This is about Financial Accounting and its concepts.

1. Financial Accounting
Semester 1
Unit 1
Introduction to Financial Accounting and its
Concepts (15%)
Dr. Radha Vyas

2. Chapter Outline
 Meaning, Functions and Limitations of Financial
Accounting
 Various Accounting Concepts & Conventions
 Nature of Accounts and Rules of Debit and Credit
 Fundamentals Accounting Assumptions

3. Meaning of Accounting
 Accounting is a process of systematically recording in the
books of accounts, the monetary transactions of a person
relating to a definite period of time.
 Here the person includes a living being like a sole
proprietor or a partner and also an artificial or a legal
person like a joint stock company, a co-operative society,
a club or an institution.

4. DEFINITION OF ACCOUNTING
 American Institute of Certified Public Accountants has
defined Accounting as follows :
 "Accounting is an art of recording, classifying and
summarizing in a significant manner and in terms of
money, transactions and events, which are in part at
least, of financial character and interpreting the reasons
thereof"

5. Functions of Financial Accounting
(1)It maintains complete record of all transactions, duly
classified and summarized. It is not possible for any human
being to remember every thing that takes place in business
from day today.
(2)It gives information of various types of expenses and
incomes, which helps the owner to control them, if
necessary.
(3)Profitability of business is shown by accounts in the form of
gross profit and net profit. The comparison of profits of past
years with the profit of the current year will give very useful
information to the management. Steps may be taken on the
basis of information provided by accounts to improve
profitability.

6. (4) It shows the true and fair financial position of business, i.e.
it gives an idea about the various types of assets, liabilities and
capital at the end of the year by preparing balance sheet.
(5) Comparison of results of business with those of other firms
as well as with those of past years of our own business will
enable the businessman to know the significant facts about the
changes and to plan the future activities.
(6) Tax authorities like income-tax and sale-tax departments
trust the systematic accounts and is a big help to the
businessman.
(7) It helps in controlling and detecting frauds and
embezzlements of cash or goods.

7. (8) It gives useful information to outside users like banks,
creditors, prospective investors etc. so that they are able to
take important decisions on the basis of such information.
(9) Management is able to take day to day decisions as well
as important decisions like investing in new projects,
discontinuing a product etc. on the basis of accounting
information.
(10) Accounting is useful in number of ways to its owner like
giving accurate value of business, if it is to be sold or
providing valuable information as evidence in court cases;
for planning the future operations etc.

8. LIMITATIONS OF ACCOUNTING
(1) Generally, a business unit has to maintain Journal,
subsidiary books, ledger and other books of account. It
requires more labour and time which results in more
expensive and comprehensive accounting procedure to a
business unit, which small businesses cannot afford.
(2) Accounting does not record non-monetary transactions.
Certain nonmonetary transactions like efficiency of business
unit, creditworthiness of business unit, employee morale
which affects the business position are not recorded in the
books of account.
(3) Final accounts and other accounting statements are
prepared on the basis of Historical cost which do not reflect
the impact of inflation on business activities. Hence,
accounting does not consider changes in prices.

9. (4) In accounting transactions are recorded in terms of
money. Money is not a stable unit, as it changes with passage
of time. Hence, accounting discipline ignores the concept of
time value of money.
(5) Certain accounting policies like valuation of inventories,
methods of depreciation, treatment of goodwill etc. differs
from one business unit to another, eventhough both are
performing same business activity.

10. (1) Business Entity Concept :
 According to this concept, it is assumed that the business is
distinct from its proprietors.
 The business has a separate entity from that of its owners
and accounting record takes note of the dealings between
the business and its owners just like dealing with outsiders.
 Joint stock companies and co-operative societies have a legal
existence and in the eyes of law they are regarded as legal
persons distinct from their owners.
 All the transactions of business are recorded in the books of
the business from the view point of the business entity and
the owner is treated as a creditor to the extent of his
capital.
 Capital is shown as a liability in the balance sheet.

11.  If husband and wife carry on a retail business in partnership,
then all expenses and incomes relating that business will be
recorded in the books of account of the firm, but their family
expenses on food, clothing etc. should not be recorded in the
books of the firm.
(2) Money Measurement Concept :
 Only monetary transactions can take place in books of
accounts.
 Transactions and events on which money value cannot be put
are not recorded in the books of account, even though the
events may be extremely important e.g. the manager of a
company retires after a long and meritorious service.
 The accountant will record the gratuity and other benefits
payable to him but he will not record the probable effect on
the company's fortune.

12.  Suppose that several key executives are killed in a plane
accident. The real value of the company will change
immediately, and this will be reflected in the market price
of the company's stock, which reflects investor's appraisal
of value.
 This type of event, how so important is may be, will not be
recorded in the accounting books.
 In spite of the above mentioned limitations of money
measurement concept, it still remains indispensable.
 The main advantage of expressing events in monetary
terms is that money provides a common denominator by
means of which heterogeneous facts of a business can be
expressed in terms of number that can be added and
subtracted.

