Financial Accounting part I

8/7/2019 Financial Accounting part I

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Financial and Management Accounting Unit 1

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Unit 1 Financial Accounting An Introduction

Structure:

1.1 Introduction

1.2 Evolution of Financial Accounting

1.3 Need

1.4 Meaning of Accountancy, book-keeping and Accounting

1.5 Characteristics of Accounting

1.6 Functions and objectives of accounting

1.7 Differences between book-keeping and accounting, accountancy1.8 Financial Accounting and Management Accounting

1.9 Basic terms

1.1 Introduction

Accounting is a branch of knowledge, concerned with recording classifying,

analyzing and reporting financial information to owners, bankers, creditors,

government and host of stakeholders regarding the financial performance of

organizations - business or non-business entities. Over a period of time,

accounting has assumed a status of a science and an art. In order to

achieve uniformity globally, international standards have also emerged in

accounting. In this Unit, the historical perspective of Accounting, its

meaning, functions and basic terms used in the subject are discussed.

Learning Objectives:

After studying this unit, you should be able to understand the following:

1. To expose the students with meaning, need and purpose of accounting.

2. To know the functions Accounting.3. To understand the difference between Financial Accounting and

Management Accounting.

4. To acquaint with the basic terminology used in the subject.


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1.2 Evolution of Financial Accounting

Any branch of knowledge does not emerge all of a sudden. Knowledge is a

product of continuous intellectual exercise and the changes in the

environmental and social demands. Accounting is an ancient art. Michael

Russel in his article Evolution of Accounting points out that as early as

8500 B.C, accounting was existing. Archeologists have found clay tokens as

old as 8500 BC in Mesopotamia which were usually cones, disks, spheres

and pellets. These tokens correspond to such commodities like sheep,

clothing or bread. They were used in the Middle West in keeping records.

Similarly in ancient civilizations like China, Babylonia, Greece and Egypt,

record keeping was in practice in the same manner as stated above. During

3600 BC in Babylonia payment of salaries was recorded in clay tablets. The

rulers of these civilizations kept track of labour and material costs by using

accounting methods.

In an article published by John R. Alexander on History of Accounting, he

stated that an improved system of book keeping known as double entry

book keeping was introduced in 14th century and the following seven key

ingredients were responsible for the creation of double entry book keeping.

Private property: The power to change ownership, because book

keeping is concerned with recording the facts about property and

property rights

Capital: Wealth productively employed, because otherwise commerce

would be trivial and credit would not exist

Commerce: The interchange of goods on a widespread level, because

purely local trading in small volume would not create the sort of press ofbusiness needed to spur the creation of an organized system to replace

the existing hodgepodge of record keeping


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Credit: The present use of future goods, because there would have

been little impetus to record transactions completed on the spot.

Writing: A mechanism for making a permanent record in a common

language given the limits of human memory.

Money: The common denominator for exchange, since there is no need

for book keeping except as it reduces transactions to a set of monetary

values.

Arithmetic: A means of computing the monetary details of the deal.

Double entry records first came out during 1340 A.D. in Genoa. In 1494, thefirst systematic record keeping was formulated by Fra Luca Pacioli a

Franciscan monk and one of the most celebrated mathematicians to this

day. Pacioli is considered as the father of accounting.

Michael Russel, in his article states that industrial revolution, which brought

paradigm changes in the working and business transactions paved way to

the specialized field of accounting called cost accounting in order to meet

the need for the analysis of various costs. Mean while, corporate form of

organisation came into being which made it necessary to report financial

information to the owners (shareholders) by the management. Virtually

management and ownership got separated and to instill confidence of the

shareholders, managers had to submit reports, as prepared on the basis of

accounting information.

Welsch and Anthony, in their book Fundamentals of Financial Accounting,

comment that the growth of business organizations in size, particularly

publicly held corporations, has brought pressure from stock holders,

potential investors, creditors, government agencies, and the public at large,

for increased financial disclosure. The publics right to know more about

organizations that directly or indirectly affect them (whether or not they are

shareholders) is being increasingly, recognized as essential. An open


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society is one that has a high degree of freedom at the individual level and

typically evidences an effective commitment to measuring the quality of lifeattained. These characteristics make it essential that the members of the

society be provided adequate, understandable, and dependable financial

information from the major institutions that comprise it. So accountants have

a greater responsibility of not only being accurate but also transparent to the

possible extent.

