1. Financial Systems and Auditing Unit – 1
Unit – 1 Financial Systems
Structure
1.1 Introduction
1.2 Accounting Concepts
1.3 Conventions regarding Financial Statements
1.4 Branches of Accounting
1.5 Systems
1.6 Financial Statements and their nature
1.7 Accounting Standards
Learning Objectives
After reading this unit, one should be able to understand:
 The financial Systems.
 The financial Statements.
 Accounting Concepts.
 Accounting Standards.
1.1 Introduction
A business house must necessarily keep a systematic record of what happens
from day-to-day so that it can know where it stands and so that it can satisfy the
ever increasing curiosity of the income tax officer, if nothing else. Most of the
business these days is run by joint stock companies and these are required by
law to prepare periodical, mostly annual, statements in proper form showing the
state of financial affairs. A systematic record of the daily events of a business
leading 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 art
must have been rudimentary in the beginning. Chankya in India clearly indicates,
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in his Arthshastra, the existence and the need of proper accounting and audit.
The Indian system of accounting is as scientific and systematic as the one
developed in the west and is certainly older.
Accounting system helps the management to know their financial transaction and
positions. Besides the management there are numerous other parties interested
in 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.
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1.2 Accounting Concepts
Accounting is the language of business; affairs of a business unit are
communicated to others as well as to those who own or manage it through
accounting information which has to be suitably recorded, classified, summarised
and 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 on
a 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.
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v) 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 – Liabilities.
vi) 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.
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1.3 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 Accounting
The accounting system, as developed originally, concerned only the financial
state of affairs and the financial results of operations. This is called Financial
Accounting. It includes preparation of accounts, generally on historical basis, so
as to enable the management to prepare the financial statements showing the
results of operations and the financial state of affairs, to exercise full control over
the property and assets of the firm or the institution concerned and to prepare
returns and statements concerning taxation.
Cost accounting developed because of the limitations of financial accounting in
respect of information relating to the cost of individual jobs etc. This information
is needed for purposes of making numerous decisions and for exercising control
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over the costs being incurred. Cost accounting basically involves estimating cost
in advance and detailed analysis.
A third branch of accounting is Management Accounting. It means such
accounting as will enable management to discharge its functions properly, chiefly
in respect of forecasting and budgeting, control over costs and revenues and
decisions, both routine and strategic.
1.5 Systems
There are two systems for recording transactions – Single Entry System and
Double Entry System. Single Entry System sounds economical but is really costly
because it is rather a lack of system. The only real system is Double Entry
System.
This system recognises the fundamental fact that a transaction is a double sided
affair. If one receives something, then either (a) some other person has given it
or (b) stock of something else has diminished or (c) some services has been
rendered. 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 received
unless it is just bad luck. For good and accurate results, a transaction should be
recorded 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 are
made only when cash is received or paid, no entry being made when a payment
or receipt is merely due. In the mercantile system, a record is made on the basis
of amounts having become due for payment or receipt. The mercantile system is
better normally since it takes into account the amounts that become due. This is
necessary for preparing financial statements on proper lines. It is required under
the accrual concept stated earlier.
Classification of Accounts
a) Personal Accounts i.e. accounts of persons (Creditors, Customers etc.)
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b) 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 debit
side of an account has a corresponding entry on the credit side of some other
account. This is the technical aspect of the principle of double entry system. This
being the tax, it is but natural that the total of all the debit balances should agree
with the total of all credit balances. In fact, all business periodically tabulate the
debit and credit balances separately in a statement to see whether the total of
debit balances agrees with the total of credit balances or not. Such a statement is
known as the Trial Balance.
1.6 Financial Statement and their Nature
Below 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 38,87,06,260
Less: 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 2,97,45,340
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The same company portrays its financial position as on March 31, 2001 as
follows through its Balance Sheet:
Fixed Assets, at cost less depreciation 4,43,93,388
Capital work in progress 52,51,620
Total Fixed Assets 4,96,45,008
Investments 4,000
Current 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
14,91,15,049
Less: Current Liabilities 6,86,14,371
8,05,00,678
Less: Loan Funds 48,32,548
Shareholders’ Funds 7,56,68,130
What the company wishes to state is that various customers bought goods from
the 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 for
Rs. 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. 2.97
crore out of which the company will deduct the interest and income tax payable
by it; the balance will be net profit and will belong to the shareholders.
