depreciation from one method to another. The change cannot be entertained. Ifany change has to be incorporated, the valid reason for change should be emphasized.Convention of conservatismThe conservatism won’t give any emphasis on the anticipation of the firm; instead it gives paramountimportance to all possible un eventualities of the firm without considering the future profits.Convention of disclosureAccording to this convention, the entire status of the firm should be highlighted / presented in detailwithout hiding anything; which has to furnish the required information to various parties involved in theprocess of the firm.BRANCHES OF ACCOUNTING Accounting may be classified mainly into THREE categories; viz;  Financial accounting  Management accounting  Cost accountingFINANCIAL ACCOUNTING Financial accounting is concerned with the recording of transactions for a businessenterprise or other economic unit and the periodic preparation of various reports from suchrecords. The reports may be for general purpose or specific purpose. The reports provide usefulinformation for the owners, share holders, creditors, banks and other agencies.MANAGEMENT ACCOUNTING It is accounting for the management i.e., accounting which provides necessaryinformation to the management for discharging its function. Management accounting is the application of professional information in such a way as toassist the management in the formation of policies and in the planning and control of theoperations of the business.COST ACCOUNTING Cost accounting emphasizes the determination and the control of costs. It is concernedwith the cost of manufacturing process and of manufactured products and also giving importanceof distribution costs. 6
  • 7. Classification of Accounts: The entire process of accounting brought under three major segments; which are broadly groupedinto two categories. The entire accounts of the enterprise are broadly classified into two categories viz.; PersonalAccounts and Impersonal Accounts. The Impersonal accounts are further classified into two categoriesviz.; Real accounts and Nominal accounts. ACCOUNTS PERSONAL ACCOUNTS IMPERSONAL ACCOUNTS REAL ACCOUNTS NOMINAL ACCOUNTSPersonal Accounts It is an account which deals with a due balance either to or from these individuals on a particularperiod. It is an account normally reveals the outstanding balance of the firm to individuals e.g. suppliersor outstanding balance from individuals e.g. customers. This is the only account which emphasizes thefuture relationship in between the business firm and the individuals .Real Accounts It is a major classification which highlights the real worth of the assets. This is the accountespecially deals with the movement of assets. It is an account not only reveals the value and movement ofthe assets taking place in between the firm and also other parties due to any transactions.Nominal Accounts This is an account deals with the amount of expenses incurred or incomes earned. It includes allexpenses and losses as well as incomes and gains of the enterprise. This nominal account records theexpenses and incomes which are not carried forwarded to near future. 7
  • 8. ACCOUNTING RULES PERSONAL Debit the Credit the ACCOUNTS Receiver Giver REAL Debit What Credit What ACCOUNTS comes in goes out NOMINAL Debit all the expenses Credit all incomes ACCOUNTS and losses and gainsJOURNAL ENTRY It is an entry systematically recorded to the tune of golden rules of accounting in the journal bookis known as journal entries.TRIAL BALANCE The statement (summary) of accounting balances and their names for the specified accountingperiod to the tune of principle of grouping transactions, known as Trial Balance. Trial Balance is a list of accounting balances and their names; of the enterprise during thespecified period which includes debit and credit balances of the various balanced ledger accounts out ofthe journal entries.Purposes of preparing the Trial Balance:  To prepare a statement of disclosure of final accounting balances of various ledger accounts on a particular date  To prepare a statement of cross checking device of accounting while in the process of posting of entries which mainly on the basis of Double entry accounting principle. It facilitates the accountant to have systematic posting of entries  It facilitates the enterprise for the preparation of Trading & Profit and Loss Accounts for the year ended…………….. and the Balance sheet as on dated ………………..  It provides the birds eye view of accounting balances of various ledger accounts during the specified period. 8