At present, there have been tremendous advancements in accounting to

meet the needs brought about by information technology. Work is done

faster, more accurate, and more dependable by using computers. Business

can be transacted without even facing one another and accounting has

become so customer friendly that records and reports are generated

instantaneously to all parties concerned.

Self Assessment Questions 1:

1. __________ is the father of Accounting.

2. A new accounting system called _______ emerged during industrial

revolution.

3. Double Entry book keeping was introduced during ___________

century.

1.3 Need

Economic activities are carried on by trading and non-trading organizations,

the former with profit motive and the latter with a focus on service. Business

is prominently carried on under different forms of organizations, namely sole

trading, partnership, Hindu undivided family firms (HUF), cooperative

societies and companies. Having invested capital in the business, one has

to find out at the end of a particular period whether the business has yielded

any profit or loss; any assets are created; the liabilities payable; total


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expenses incurred; total revenues generated and so on and so forth.

Innumerable business transactions might have taken place during the periodand remembering all transactions is humanly impossible, let alone finding

the results of the transactions. Even to put them in a computer, it requires a

systematic approach to record, classify, analyse and report the financial

data to the stake holders of a business enterprise. Precisely for this

purpose, financial accounting is needed.

Proprietor/s in case of sole trading and partnership firms, members in case

of cooperative institutions, shareholders in case of companies, suppliers,

customers, tax authorities, banking institutions, lenders, borrowers,

employees, government agencies and general public are the various parties

interested in the financial information of a business enterprise and each one

them is interested in different aspects of the business. Accounting

information has to be supplied in a prescribed manner to these parties and

this information is contained in the form of different statements such as

trading account, profit and loss account, balance sheet, cash flow

statement, fund flow statement, statement of investments and so on. While

a proprietor/ partner/member/shareholder is interested in profit and loss

account and balance sheet, bankers are interested in cash and fund flow

statements in addition to P&L account and balance sheet, government is

interested in the amount of tax collections, employees are interested in P&L

account, customers, in total sales, suppliers in cash statements, security

analysts in the ratio analysis of various financial parameters of the business

organization. Financial accounting fulfills the aspirations of the above parties

regarding the enterprise. Thus Accounting has emerged for two purposes,

namely to record all business transactions since one can not remember

them and communicate the results of financial data to all interested parties.


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1. What are the two purposes of accounting?2. Shareholders of a company are interested in ______ and _______ of a

business.

3. Bankers are interested in _________ and _______ besides P&L A/C

and balance sheet.

1.4 Meaning of Accountancy, Book-keeping and Accounting

Book-keeping, accounting and accountancy are the terms used in the

science of financial accounting. Book-keeping means recording of business

transactions in the books of accounts in accordance with the principles of

accounting. Book keeping is an adjunct for accounting. Day to day

transactions are entered in a systematic manner to facilitate the preparation

of profit and loss account, balance sheet and other statements containing

information about debtors, creditors, tax payment etc., For the purpose of

recording the financial data, debit and credit principles are adopted so that

cross checking is made possible, summary of each account is known at the

end of an accounting period.

Accounting on the other hand is the discipline of measuring, communicating

and interpreting financial activities and it is widely referred to as language of

business.

Way back in 1941, the definition for the word Accounting was given by the

Committee on Terminology of the American Institute of Chartered Public

Accountants, (AICPA)thus, accounting is an art of recording, classifying and

summarizing in a significant manner and terms of money transactions and

events which are, in part at least, of a financial character, and interpreting

the results thereof.


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The American Accounting Association (AAA) in 1966 provided the following

definition: Accounting is the process of identifying, measuring and

communicating economic information to permit informed judgements and

decisions by users of the information

In 1970, the AICPA emphasized accounting with reference to the concept of

information.. Accounting is treated as a service activity. The function of

accounting is to provide quantitative information, primarily financial in

nature, and about economic activities, that is intended to be useful in

making economic decisions.