13.  For example, a business owns the following assets : Cash Rs.
500, bank balance of Rs. 5,000, one table, four chairs, one
cupboard, one scooter, stock of 10,000 meters of cloth and
book debts of Rs. 10,000.
 In the absence of money measurement concept, these
different units of measurement cannot be added to provide a
meaningful information but if they are expressed in monetary
terms, they will reveal the total assets of the business as
under : Cash Rs. 500; Bank balance Rs. 5,000; Table Rs. 1,000;
Four chairs Rs. 600; Cupboard Rs. 700; Scooter Rs. 3,000;
Stock-in-trade Rs. 80,000; Books Debts Rs. 10,000. Now we
can add up the assets and it is useful for comparison and
other purposes.
 When transactions and events are recorded and expressed in
terms of money, there is an implied assumption that the real
value of money or the purchasing power of money is constant.

14.  This stable money value is not true and the value of money
varies considerably from time to time.
 Accounting however fails to take care of the change in the
value of money and therefore recording of transactions and
presentation of accounts are inaccurate.
(3) Going Concern Concept:
 This accounting concept is based on the assumption that the
business operations are to be carried on indefinitely.
 In other words, continuing activity and not liquidation, is the
normal business process.
 It is due to this assumption that the fixed assets are usually
stated in balance-sheet at acquisition cost less provision for
depreciation, without any regard to the realisable value of the
particular asset.

15.  The transactions are so recorded that the benefit likely to
accrue in future of the money spent now of future
consequences of events occurring now are also taken into
account.
 For example, a machine is likely to last for 10 years, then
the cost of machine is spread over a suitable basis over the
next 10 years for the ascertainment of profit (or loss) of
each year.
 The total cost of the machine is not treated as an expense in
the year in which it is acquired.
 Contingent liabilities are shown at footnote of the balance-
sheet with the assumption that the business is going to
continue for a long time.

16. (4) Cost Concept:
 In accounting, under this concept, all transactions and events
are recorded at their monetary cost of acquisition i.e. actual
amount of money paid for the acquisition of asset or for
receiving the services provided.
 Accounting should make a record of the transactions on
objective basis.
 The personal views of the owners should be subject to
evidence that is available, e.g. If A purchases a piece of land
for Rs. 1,00,000 then land is shown in books of Rs. 1,00,000
only, because there is an evidence to show the cost of land.
This value is highly objective and free from bias.
 If we elaborate this concept, it means that if an asset does
not cost anything i.e. no money is paid for its acquisition,
then such transactions would not be recorded in the books of
accounts.

17.  Thus the knowledge and skill that is built up as business
operates, the team work that grow up within the
organisation, a favourable location that becomes increasing
importance as time goes by a good reputation with its
customers-none of these appears as in the accounts of the
company.
 There are certain limitations of this concept :
(1)In times of continuously rising prices, the historical cost
becomes meaningless. If the land purchased for Rs. 1,00,000
in 1980 now cost Rs. 10,00,000 in 1993, then the accounts
will not show the true position, if land is still shown at Rs.
1,00,000.
(2)Because of the same reasons the accounts are not
comparable.
(3)Those assets which have no acquisition costs are not recorded
in accounts.

18. (5) Realisation Concept:
 According to principle of realisation, profit is not
recognised to have been earned till it is realised in cash or
till a third party has legally becomes liable to pay the
amount.
 Realisation may be said to occur when a change in an asset
or liability has become sufficiently definite to warrant
recognition in accounts.
 For e.g. when we receive an order to supply goods of Rs.
5,000 to Mr. X, it is not considered as transaction and as
such it is not recorded, but when we execute the order, i.e.
when goods are delivered to Mr. X, it is recorded as sales. In
this case, goods (asset) go out of business and in exchange
either cash (asset) comes in the business or if the goods are
sold on credit then Mr. X is indebted to the business, thus
Mr. X becomes debtor (asset) of the business.

19.  In business, normally, revenue would be considered as
earned when goods are delivered to the customer or
services requested have been rendered.
 Thus in case of retail and manufacturing business, where
goods or products are sold to the customer, then the
time of sale is generally considered as appropriate point
of time for revenue recognition.

20. (6) Accrual Concept:
 This concept is based on realisation concept.
 Accrual means recognition of revenue and costs as they are
earned or incurred.
 This concept implies recording revenue or expense in the
accounting period to which it relates, though the required
receipt or outlay may take place, in whole or in part, in the
preceding or following period.
 The accrual concept is concerned with recognising revenue
and expenses during a particular period and also with
identifying assets and liabilities.
 Under this concept, the revenue is taken credit for when it
is recognised and not when it is received.

