01 unit1 (1)

Financial Systems and Auditing Unit – 1

Sikkim Manipal University Page No.: 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,



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.



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.



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.



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



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.)



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



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 3,57,48,7729,94,66,041

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



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.



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



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



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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