Accountancy is the profession and the practitioners of accountancy are

called accountants. Therefore book keeping is the basic activity of

recording, accounting is the analysis and reporting function and

accountancy is the profession of carrying the above activities.


1. What is book keeping?

2. Define Accounting.

3. Accountancy is a __________ and the practitioners of accountancy are__________ .

1.5 Characteristics of Accounting

From the above definitions of Accounting, one can list out the characteristics

of accounting:

1. Accounting is an art and science: Recording and maintenance of

accounts of various transactions needs special skill and knowledge.

Reading and interpreting the results, obtained by the accounting systemrequires experience. From this angle, accounting is an art. Accountants

are endowed with this special skill and aptitude and it is difficult to

acquire proficiency in this art. It is like a doctor who diagnoses and


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prescribes medicines just by looking to the medical reports, an

accountant on a gaze of the financial reports can find out the financialhealth of an enterprise and suggests measures to improve the financial

position. Accounting is also a science, not like physics or chemistry, but

it is an exacting science. Accounting is governed by definite principles,

rules, concepts, conventions and policies. A systematic and scientific

approach is adopted to classify, record, analyse and interpret the

accounting information.

2. Accounting involves a process of identifying, classifying and recording

financial information, expressed in terms of money. All financial

transactions are expressed in terms of money. Incomes, expenses,

acquisition of assets, payment of liabilities, capital of shareholders etc.,

are stated in money terms and all transactions are broadly classified as

related to definite heads of account, namely personal, real and

nominal. After classification, they are recorded in the books of original

entry as per the accounting principles. The book of original entry is

called Journal. From Journal, the transactions are summarized under

each head of relevant account and posting takes place to a book called

ledger. At the end of a particular accounting period, the gist or the net

balance of all ledger accounts is aggregated to prepare a trail balance.

From trial balance, it is possible to prepare trading, profit and loss

accounts and balance sheet.

3. Events of non financial nature can not be recorded, even though such

events may have an impact on the operational results of the enterprise.

For instance financial manager and production manager of a concern

do not have good relationship and owing to this the production process

is affected and subsequently the profitability. This event of non financial

nature can not be reflected in accounts.


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4. Accounting is an information system. The results of analysis and

interpretation are communicated to the management and otherinterested parties. Internal control is effectively exercised and

accountability is ensured through accounting information.

5. It helps in taking managerial decisions.


1. The book of original entry is called __________ .

2. Profitability of an enterprise is affected if the finance manager and

production manager do not agree each other. Does this picture inaccounts?

1.6 Functions and Objectives of Accounting

From the above paragraphs, it can be concluded that accounting involves

the following functions and objectives.

a) Systematic recording of all business events or transactions and

subsequent posting to ledger to finally prepare financial statements

profit and loss account and balance sheet.

b) Reporting the results to management, shareholders, creditors, bankers,

investors, stock brokers, stock exchanges, employees, governments

etc.,

c) Satisfying the statutory requirements, especially of Registrar of

Companies, SEBI (Securities Exchange Board of India) in case the

company is listed, tax authorities (sales tax, excise, customs, income

tax) and government in order to protect the interest of general public.

d) Protecting the properties of business by recording them on the date of

acquisition and showing their accounts in the balance sheet.


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e) It helps for internal control by holding the concerned persons

responsible for any errors, lapses or under performance. Equally it helpsto identify the strong areas of excellent performance and subsequently

pin point the individuals or departments to be rewarded or appreciated.

f) Accounting is a tool for effective planning. Current years financial

performance becomes the basis for future predictions and estimations.

Since it is tool for planning, it also acts as tool for controlling.

Preparation of budgets, cost analysis, tax planning, auditing are some of

the functions of accounting.


1. State any two functions of accounting.

2. Name the different parties to whom accounting information has to be

reported?