  • 9. TRADING ACCOUNT This is first financial statement prepared by the owner of the enterprise to determine the gross profitduring the year through the matching concept of accounting.The gross profit of the enterprise is calculated through the comparison of purchase expenses,manufacturing expenses, and other direct expenses with the sales.It is prepared normally for one year in accordance with accounting period concept i.e., operating cycle ofthe enterprise which should not exceed 15 months with reference to the Companies Act 1956.PROFIT & LOSS ACCOUNT It is a second statement of accounting in connection with the earlier to determine the Netprofit/loss of the enterprise out of the early found Gross profit/loss. This is an accounting statementmatches the administrative, selling and distribution expenses with the gross profit and other incomes ofthe enterprise.This is an account prepared for one operating cycle of the firm i.e. 12 months in period. The transactionsare recorded in accordance with golden rules of nominal account. In the profit & loss account, theexpenses and losses are debited and incomes and gains are credited. The reason for bringing down thegross loss /gross profit of the trading account into the debit and credit side of Profit & Loss A/crespectively, are only to the tune of nominal accounting ruling with reference to debit all expenses andlosses and credit all incomes and gains.BALANCE SHEET Balance sheet is the third financial statement which reveals the financial status of the enterprisethrough the total amount of resources raised and applied in the form of assets. This is the fundamentalstatement of the firm which explores the firm financial stature through the resources mobilized andinvestments applied i.e. Liabilities and Assets respectively. From the early, according to double entryconcept or Duality concept, the balance sheet can be divided into two distinct sides, known as liabilitiesand assets.Account: A record that holds the results of financial transactions.Accountants Equation: The equation that is the basis of the Balance Sheet: Assets =Liabilities + Owners Equity.Accounting: A service that oversees, measures, and evaluates financial information for decisionmaking purposes.Accounts Payable: Amounts due from your business to your creditors. Generally these are shortterm liabilities (30-120 days), and are shown under the Current Liabilities section in the BalanceSheet. Amount owed to a CREDITOR for delivered goods or completed services.Accounts Receivable: Amounts due to your business from your customers. Generally theseamounts are short term receivables (30-120 days), and are shown under Current Assets section inthe Balance Sheet. Claim against a DEBTOR for an uncollected amount, generally from a completedtransaction of sales or services rendered. 9
  • 10. Bad Debt: An uncollectible Account Receivable.Balance sheet: A balance sheet is an itemized statement which lists the total assets and the totalliabilities of a given business to show its net worth at a given moment in time (like a snapshot).Bank Reconciliation: Verification that your bank statement and your checkbook balance.Bad Debt: All or portion of an ACCOUNT, loan, or note receivable considered to beuncollectible.Balance Sheet: Basic financial statement, usually accompanied by appropriate disclosures thatdescribe the basis of accounting used in its preparation and presentation of a specified date theentitys assets, liabilities and the equity of its owners. Also known as “statement of financialcondition”.Bond: One type of long term promissory note, frequently issued to the public as a securityregulated under federal securities laws or state blue sky laws. Bonds can either be registered inthe owners name or are issued as bearer instruments.Book Value: Amount, net or contra account balances, that an asset or liability shows on thebalance sheet of a company. also known as carrying value.Budget: Financial plan that serves as an estimate of future cost, revenues or both.Current Asset: Asset that one can reasonably expect to convert into cash, sell, or consume inoperations within a single operating cycle, or within a year if more than one cycle is completedeach year.Current Liability: Obligation whose liquidation is expected to require the use of existingresources classified as current assets, or the creation of other current liabilities.Depreciation: Expense allowance made for wear and tear on an asset over its estimated usefullife.Intangible Asset: Asset having no physical existence such as trademarks and patents.Inventory: Tangible property held for sale, or materials used in a production process to make aproduct.Investment: Expenditure used to purchase goods or services that could produce a return to theinvestor.Journal: Any book containing original entries of daily financial transactions.Ledger: Any book of accounts containing the summaries of debit and credit entries. 10
  • 11. Lease: Conveyance of land, buildings, equipment or other assets from one person (lessor) toanother (lessee) for a specific period of time for monetary or other consideration, usually in theform of rent.Leasehold: Property interest a lessee owns in the leased property.Ledger: Any book of accounts containing the summaries of debit and credit entries.Lessee: Person or entity that has the right to use property under the terms of a lease.Lesser: Owner of property, the temporary use of which is transferred to another (Lessee) underthe terms of a lease.Letter of Credit: Conditional bank commitment issued on behalf of a customer to pay a thirdparty in accordance with certain terms and conditions. The two primary types are commercialletters of credit and standby letters of credit.Liability: debts or obligations owed by one entity (debtor) to another entity (creditor) payable inmoney, goods, or services.Liquid Assets: Cash, cash equivalents, and marketable