21.  Similarly, revenue received for next year or previous year
are excluded and outstanding revenue is taken credit for.
 Likewise, expenses whether paid or not are recorded when
they are incurred and not when they are actually paid.
 An adjustment has to be made for outstanding expenses and
expenses of previous year or subsequent year are excluded
and not charged to current year's revenue.
 The accrual system differs from cash system of accounting
in which revenue is recognised only when actual cash is
received and expenses are said to be incurred when actually
paid.
 Even the Indian Companies Act as amended in 1988 has
made it compulsory for companies to adopt accrual system
accounting.

22. (7) Matching Concept :
 According to matching principle, the revenues and the
relevant expenses (cost) incurred should be correlated and
matched so that a complete picture of the business
operation is available in respect of a particular period.
 For a given accounting period once revenue is recognised as
being earned, then the problem would be to find out
deductions (expenses and losses) from that revenue in order
to arrive at net income for the period.
 The implications of the principle are as follows :
(1) When revenue is recognised to be earned then all costs
incurred to produce or sell must be considered, i.e. when an
item of revenue is entered in the Profit and Loss Account, then
all the cost incurred (whether paid or not) should be charged
to Profit and Loss Account.

23.  Suppose a printing press has completed a job of printing a
particular book, but certain wages of the compositors and
certain cost incurred for the particular job, are unpaid, then for
finding out the cost incurred for the particular job, expenses
incurred but not paid should also be taken into account.
 Moreover, the depreciation of types, printing machine etc.
should also be considered.
(2) When the cost is incurred but the revenue is likely to be earned
in future, then such cost should not be considered as expenses
during the current period; it will be charged against revenue,
when actual revenue takes place.
 Suppose that the press has spent Rs. 1,000 for labour, Rs. 200
for block making, Rs. 800 for paper and if the job is incomplete
at the end of the accounting period, then the total cost of Rs.
2,000, should not be charged as costs in that period but it will
be charged to Work-in Progress Account, which will be shown as
an asset in the balance-sheet.

24.  If the revenue is earned in next year then the amount of work-
in-progress along with other amounts spent will be debited to
Profit and Loss Account of the next year.
 The purpose of these two implications is that the figures
shown in Profit and Loss Account are mutually interrelated and
the result is arrived at only after considering relevant revenue
and relevant cost. This process is known as matching of
revenue with cost.
 Revenue is the gross inflow of cash, receivables or other
consideration, arising in the course of the ordinary activities
of an enterprise like (1) from sale of goods, (2) from the
rendering of services and (3) from the use by other of
enterprise resources yielding interest, royalties and dividends.
 Expenses are outflows or other exhaustion of assets or
incurrences of liabilities during a period from delivering or
producing goods, rendering services or carrying out other
activities that constitute an enterprise's earning process.

25. (8) Periodicity Concept :
 Directly related to the going concern concept is the periodicity
concept which signifies that the performance measurement
and appraisal of financial position of business must be done at
periodic intervals during the lifetime of the business
enterprise.
 It is not wise to wait for determination of trading results till
the end of the life of the business unit, which may be 50 or
100 years.
 Hence, this indefinite life period is divided into convenient
periods for the purpose of preparing Profit and Loss Account
(Income Statement) and Balance Sheet (Position statement)
which are together called financial statements.
 The former measures the performance of business i.e. shows
profit or loss and the latter appraises the financial position of
business i.e. it shows true state of affairs of business.

26.  The accounting period is the interval of time at the end of
which Income Statement and Balance Sheet are prepared.
 The normal accounting period is twelve months, although the
shorter or longer period may be adopted for certain reasons.
 This gives rise to some important problems of accounting i.e.
segregation of capital and revenue items and matching costs
with revenue in the various accounting period.
 Accrual concept operates along with periodicity concept.
 Accrued expenses and accrued income are taken into
consideration for preparing periodic financial statements.
 Costs are matched against revenue recognised for a particular
time period of say, one year and the question of adjustments
for outstanding expenses and incomes arises.

27. (9) Dual Aspect Concept:
 In double entry book-keeping, every financial transaction has
two effects, one debit effect and the other credit effect.
 An account that receives the benefit is debited and the
account that gives the benefit is credited.
 Hence, total amount debited in the books of account is
always equal to the total amount credited.
 If we take the Accounting Equation, we see that assets
(debits) are equal to the Capital and Liabilities.
 Assets = Liabilities + Capital
 Here resources owned by a business are called "assets" and
assets are acquired with either capital, called owners' equity
or with borrowed funds called liabilities or creditors equity.