1.7 Differences between Book-keeping and Accounting,

Accountancy

As already said, book keeping is a system of recording the day to day

transactions in the books of enterprise. Accounting enjoys wider scope and

includes not only book keeping but also analysis, interpretation and

reporting of financial information. The later part of accounting is the core

function of accounting. Now - a-days, owing to information technology,

ready made packages like Tally are available, which facilitate entry of

transactions and preparation of ledger accounts are made easy. In case of

large industrial enterprises and multi national corporations, regular journal

entries are not recorded owing to very large number of transactions taking

place day in and day out. On the other hand subsidiary books such as cash

book, sales book, purchases book, bills receivable book are prepared and

ledger accounts are drawn from them. The differences between book

keeping and accounting are as under:


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Book keeping Accounting

It is a process of recording thetransactions in books of

accounts

It includes recording, analyzingand communicating

Adopt principles of accounting

for recording

Analysing and interpreting

requires skill, knowledge and

experience

Book keeping is an adjunct to

accounting

Accounting starts when book

keeping ends

The objective is to prepare

final accounts and balance

sheet at the end of accounting

period

The objective is to inquire and

find out the reasons for financial

results and communicate the

results to all stakeholders in a

manner they understand.


1. When book keeping ends, ________________ commences.

2. State two differences between book keeping and accounting.

1.8 Financial Accounting and Management Accounting

Financial accounting is the preparation and communication of financial

information to outsiders such as creditors, bankers, government, customers

and so on. Another objective of financial accounting is to give complete

picture of the enterprise to shareholders. Management accounting on the

other hand aims at preparing and reporting the financial data to the

management on regular basis. Management is entrusted with the

responsibility of taking appropriate decisions, planning, performance

evaluation, control, management of costs, cost determination etc., For both

financial accounting and management accounting the financial data is the

same and the reports prepared in financial accounting are also used in


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management accounting But the following are major differences between

Financial accounting and Management accounting.

Financial accounting Management accounting

The primary users of financial

accounting information are

shareholders, creditors,

government authorities,

employees etc.,

Top, middle and lower level managers

use the information for planning and

decision making

Accounting information is always

expressed in terms of money

Management accounting may adopt

any measurement unit like labour

hours, machine hours or product units

for the purpose of analysis

Financial data is presented for a

definite period, say one year or a

quarter

Reports are prepared on continuous

basis, monthly or weekly or even daily

Financial accounting focuses on

historical data

Management accounting is oriented

towards future

Financial accounting is a

discipline by itself and has its

own principles, policies and

conventions

Management accounting makes use of

other disciplines like economics,

management, information system,

operation research etc.,


1. Management accounting is concerned with _____________.

2. State any two differences between Financial accounting and

Management accounting.

1.9 Basic Terms

To understand the subject, proper understanding of the following terms is

essential.

1. Transaction: It is transfer of money or goods or service from one

person or account to another person or account. For example,

purchase of goods, sale of goods, payment of cash towards rent,

receipt of cash towards interest on loans given, cash brought in as


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capital dividend paid to share holders etc are all transactions. There

are cash transactions, credit transactions and paper transactions. In allcash transactions, cash is paid or received immediately. Ex: Rama paid

cash Rs.10000 for purchase of goods. Krishna sells goods for cash

Rs1000.Credit transaction is one where there is a promise to

pay/receive cash at a future date. EX: Rama purchases goods from

Gopal and promises to pay cash one month after the date. Paper

transaction is one where there is no cash inflow or outflow but

adjustment is made in the records only. Bad debts of previous year are

written off; depreciation provided on fixed assets etc.,

2. Capital: Funds brought in to start business, by the owner/s. In the case

of a company, capital is collected by issue of shares. Capital used to

purchase fixed assets is called fixed capital and that capital used for

day to day affairs of business is known as working capital. From

business point of view, Capital is a liability.

3. Assets: Every enterprise has assets. Land and buildings, plant and

machinery, furniture and fixtures, cash in hand and at bank, debtors

and stock etc., are regarded as assets, by the use of which business is

carried on. Assets may be fixed, current, liquid or fictitious. Fixed

assets are those which are held for use in the production or supply of

goods and services. Ex: plant and machinery, which is used fairly for

long period. Current assets are those which are held or receivable

within a year or within the operating cycle of the business. They are

intended to be converted into cash within a short period of time. Ex:

Stock in trade, debtors, bills receivable, cash at bank etc., Liquid

assets are those which can be easily converted into cash and for

instance, cash in hand, cash at bank, marketable investments etc.,

Fictitious assets are in the form of such expenses which could not be

written off during the period of their incidence. For example,


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promotional expenses of a company which could not be treated as

expenditure in the year of incidence are shown as fictitious asset.