securities.Liquidation: Winding up an activity by distributing its assets to the appropriate parties andsettling its debts.Long-Term Debt: Debt with a maturity of more than one year from the current date.Loss: Excess of expenditures over revenue for a period or activity.Margin: Excess of selling price over the unit cost.Marketable Securities: Stocks and other negotiable instruments which can be easily bought andsold on either listed exchanges or over the counter markets.Prepaid Expense: Cost incurred to acquire economically useful goods or services that areexpected to be consumed in the revenue earning process within the operating cycle.Tangible Asset: Assets having a physical existence, such as cash, land, buildings, machinery, orclaims on property, investments or goods in process.Working Capital: Excess of current assets over current liabilities. 11
  • 12. Assets: Economic resources owned or controlled by a person or company. An Asset is a propertyof value owned by a business. Physical objects and intangible rights such as money, accountsreceivable, merchandise, machinery, buildings, and inventories for sale are common examples ofbusiness assets as they have economic value for the owner. Accounts receivable is an unwrittenpromise by a client to pay later for goods sold or services rendered. Assets are generally listed on a balance sheet according to the ease with which they canbe converted to cash. They are generally divided into three main groups:  Current   Fixed   IntangibleCurrent Asset A current asset is an asset that is either:  Cash – includes funds in checking and savings accounts  Marketable securities such as stocks, bonds, and similar investments  Accounts Receivables, which are amounts due from customers   Notes Receivables, which are promissory notes bycustomers to pay a definite sum plus interest on a certain date at a certain place.  Inventories such as raw materials or merchandise on hand  Prepaid expenses – supplies on hand and services paid for but not yet used (e.g. prepaid insurance) In other words, cash and other items that can be turned back into cash within a year areconsidered a current asset.Fixed Assets Fixed assets refer to tangible assets that are used in the business. Commonly, fixed assetsare long-lived resources that are used in the production of finished goods. Examples arebuildings, land, equipment, furniture, and fixtures. These assets are often included under the titleproperty, plant, and equipment that are used in running a business. There are four qualitiesusually required for an item to be classified as a fixed asset. The item must be:  Tangible   Long -lived   Used in the business   Not be available for sale Certain long-lived assets such as machinery, cars, or equipment slowly wear out orbecome obsolete. The cost of such as assets is systematically spread over its estimated usefullife. This process is called depreciation if the asset involved is a tangible object such as abuilding or amortization if the asset involved is an intangible asset such as a patent. Of thedifferent kinds of fixed assets, only land does not depreciate. 12
  • 13. Intangible Assets Intangible Assets are assets that are not physical assets like equipment and machinery butare valuable because they can be licensed or sold outright to others. They include cost oforganizing a business, obtaining copyrights, registering trademarks, patents on an invention orprocess and goodwill. Goodwill is not entered as an asset unless the business has beenpurchased. It is the least tangible of all the assets because it is the price a purchaser is willing topay for a company’s reputation especially in its relations with customers.Liabilities A Liability is a legal obligation of a business to pay a debt. Debt can be paid with money,goods, or services, but is usually paid in cash. The most common liabilities are notes payable andaccounts payable. Accounts payable is an unwritten promise to pay suppliers or lenders specifiedsums of money at a definite future date. Current Liabilities Current liabilities are liabilities that are due within a relatively short period of time. Theterm Current Liability is used to designate obligations whose payment is expected to require theuse of existing current assets. Among current liabilities are accounts payable, notes payable, andaccrued expenses. These are exactly like their receivable counterparts except the debtor-creditorrelationship is reversed.Accounts Payable is generally a liability resulting from buying goods and services oncredit Suppose a business borrows $5,000 from the bank for a 90-day period. When themoney is borrowed, the business has incurred a liability – a Note Payable. The bank mayrequire a written promise to pay before lending any amount although there are many creditplans, such as revolving credit where the promise to pay back is not in note form. On the other hand, suppose the business purchases supplies from the ABC Company for$1,000 and agrees to pay within 30 days. Upon acquiring title to the goods, the business has aliability – an Account Payable – to the ABC Company. In both cases, the business has become a debtor and owes money to a creditor. Othercurrent liabilities commonly found on the balance sheet