Financial Systems and Auditing                                             Unit – 1Unit – 1                               ...
Financial Systems and Auditing                                           Unit – 1in his Arthshastra, the existence and the...
Financial Systems and Auditing                                              Unit – 11.2 Accounting ConceptsAccounting is t...
Financial Systems and Auditing                                               Unit – 1v) Dual aspect concept: Each transact...
Financial Systems and Auditing                                                 Unit – 11.3 Conventions regarding financial...
Financial Systems and Auditing                                              Unit – 1over the costs being incurred. Cost ac...
Financial Systems and Auditing                                                Unit – 1b) Impersonal Accounts:     i) Real ...
Financial Systems and Auditing                                                  Unit – 1The same company portrays its fina...
Financial Systems and Auditing                                                Unit – 1Balance Sheet. The assets of the com...
Financial Systems and Auditing                                                Unit – 1The Balance Sheet records on one sid...
Financial Systems and Auditing                                             Unit – 1     be treated as revenue for the curr...
Financial Systems and Auditing                                           Unit – 1and existing shareholders may have opposi...
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  1. 1. Financial Systems and Auditing Unit – 1Unit – 1 Financial SystemsStructure1.1 Introduction1.2 Accounting Concepts1.3 Conventions regarding Financial Statements1.4 Branches of Accounting1.5 Systems1.6 Financial Statements and their nature1.7 Accounting StandardsLearning ObjectivesAfter reading this unit, one should be able to understand: The financial Systems. The financial Statements. Accounting Concepts. Accounting Standards.1.1 IntroductionA business house must necessarily keep a systematic record of what happensfrom day-to-day so that it can know where it stands and so that it can satisfy theever increasing curiosity of the income tax officer, if nothing else. Most of thebusiness these days is run by joint stock companies and these are required bylaw to prepare periodical, mostly annual, statements in proper form showing thestate of financial affairs. A systematic record of the daily events of a businessleading to presentation of a complete financial picture is known as accounting.Accounting is an ancient art. Certainly as old as money itself even though the artmust have been rudimentary in the beginning. Chankya in India clearly indicates,Sikkim Manipal University Page No.: 1
  2. 2. Financial Systems and Auditing Unit – 1in his Arthshastra, the existence and the need of proper accounting and audit.The Indian system of accounting is as scientific and systematic as the onedeveloped in the west and is certainly older.Accounting system helps the management to know their financial transaction andpositions. Besides the management there are numerous other parties interestedin the financial statements. These are the following:1) Shareholders: In the case of Companies, shareholders come to know of the results of operations and financial position of the company only through the annual statements showing the profits earned (or loss suffered) and assets and liabilities.2) Investors: Those who are interested in buying the shares in a company or in advancing money to the company are also naturally interested in the financial statements.3) Creditors: A number of suppliers make supplies on credit. They also would like to be satisfied that they will be paid on time. The financial statements greatly help them in properly assessing the capability of the firm or the institution to do so.4) Labour: Employees are also much interested in knowing the profit earned or loss suffered by the firm. This knowledge also helps them in conducting negotiations for bonus or wages.5) Government: Governments all over the world are using financial statements for compiling statistics concerning business which, in turn, help in compiling national accounts. The statements are obivious importance for ascertaining the income tax payable.6) Researchers: The financial statements, being mirror of business conditions are of inestimable value to research into business affairs.Sikkim Manipal University Page No.: 2
  3. 3. Financial Systems and Auditing Unit – 11.2 Accounting ConceptsAccounting is the language of business; affairs of a business unit arecommunicated to others as well as to those who own or manage it throughaccounting information which has to be suitably recorded, classified, summarisedand presented. To make the language convey the same meaning to all people,as far as practicable and to make it full of meaning, accountants have agreed ona number of concepts which they try to follow. These are: i) Business Entity Concept: Accountants treat a business as distinct from the persons who own it; then it becomes possible to record transactions of the business with the proprietor also. Without such a distinction, the affairs of the firm will be all mixed up with the private affairs of the proprietor and the true picture of the firm will not be available. The concept has now been extended to accounting separately for various divisions of a firm in order to ascertain the results for each division separately. It has been of immense value in determining results by each responsibility centre – Responsibility accounting.ii) Money measurement concept: Accounting records only those transactions which are expressed in monetary terms, though quantitative records are also kept. It should be remembered that money enables various things of diverse nature to be added up together and dealt with.iii) Cost concept: Transactions are entered in the books of account at the amounts actually involved. Suppose a firm purchases a piece of land for Rs. 1,00,000 but considers it as worth Rs. 2,00,000. The purchase will be recorded at Rs. 1,00,000 and not any more. This is one of the most important concepts – it prevents arbitrary values being put on transactions, chiefly those resulting in acquisition of assets.iv) Going concern concept: It is assumed that the business will exist for a long time and transactions are recorded from this point of view.Sikkim Manipal University Page No.: 3