4. Liability: Obligation to be fulfilled in future with respect to payment

towards acquisition of an asset or performance of a service. Current

liability is that obligation which has to be satisfied within a year. For

example, payment to be made sundry creditors for the goods supplied

by them on credit; bills payable accepted by the businessman;

overdraft raised by the businessman in a bank etc.

5. Goods: Commodities or articles purchased for resale are called

goods. Furniture items dealt by a furniture dealer constitute goods for

that business. If rice dealer purchases furniture, not for resale but for

use, it is called purchase of asset and the same furniture becomes

asset. Rice for rice dealer is goods, because he purchases only for

resale.

6. Trade: Purchase and sale of goods is called trade.

7. Purchases: It refers to goods bought in exchange for cash or credit. In

case of credit purchase, goods are received against a promise to pay

the price for the same at a future date.

8. Sales: Goods sold to customers either for cash or for credit are

regarded as sales. In case of cash sales, cash is received immediately

and in case of credit sales, cash will be received at a future date.

9. Sole trader: A single individual carrying on business with or without the

help of his kith and kin is called sole trader.

10. Partnership: It is a relationship between partners to contribute capital

to start business, agree to distribute profits and losses in an agreedproportion and the business being carried on by all or any one acting

for all. Partnership firm refers to business where as the partnership

refers to relationship caused by agreement.


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11. Joint Stock Company: It is an organization, for which the capital is

contributed by shareholders to carry on business and it is registeredunder Companies Act and it has a legal entity, having perpetual

existence and a common seal.

12. Debtor: Debtor is a person who owes some thing to business. A

person to whom goods are sold on credit becomes a trade debtor to

the business.

13. Creditor: A creditor is a person to whom the business owes some

thing. For example, a person from whom goods are purchased on

credit and amount is yet to be paid is called a trade creditor.

14. Stock: Total goods kept on hand by a trader or industrial enterprise on

a given date. It represents unsold part of goods.


1. A company is registered under ___________ .

2. A partnership is ___________ among partners.

3. Rama & Co., owned by Govind. Is it a firm or sole trader?

4. If A purchases goods from B, A is ___________ to B and B is

_________ to A.

5. X co Ltd., sold goods to Y Co Ltd and Y Co gave a cheque payable

after one month. Is it a cash sale or credit sale?

6. Mr. P brings furniture worth Rs.10000 and goods worth Rs.200000 into

his business. Is it capital?

Terminal Questions

1. Briefly describe the meaning of accountancy, book-keeping and

accounting.

2. Write the differences between accounting and book-keeping.

3. Brief describe the need and evolution of accounting.


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4. State the meaning of the folling terms

a. Transactionb. Assets

c. Joint stock company

d. Goods

e. Trade.

Answer for Self Assessment Questions


1. Fra Luca Pacioli2. Cost Accounting

3. 14th Century


1. Record all business transactions and communicate the results to

interested parties.

2. Profit and loss and balance sheet

3. Cash flow and fund flow statements


1. Recording business transactions as per accounting principles

2. Accounting is the discipline of measuring, communicating and

interpreting financial activities.

3. Profession, accountants.


1. Journal

2. No, because this is not financial in nature.


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1. Systematic recording, reporting, Satisfying statutory requirements,protecting the properties, internal control, tool for effective planning (Any

two).

2. Shareholders, creditors, bankers, brokers, debtors, customers,

suppliers, Government etc.


1. Accounting

2. Book keeping is a process of recording but accounting is not onlyrecording but also analyzing and communicating; book keeping requires

the knowledge of accounting principles but accounting requires not only

knowledge but also skill and experience.


1. Taking decisions, planning, evaluating and controlling

2. FA considers historical data and MA focuses on future; FA is a discipline

by itself but

MA makes use of other disciplines like economics, information system

etc.


1. Companies Act,

2. An agreement

3. Sole Trading concern

4. Debtor, Creditor

5. Credit sale6. Yes, it is capital.


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Answer for Terminal Questions:

1. Refer to unit 1.22. Refer to unit 1.6

3. Refer to unit 1.1

4. Refer to unit 1.8

Financial Accounting part I

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