Financial Accounting Introduction


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Financial Accounting Introduction

  1. 1. UNIT-I: Accounting and Economic Decisions UNIT-I: Accounting and Economic Decisions- Definition - uses of accounting – financial and management accounting – principles – GAAP- Accounting equation – Financial statements. Definition Accounting is often called the language of business. The functions of a language are to facilitate communication among individuals in a society. Accounting is the common language used to communicate financial information from one person to another in the world of industry and commerce. Accounting provides “information that is useful in making business and economic decisions for making reasoned choices among alternatives uses of scarce resources in the conduct of business and economic activities.” It is the principal means of communicating financial information to owners, lenders, managers, and any others who have an interest in an enterprise. American Accounting Association states, “essentially, accounting is an information system.” Uses of Accounting Accounting information is useful in making no .of decisions that affect the income or wealth of individuals and organizations. Examples of decisions that are based on accounting information include the following: • Decide when to buy, hold or sell an equity investment. • Assess the stewardship or accountability of management. • Assess the ability of the enterprise to pay and provide other benefits to its employees. • Assess the security for amounts lent to the enterprise. • Determine taxation policies. • Determine distributable profits and dividends. • Prepare and use national income statistics • Regulate the activities of enterprises.
  2. 2. Users of Accounting Information Investors The investors are the major recipients of the financial statements of business. Accounting information enables investors to identify promising investment opportunities. They need information to decide which investments to buy, retain, or sell, as well as the timing of the purchases or sales of those investments. They also need information to monitor management performance and to assess the ability of the enterprise to pay dividends. Lenders Lenders such as banks and debenture holders need to know about the financial stability of a business that approaches them for funds. They are interested in information that would enable them to determine whether their borrowers will be able to repay the loans and pay the related interest on time. Security Analysts, Rating Agencies and Other Information Specialists Investors and creditors seek the assistance of information specialists in assessing prospective returns. These information specialists serve the needs of investors by providing them with skilled analysis and interpretation of financial reports. • Security analysts collect information about firms also through other means such as face-to-face meetings and conference calls with company executives and field visits. • Sell-side analysts work for brokerage houses, investment banks and independent research firms who use their reports to recommend to their clients whether to buy, sell or hold their investments. • In contrast, buy-side analysts produce research reports for in-house use by mutual funds and other investment firms where they are employed. Managers Managers need information for planning and controlling operations, for making special decisions, and for formulating major plans and policies. They use to evaluate potential investment projects. Since managers are responsible for reporting enterprise performance to owners and others, they monitor the key financial indicators that appear in the financial reports. Besides, they compare their firm’s performance with that of their competitors’ performance.
  3. 3. Employees and Trade Unions Employees are keen to know about the enterprise’s general operation, stability and profitability. Current Employees have a natural interest in the financial condition of the enterprise because, often, their compensation income will depend on the financial performance of the firm. Potential Employees may use financial information in order to gauge the enterprise’s prospects. Past Employees, who depend on their former employer for their post- retirement benefits. Trade unions use financial reports for negotiating enhancements in wages, bonus and other benefits. Suppliers and Trade Financiers Suppliers regard the enterprise as an outlet for their products or services. They use financial information to assess the likelihood for the enterprise continuing to buy from them. Trade financiers provide short-term financial support. Customers Present, prospective and past customers use information about the financial affairs of an enterprise in deciding whether business has anything to do with it and how much. Government and Regulatory Authorities The three levels of government in India – Central, state and local – allocate resources and are concerned with the activities of enterprises. They require information in order to regulate the business practices of enterprises, determine taxation policies, and provide a basis for national income and similar statistics. Ex: Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) etc. The Public Enterprises affect members of the public in a variety of ways. Financial statements assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities.