28.  Suppose, Mr. A started business with cash Rs. 50,000 then.
 Assets (Rs. 50,000) = Capital (Rs. 50,000)
 If Mr. A borrows Rs. 30,000 from bank, then the equation would
be Assets (Cash 50,000 + bank 30,000) = Capital 50,000 + Bank
loan 30,000
 The above equation can also be put in the following form :
Capital = Assets - Liabilities
 Rs. 50,000 = Rs. 80,000 - Rs. 30,000

29. (10) Consistency Concept :
 The concept signifies that the accounting policies must be
consistent for every year.
 The same accounting policies, procedures and methods must
be followed continuously. Then only the accounting
statements would become comparable.
 It would be inconsistent if we value closing under FIFO
method during one year and under LIFO method in the
following year.
 The consistency concept requires that once a company has
decided one method, it will treat all subsequent events of
the same character in the same fashion unless it has a sound
reason to do otherwise.

30.  If a company makes frequent changes in the manner of
handling a given class of events in the accounting records,
comparison of its accounting figures for one period with those
of another period would be difficult.
 But consistency does not imply that same policy must be
applied to different categories of transactions.
 Fixed assets are valued at cost while stock is valued at cost or
market price whichever is lower, there, the question of
consistency does not arise.
 If however, a change in accounting policy from one accounting
period to the next becomes necessary, then its effects must be
clearly stated in financial statements.
 If a business has changed, method of providing depreciation
from straight line to diminishing balance method, then the fact
that the change of method has been made and its effects
should be clearly disclosed in annual financial statements.

31. (11) Conservatism :
 Conservatism is the age old accounting practice.
 It signifies anticipating and providing for all probable losses
and not taking credit for any favourable event, unless it has
actually taken place.
 It may be put as "anticipate no profit and provide for all
conceivable losses.”
 On the basis of this concept closing stock is valued at cost or
market price whichever is lower, while preparing final
accounts.
 The other examples of conservatism are provision for bad and
doubtful debts and provision for fluctuations in value of
investments.
 The principle of conservatism should be cautiously followed.

32. (12) Materiality :
 The principle of materiality states that if an item is
immaterial relative to the context in which it appears, it
may be treated in the most expedient manner available.
 The accountant need not record a great many events which
are so trivial that the work of recording them is not
justified by the usefulness of the results.
 For e.g., A new lead pencil is an asset of the business.
Every time when pencils is used, its value decreases. If an
attempt is made to find out how much pencils are partly
used every day and to find out depreciation on pencil
used, then time and money involved for insignificant
matter will be huge and no sensible accountant would
think of doing this exercise.

33.  Materiality is a relative concept.
 To a small business extension of building of Rs. 10,000
would be material but for a giant company extension to
building of Rs. 10,000 would be quite immaterial.
 Moreover, the materiality is not merely a matter of
amount but also of importance.
 An item is considered material if it is large or sufficient
enough to influence the judgement or decision based on
accounting reports.

34. (13) Disclosure :
 The term disclosure suggests that all accounting statements
should be scrupulously honest and to that end full disclosure
of all significant information should be made.
 The term disclosure, however, does not mean that all
information should be disclosed, but it means a sufficient
disclosure of an information which is of material interest to
proprietors, creditors and investors.
 The principle of disclosure implies that the accounting
statements conform to the generally accepted accounting
practices.
 In case of annual financial statements, the basis on which
important items are included should be disclosed, e.g. in
balance sheet the mode of valuation of assets like stock-in-
trade, investments etc. should be clearly stated.

35.  The practice of appending notes relating to various facts
on items which otherwise do not find place in annual
financial statement is due to principle of full disclosure of
material facts.
 When an important change has been made in presentation
of information, as compared to preceding accounting
periods, nature of such change should be clearly indicated,
e.g. company has changed the method from straight line to
diminishing balance method of providing depreciation.
 The principle of disclosure is so important that the
Companies Act makes sufficient provisions for the full
disclosure of information in the Company Accounts.

36. FUNDAMENTAL ACCOUNTING ASSUMPTIONS :
 The Institute of Chartered Accountant of India in its
Accounting Standard I has stated as follows:
 Certain fundamental accounting assumptions underlie the
preparation and presentation of financial statements.
 The following have been generally accepted as fundamental
accounting assumptions :
(a)Going Concern :
 The enterprise is normally viewed as a going concern, that
is, as continuing in operation for the foreseeable future.
 It is assumed that the enterprise has neither the intention
nor the necessity of liquidation or of curtaining materially
the scale of the operations.

37. (b) Consistency :
 It is assumed that accounting policies are consistent from
one period to another.
(c) Accrual :
 Revenues and costs are accrued, that is, recognised as
they are earned or incurred and not as money is received
or paid and recorded in the financial statements of the
period to which they relate.

38. THANK YOU