include salaries payable and taxespayable. Another type of current liability is Accrued Expenses. These are expenses that have beenincurred but the bills have not been received for it. Interest, taxes, and wages are some examplesof expenses that will have to be paid in the near future.Long-Term Liabilities Long term liabilities are obligations that will not become due for a comparatively longperiod of time. The usual rule of thumb is that long-term liabilities are not due within one year.These include such things as bonds payable, mortgage note payable, and any other debts that donot have to be paid within one year. You should note that as the long-term obligations come within the one-year range theybecome Current Liabilities. For example, mortgage is a long-term debt and payment is spreadover a number of years. However, the installment due within one year of the date of the balancesheet is classified as a current liability. 13
  • 14. Capital Capital, also called net worth, is essentially what is yours – what would be left over ifyou paid off everyone the company owes money to. If there are no business liabilities, theCapital, Net Worth, or Owner Equity is equal to the total amount of the Assets of the business.Financial Statements In order to manage your business effectively you need reports that tell you how yourbusiness is performing. For example, you may want to know the value of your assets like, Cashyou have on hand, Cash in bank, and Inventory in stock. In addition, you would like to know thevalue of your liabilities, loans, income earned, and expenses incurred. Accountants preparefinancial statements that summarize these transactions. Two of the most important reports formanaging your business are Income Statement and the Balance Sheet.INCOME STATEMENT An Income Statement is also called a Profit and Loss Report. In addition, the wordRevenue is often used in place of the word Income. An Income Statement is used to inform youabout the income earned, expenses incurred, and the total profit or loss in a particular period.Two common periods for creating an income statement are monthly and annually. This report summarizes all Income (or sales), the amounts that have been or will bereceived from customers for goods delivered or services rendered to them, and all expenses, thecosts that have arisen in generating revenues. To show the actual profit or loss of a company, theexpenses are subtracted from the revenues to show the net income – profit or the “bottom line”.BALANCE SHEET A Balance sheet is like a “snapshot” that gives you the overall picture of the financialhealth of a company at one moment in time. This report lists the assets, liabilities, and owner’sequity in the business. Unlike the income statement, this report is always created to show thefinancial status as of a certain date. Two common ending periods to create a balance sheet are theend of a month and the end of the year. The Balance Sheet has two sections. The first section lists all the Asset accounts and theirbalances. At the end of the list, the totals of all assets are listed. In the second section, theLiability and Owner’s Equity accounts are listed. There are two sub-totals for the Liability andthe Equity accounts. At the end, there is a combined total of the Liabilities and Owner’s Equity.As discussed earlier in the accounting equation, the Assets equal the sum of the Liabilities andthe Equities. You will also notice that the Profit from the income statement is listed in the Equitysection of the balance sheet. Some of the important accounts in the balance sheet are:Current Assets: Current assets are always listed first and include cash and other items that can beconverted into cash within the following year. This includes funds in checking and savingsaccounts. 14
  • 15. Accounts Receivable: Accounts Receivable represents money owed to the business. These usually result fromthe sale of merchandise or performance of services for a client on account. The phrase onaccount indicates that on the date the goods were sold to the client, or the service performed forhim, the business did not receive full payment. However, it did obtain an asset – the right tocollect payment for merchandise sold or Services performed. The claim a business has against acredit client is referred to as an Account Receivable. It is an asset because it represents a legalclaim to cash.Inventory: Inventories may represent merchandise purchased for resale as well as the raw materialsacquired by a manufacturing firm to put into the product. In the case of a manufacturer, the terminventories also includes manufacturing supplies, purchased parts, the work that is in process,and finished goods. Inventory is also an asset account.Accounts Payable: When you purchase goods or services on account, you are usually required to pay withina fixed period of time. These amounts you owe for the goods or services purchased are calledaccounts payable. The payment of these purchases is usually due within a relatively short periodof time. Usually this period is one year or less. Typical periods are thirty to sixty days. Thepayment for these short-term liabilities requires the use of existing resources like the Cash or TheChecking Account. 15