  4. 4. Financial Systems and Auditing Unit – 1v) Dual aspect concept: Each transaction has two aspects; if a business has acquired an asset, it must have resulted in one of the following: a) some other asset has been given up; or b) the obligation to pay for it has arises; or, rather c) there has been a profit, leading to an increase in the amount that the business owes to the proprietor or d) the proprietor has contributed money for the acquisition of the asset. The reverse is also true. If for instance, there is an increase in the money owed to others, there must have been an increase in assets or loss. At any time: Assets = Liabilities + Capital or rather; Capital = Assets – Realisation concept: Accounting is a historical record of transactions; it records what has happened. It doesnot anticipate events though anticipated adverse effects of events that have already occurred are usually recorded. This is if great importance in stopping business firms from inflating their profits by recording sales an incomes that are likely to accrue. Unless money has been realised – either cash has been received or a legal obligation to pay has been assumed by the customer – no sale can be said to have taken place and no profit or income can be said to have arisen.vii) Accrual concept: If an event has occurred or a transaction has been entered into, its consequences will follow. Normally, all transaction are settled in cash but even if cash settlement has not yet taken place, it is proper to bring the transaction or the event concerned into the books. Income or profit arises only out of business operations – when there has been an increase in the owner’s share of the assets of the firm (called owner’s equity) but not if the increase has resulted from money contributed by the owner himself. Any increase in the owner’s equity is called revenue and anything that reduces the owner’s equity is expense (or loss) profit results only when the total of revenues exceeds the total of expenses or losses.Sikkim Manipal University Page No.: 4
  5. 5. Financial Systems and Auditing Unit – 11.3 Conventions regarding financial statements i) Consistency: The accounting practices should remain the same from one year to another – for instance, it would not be proper to value stock-in-trade according to one method one year and according to another method next year. If a change becomes necessary, the change and its effect should be stated clearly.ii) Disclosure: Apart from legal requirements good accounting practice also demands that all significant information should be disclosed. Not only various assets, for example, have to be stated but also the mode of valuation should be disclosed. Various types of revenues and expenses properly grouped must also be disclosed. Whether something should be disclosed or not will depend on whether it is material or not. Materiality depends on the amounts involved in relation to the asset or transaction group involved or to profits.iii) Conservation: Financial statements are usually drawn up on rather a conservative basis, windowdressing i.e. showing a position better than what it is, is not permitted. It is also not proper to show a position substantially worse than what it is. In other words, secret reserves are not permitted.1.4 Branches of AccountingThe accounting system, as developed originally, concerned only the financialstate of affairs and the financial results of operations. This is called FinancialAccounting. It includes preparation of accounts, generally on historical basis, soas to enable the management to prepare the financial statements showing theresults of operations and the financial state of affairs, to exercise full control overthe property and assets of the firm or the institution concerned and to preparereturns and statements concerning taxation.Cost accounting developed because of the limitations of financial accounting inrespect of information relating to the cost of individual jobs etc. This informationis needed for purposes of making numerous decisions and for exercising controlSikkim Manipal University Page No.: 5