  4. 4. Financial and Management Accounting Financial Accounting is the preparation and communication of financial information for use primarily by those outside the enterprise. Its chief purpose is to provide information about the performance of ht enterprise’s management to its owners. Management Accounting is the preparation and communication of financial and other information to the management, which helps it carry out its responsibilities in planning and controlling operations. It is more detailed and timely that that is available to external users. Principles of Accounting Accounting is an act of recording, classifying, summarizing the transactions which are at financial in nature and interpret the results thereof. Concepts 1) Business Entity Concept: This concept implies that the business is distinct from the owners. If the owner takes cash or goods from the business, the drawings account is debited and cash or goods account is credited otherwise the personal & business transactions will get mixed up and the accounting statements become confused. Assets = Liabilities + Capital 2) Money Measurement Concept: All recording of accounting are done in terms of standard currency of the country where the business is setup. All the transactions and events which are expressed in terms of money are recorded in the books of account. 3) Cost Concept: Usually all the transactions will be recorded as cost in books. However, at the end of every year the accountant show the reduced value of the assets, after providing for depreciation. This approach is preferred because it is difficult & time consuming to ascertain the market values.
  5. 5. 4) Dual Aspect Concept: This concept explains that each transaction has two fold effect, the receiving of the benefit the giving of the benefit. The receiving aspect is termed as debit and giving aspect is termed as credit. For every debit there will be corresponding credit. A famous elictus says that every receiver is also a giver and every giver also a receiver. Liabilities (Equities) = Assets (Or) Capital + Outsider Liabilities = Assets 5) Going Concern Concept: It is assumed that the business will continue for a long time. With this assumption fixed assets are recorded in the books at their original cost. Keeping this assumption in view prepared expenses are not treated as the expenses of the year in which they are incurred. It is assumed that the business derives and benefit out of it in the year to come. 6) Material Concepts: Under this concept the trader recording important about the commercial activities in the form of financial statements. If any unimportant information is to be given for the sake of clarity. It will be given as footnotes. 7) Matching Cost Concept: The concept deals with matching of cost, first being the revenue recognition, determining net income from business operations, all costs which are applicable to revenue of period should be charged against that revenue. Conventions 1) Conservation: This convention warns the trader not to take unrealized income into account i.e., why the practice of valuing stock at cost or market price whichever is lower is in vague. This is the policy of playing safe. It takes into consideration all prospective losses but leaves all prospective profits. 2) Consistency: The methods or principles followed in the preparation of various accounts should be followed in the year to come. It means that there should be consistency in the methods or principles followed or else the results of one year cannot be continently compared with that of another. 3) Disclosure: This concept deals with the convention that all information which is of material importance should be disclosed in the accounting statements. The Company’s Act 1956 makes it compulsory to provide all the information in the prescribed form.
  6. 6. Generally Accepted Accounting Principles (GAAP): The set of conventions, rules, and procedures that define accepted accounting practice is referred to as Generally Accepted Accounting Principle. GAAP represents the fundamental positions that have been generally agreed upon, often tacitly, by accountants and encompasses contemporary permissible accounting practice. GAAP includes accounting measurement assumptions – accounting entity, going concern, money measurement and periodicity – and has been evolved in response to the economic circumstances of users of information. The Accounting Equation The accounting equation shows the relationship between the economic resource of a business and the claims against those resources. Economic Resource = Claims Another term for Economic Resources is Assets. The Claims consists of creditors’ claims, or liabilities and owners’ claims or equity. The accounting equation may now be modified as follows: Assets = Liabilities + Equity Assets: These are resources “controlled by the enterprise as a result of past events from which future economics benefits are expected to flow to the enterprise.” Ex: Cash, Investments, land, building and plant and machinery. Liability: It is “a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resource embodying economic benefits.” Ex.: Loans Payable, salaries payable, estimated warranty obligation, pensions payable, and income tax payable. Equity: It is “the residual interest in the assets of the enterprise after deducting all its liabilities.” The equity of a company is called shareholders’ equity. Its components include share capital, share premium, and retained profits.