The Balance Sheet figures show that the shareholders of the company
collectively own Rs. 7.57 crore. The company owes Rs. 48.32 lakh by way of
loans, presumbly due for repayment only in the long run and Rs. 6.86 crore as
current liabilities i.e. payment is due to be made within one year if the date of the
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Balance Sheet. The assets of the company total Rs. 14.91 crore of which
Rs. 4.96 crore represent fixed assets, installed a being installed, that is, assets
acquired for use in production of goods and not for resale or conversion into
finished goods Rs. 9.95 crore worth of assets are “current” – either cash or
assets which are meant to be converted into cash within one year. Sundry
debtors, customers who purchased goods but have not yet paid for them, will pay
Rs. 1.14 crore. Stocks of material, stores etc. total Rs. 3.43 crore; these will be
converted into finished goods for sale to customers. Amounts advanced to
various parties for various parties, for example, advances to suppliers of
materials 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 and
Expenditure Account in the case of non-profit organisations, should be drawn in
such a manner as to enable those who go through it carefully to have a fair idea
of the results of the day to day operations (like producing goods and selling
them) together with significant details. In case of a Joint Stock Company, the
Profit and Loss Account is legally required to give a true and fair view of the profit
earned or loss suffered during the year. The Balance Sheet, similarly is required
in case of joint stock companies to give a true and fair view of the financial
position at the end of the year.
Those who study the Balance Sheet should be able to judge whether the firm or
institution 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 in
other case.
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The 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 its
work. On the other side is recorded the sources from which the necessary funds
have been derived – contribution by the proprietors (Capital) and loans raised
and credit received from outsiders. The balance sheet may also be looked upon
as indicating the total of the resources placed at the disposal of the firm and
showing how the resources have been utilized. There is a view, called the Assets
and Liabilities view, of Profit or Loss derived from the change in the net economic
resources of a business for a period. The measurement of profit proceeds from a
statement of assets and liabilities on the relevant dates; profit or loss equals the
change in the net resources (or the net assets) of the undertaking. The Balance
Sheet, 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 account
supplies much, though not all, of the explanation of the causes leading to the
change in the financial position. The basic principle to prepare the financial
statements is called the “Matching Principle”: Without the application of this
principle, neither the Profit and Loss Account nor the Balance Sheet can be
treated as true and fair.
Matching Principle: According to this principle, the revenues and relevant
expenses incurred should be correlated and matched so that a complete picture
is 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 not
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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 to
be earned should be charged off to the profit and loss account in the year in
which they are incurred.
1.7 Accounting Standard
The Institute of Chartered Accountants of India has issued, an accounting
standard called AS – 9 on Revenue Recognition. This accounting standard was
issued in November, 1985. It has been made mandatory in respect of accounts
for periods commencing on or after 1-4-1991. This accounting standard assumes
that three fundamental accounting assumptions i.e. going concern, consistency
and accrual have been followed in the preparation and presentation of financial
statements.
Utility of Accounting Standards: The Management of every business house is
interested in reliable accounting data so that it may get the required information
for making correct decisions and discharge its functions efficiently. Thus, there
are shareholders, investors, creditors, workers, Govts., researcher etc. who are
also interested in reliable accounting data. Accounting standards play a very
significant role; they make it possible that the people get the reliable and
comparable accounting data. Thus, they help the investor to make more informed
investment decisions. The Government officials can use the accounting data for
planning etc. with greater confidence. The researchers can make better analysis
and draw more reliable conclusions. Even the job of Chartered Accountants is
made easy. They can guide their clients much better and refuse any demand by
clients to accept data which are not in conformity with accounting standards.
Sometimes, there is a conflict of financial interests among the various groups that
rely upon published financial statements. For example, potential shareholders
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and existing shareholders may have opposite interests in assessing the
profitability and the net worth of a company. Accounting Standards help in
resolving such a conflict because financial statements which have been prepared
on the basis of accounting standards will be acceptable to all the parties. It
follows that accounting standards must be such as may command the greatest
possible credibility among all those who use accounting data.
Accounting Standards Board: The Institute of Chartered Accounts of India
constituted the Accounting Standards Board (ASB) on 21st April, 1977. The
Accounting Standards Board is performing the function of formulating the
accounting standards. While doing so, it takes into account the applicable laws,
customs, usages and business environment. It gives adequate representation to
all 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?
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