  6. 6. Financial Systems and Auditing Unit – 1over the costs being incurred. Cost accounting basically involves estimating costin advance and detailed analysis.A third branch of accounting is Management Accounting. It means suchaccounting as will enable management to discharge its functions properly, chieflyin respect of forecasting and budgeting, control over costs and revenues anddecisions, both routine and strategic.1.5 SystemsThere are two systems for recording transactions – Single Entry System andDouble Entry System. Single Entry System sounds economical but is really costlybecause it is rather a lack of system. The only real system is Double EntrySystem.This system recognises the fundamental fact that a transaction is a double sidedaffair. If one receives something, then either (a) some other person has given itor (b) stock of something else has diminished or (c) some services has beenrendered. If one ‘loses’ something in the sense that either cash (or its equivalent)has to be given up, then a corresponding benefit must have been receivedunless it is just bad luck. For good and accurate results, a transaction should berecorded in both the aspects. This is what is done in the Double Entry Systems.Cash and Mercantile System: In the cash system of accounting, entries aremade only when cash is received or paid, no entry being made when a paymentor receipt is merely due. In the mercantile system, a record is made on the basisof amounts having become due for payment or receipt. The mercantile system isbetter normally since it takes into account the amounts that become due. This isnecessary for preparing financial statements on proper lines. It is required underthe accrual concept stated earlier.Classification of Accountsa) Personal Accounts i.e. accounts of persons (Creditors, Customers etc.)Sikkim Manipal University Page No.: 6
  7. 7. Financial Systems and Auditing Unit – 1b) Impersonal Accounts: i) Real Accounts (i.e. accounts of properties and assets) and ii) Nominal Accounts i.e., accounts of incomes, expenses or losses.Trial Balance: It has been seen how every amount that is placed on the debitside of an account has a corresponding entry on the credit side of some otheraccount. This is the technical aspect of the principle of double entry system. Thisbeing the tax, it is but natural that the total of all the debit balances should agreewith the total of all credit balances. In fact, all business periodically tabulate thedebit and credit balances separately in a statement to see whether the total ofdebit balances agrees with the total of credit balances or not. Such a statement isknown as the Trial Balance.1.6 Financial Statement and their NatureBelow is an extract from the final accounts of a joint stock company – Profit and Loss Account for the year ended March 31, 2001 Rs. Rs.Sales 38,87,06,260Less: Consumption of materials 19,50,70,709 Consumption of stores and spare parts 5,74,57,152 Salaries, Wages, Bonus and Commission 4,40,45,934 Depreciation 45,75,465 Other expenses 5,78,11,660 35,89,60,920 Trading Profit 2,97,45,340Sikkim Manipal University Page No.: 7
  8. 8. Financial Systems and Auditing Unit – 1The same company portrays its financial position as on March 31, 2001 asfollows through its Balance Sheet:Fixed Assets, at cost less depreciation 4,43,93,388Capital work in progress 52,51,620Total Fixed Assets 4,96,45,008Investments 4,000Current assets: Stocks, Stores and Spare parts 3,43,41,673 Sundry Debtors 1,13,83,095 Cash and Bank balances 1,79,92,501 Loans and Advances 3,57,48,772 9,94,66,041 14,91,15,049Less: Current Liabilities 6,86,14,371 8,05,00,678Less: Loan Funds 48,32,548Shareholders’ Funds 7,56,68,130What the company wishes to state is that various customers bought goods fromthe company for Rs. 38.87 crores and paid or payable to the company. Further,the costs incurred by the company totalled Rs. 35.90 crore for which except forRs. 45.75 lakh representing wear and tear of machinery etc. called depreciation,the company paid or will pay cash; no payment being involved for depreciation.The operations of manufacture and sale of goods resulted in a profit of Rs. 2.97crore out of which the company will deduct the interest and income tax payableby it; the balance will be net profit and will belong to the shareholders.The Balance Sheet figures show that the shareholders of the companycollectively own Rs. 7.57 crore. The company owes Rs. 48.32 lakh by way ofloans, presumbly due for repayment only in the long run and Rs. 6.86 crore ascurrent liabilities i.e. payment is due to be made within one year if the date of theSikkim Manipal University Page No.: 8
  9. 9. Financial Systems and Auditing Unit – 1Balance Sheet. The assets of the company total Rs. 14.91 crore of whichRs. 4.96 crore represent fixed assets, installed a being installed, that is, assetsacquired for use in production of goods and not for resale or conversion intofinished goods Rs. 9.95 crore worth of assets are “current” – either cash orassets which are meant to be converted into cash within one year. Sundrydebtors, customers who purchased goods but have not yet paid for them, will payRs. 1.14 crore. Stocks of material, stores etc. total Rs. 3.43 crore; these will beconverted into finished goods for sale to customers. Amounts advanced tovarious parties for various parties, for example, advances to suppliers ofmaterials total Rs. 3.57 crore.Trial balance provides the basic information for preparing the two statements –the Profit and Loss Account and the Balance Sheet.The Profit and Loss Account, also called the Income Statement and Income andExpenditure Account in the case of non-profit organisations, should be drawn insuch a manner as to enable those who go through it carefully to have a fair ideaof the results of the day to day operations (like producing goods and sellingthem) together with significant details. In case of a Joint Stock Company, theProfit and Loss Account is legally required to give a true and fair view of the profitearned or loss suffered during the year. The Balance Sheet, similarly is requiredin case of joint stock companies to give a true and fair view of the financialposition at the end of the year.Those who study the Balance Sheet should be able to judge whether the firm orinstitution is financially sound or not.Profit and Loss Account gives information about(1) The revenue or income earned and other gains made by the concern and(2) Money spent to earn the revenue or incomes and other losses that may have been suffered.The difference between the above 1 and 2 is profit if first one is bigger or loss inother case.Sikkim Manipal University Page No.: 9