  7. 7. Financial Statements It provides information about an enterprise’s revenues, expenses, assets, liabilities, and equity. A complete set of financial statements normally consists of a balance sheet, a profit and loss accounts, a cash flows statements, notes, and related statements and explanatory material. Business enterprises publish three major financial statements: • The Profit and Loss account reports the financial performance of an enterprise during a period. • The Balance Sheet shows the financial position of the enterprise at a point in time. • The Cash flow statement summarizes the cash inflows and outflows of the business enterprise resulting from its operations, investing, and financing activities during a period. Check following material if needed. The below material is not necessary for Gitam University Meaning of Management Accounting: Management accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control functions. In contrast to financial accountancy information, management accounting information is: • designed and intended for use by managers within the organization, whereas financial accounting information is designed for use by shareholders and creditors. • usually confidential and used by management, instead of publicly reported; • forward-looking, instead of historical; • Computed by reference to the needs of managers, often using management information systems, instead of by reference to financial accounting standards. According to the Chartered Institute of Management Accountants (CIMA), Management Accounting is "the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its Resource (economics)resources. Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory agencies and tax authorities" (CIMA Official Terminology).
  8. 8. The American Institute of Certified Public Accountants(AICPA) states that management accounting as practice extends to the following three areas: Strategic Management—Advancing the role of the management accountant as a strategic partner in the organization. Performance Management—Developing the practice of business decision- making and managing the performance of the organization. Risk Management—Contributing to frameworks and practices for identifying, measuring, managing and reporting risks to the achievement of the objectives of the organization. The Institute of Certified Management Accountants (ICMA), states "A management accountant applies his or her professional knowledge and skill in the preparation and presentation of financial and other decision oriented information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking. Management Accountants therefore are seen as the "value-creators" amongst the accountants. They are much more interested in forward looking and taking decisions that will affect the future of the organization, than in the historical recording and compliance (scorekeeping) aspects of the profession. Management accounting knowledge and experience can therefore be obtained from varied fields and functions within an organization, such as information management, treasury, efficiency auditing, marketing, valuation, pricing, logistics, etc. Nature of Management Accounting Characteristics of Management Accounting: 1. It is a selective technique. It compiles only the data from balance sheet and profit and loss, which is relevant and useful. 2. It is concerned with data not decisions. It can inform but not prescribe. 3. It deals with future. It is a kind of planning for the future because decisions are taken for future course of action. 4. It examines the cause and effect of relationship. Normally, a profit and loss account will show the amount of profit or loss for the year but does not tell us the reasons for it. Management accounting studies the causes of
  9. 9. profit or losses. 5. It does not follow rigid rules and formats like financial accounting. The necessary info is provided in the shape of various statements or reports in order to meet the needs of the management. Objectives of Management Accounting: 1. To help the management in promoting efficiency. 2. To finalize budgets covering all functions of a business. 3. To study the actual performance with plan for identifying deviations and their causes. 4. To analyze financial statements to enable the management to formulate future policies. 5. To help the management at frequent intervals by providing operating statements and short-term financial statements. 6. To arrange for the systematic allocation of responsibilities for the implementation of plans and budgets. 7. To provide a suitable organization for discharging the responsibilities. Scope of Management Accounting: 1. Financial accounting: Related to the recording of business transactions including income, expenditure, inventory movement, assets, liabilities, cash receipts, etc. 2. Cost accounting: Costing is a branch of accounting. It is the process of and technique of ascertaining costs. It includes standard costing, marginal
  10. 10. costing, differential and opportunity cost analysis. 3. Budgeting and forecasting: Covers budgetary control 4. It reports financial results to the management 5. It provides statistical data to various departments. Functions of Management Accounting: 1. It assists in planning and formulating future policies. 2. It helps to interpret and analyze the financial information. 3. It controls and monitors performance. 4. It helps to organize various functions of an organization. 5. It offers solution for strategic business problems. 6. It coordinates various departmental operations. 7. It motivates employees. Functions of management Accountant: 1.Collection of data 2.Analysis 3.Presentation of data 4. Planning: A management accountant plans the entire accounting functions. 5. Controlling: Examines the performance against the set standard and reports it to the management. 6. Reporting: He reports to the management and advises them on future decisions. 7.Coordinating: preparation of master budget 8.Decision making