  10. 10. Financial Systems and Auditing Unit – 1The Balance Sheet records on one side what the firm possesses, called assets.Assets may be convertible into cash or they may enable the firm to carry on itswork. On the other side is recorded the sources from which the necessary fundshave been derived – contribution by the proprietors (Capital) and loans raisedand credit received from outsiders. The balance sheet may also be looked uponas indicating the total of the resources placed at the disposal of the firm andshowing how the resources have been utilized. There is a view, called the Assetsand Liabilities view, of Profit or Loss derived from the change in the net economicresources of a business for a period. The measurement of profit proceeds from astatement of assets and liabilities on the relevant dates; profit or loss equals thechange in the net resources (or the net assets) of the undertaking. The BalanceSheet, in this view, will gain prominancy over the Profit and Loss Account.The two statements Profit and Loss Account and Balance Sheet are inter linked –the balance sheet portrays the financial position while the profit and loss accountsupplies much, though not all, of the explanation of the causes leading to thechange in the financial position. The basic principle to prepare the financialstatements is called the “Matching Principle”: Without the application of thisprinciple, neither the Profit and Loss Account nor the Balance Sheet can betreated as true and fair.Matching Principle: According to this principle, the revenues and relevantexpenses incurred should be correlated and matched so that a complete pictureis available. The implications of the principle are the following: (i) When an item of revenue is entered in the profit and loss account, all the expenses incurred should be set down on the expenses side.(ii) If an amount is spent but against it revenue will be earned in the next period, the amount should be carried forward to the next period (and shown in the balance sheet as an asset) and then in the next year treated as an expense.(iii) If an amount of revenue nature is received but against the services which is to be rendered or goods are to be supplied in future, the amount must notSikkim Manipal University Page No.: 10
  11. 11. Financial Systems and Auditing Unit – 1 be treated as revenue for the current year but only next year – for current year, it will be shown as liability.It should be noted that losses, against which no revenue is earned or expected tobe earned should be charged off to the profit and loss account in the year inwhich they are incurred.1.7 Accounting StandardThe Institute of Chartered Accountants of India has issued, an accountingstandard called AS – 9 on Revenue Recognition. This accounting standard wasissued in November, 1985. It has been made mandatory in respect of accountsfor periods commencing on or after 1-4-1991. This accounting standard assumesthat three fundamental accounting assumptions i.e. going concern, consistencyand accrual have been followed in the preparation and presentation of financialstatements.Utility of Accounting Standards: The Management of every business house isinterested in reliable accounting data so that it may get the required informationfor making correct decisions and discharge its functions efficiently. Thus, thereare shareholders, investors, creditors, workers, Govts., researcher etc. who arealso interested in reliable accounting data. Accounting standards play a verysignificant role; they make it possible that the people get the reliable andcomparable accounting data. Thus, they help the investor to make more informedinvestment decisions. The Government officials can use the accounting data forplanning etc. with greater confidence. The researchers can make better analysisand draw more reliable conclusions. Even the job of Chartered Accountants ismade easy. They can guide their clients much better and refuse any demand byclients to accept data which are not in conformity with accounting standards.Sometimes, there is a conflict of financial interests among the various groups thatrely upon published financial statements. For example, potential shareholdersSikkim Manipal University Page No.: 11
  12. 12. Financial Systems and Auditing Unit – 1and existing shareholders may have opposite interests in assessing theprofitability and the net worth of a company. Accounting Standards help inresolving such a conflict because financial statements which have been preparedon the basis of accounting standards will be acceptable to all the parties. Itfollows that accounting standards must be such as may command the greatestpossible credibility among all those who use accounting data.Accounting Standards Board: The Institute of Chartered Accounts of Indiaconstituted the Accounting Standards Board (ASB) on 21st April, 1977. TheAccounting Standards Board is performing the function of formulating theaccounting standards. While doing so, it takes into account the applicable laws,customs, usages and business environment. It gives adequate representation toall the interested parties; the Board consists of representatives of industries.Central Board of Direct Taxes and the Comptroller and Auditor General of India.Questions for review(1) Briefly describe the different accounting concepts.(2) What do you mean by accounting equation ?(3) Explain Matching Principle.(4) What is the scope of Accounting Standards?Sikkim Manipal University Page No.: 12