Unit I

Introduction- Meaning, Scope and Importance of Financial Accounting

DEFINITION
Accounting is the 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 a financial character, and interpreting the results thereof Accounting is the language of the Business

Characteristics of Accounting
Recording of Financial transactions only Recording in Journal Classifying is grouping into accounts Summarizing is balancing ledger & Trial Balance is prepared Recording in terms of money Interpretation of the results by preparing Trading and Profit & Loss Account and Balance Sheet

ACCOUNTING CYCLE
Trading and Profit & Loss A/c and Balance Sheet

Transaction

Trial Balance

Journal

Ledger

Recording of Financial Transactions

Only those transactions which can be measured in terms of monetary value are recorded. Though there are some events which are very important for the business they cannot be recorded in the books as they cannot be expressed in terms of money. For E.g.- Resignation by an able and experienced manager

Recording
It is an art of recording business transactions, according to some specified rules. In a small business where the no. of transactions are quite small, they are recorded in a book called Journal. But where the number of transactions increase the Journal is further divided into various subsidiary books viz., Cash Book, Purchases Book, Sales Book, etc.

Classifying
It is the process of grouping the transactions of one nature at one place, in a separate account. The book in which various accounts are opened is called Ledger For E.g.- Wages Account, Advertisement Account, etc,.

Summarizing
It is the art of presenting the classified data in a manner which is understandable and useful to the management and the other users of such data. This involves the balancing of ledger accounts and the preparation of Trial Balance with the help of such balances. Final Accounts are prepared with the help of Trial Balance.

Recording in terms of money

Each transaction to be recorded in terms of money only. For E.g. If a business possesses Rs.5000 in cash, land measuring 200 mts., 5 trucks, 5 machines, 10 ton of raw materials, 200 chairs, etc., then in the absence of money measurement concept these assets cannot be added and hence of no use unless specified in terms of money.

Interpretation of the results

The results of the business are presented in such a manner that the parties interested in the business such as proprietors, managers, banks, creditors, employees, etc. can have full information about the profitability and the financial position of the business.

Objectives or Functions Of Accounting

To keep systematic record of business transactions-Complete record of business transactions according to specific rules so as to avoid omission or fraud- Journal Ledger
To calculate profit or loss-purchases, sales, various expenditures, revenues, etc,-Trading and Profit & Loss Account To know exact reasons leading to net profit or net loss

Advantages and Uses of Accounting

Helpful in Management of business-Planning, Decision-Making, Controlling Provides Complete and Systematic Record Information regarding profit or loss Information regarding financial position Enables comparative study

Evidence in legal matters Facilitates Sale of Business Helpful in Raising loans Helpful in Prevention and Detection of Errors and Frauds Helpful in Assessment of tax liability

 To prevent and detect errors and frauds

To ascertain the financial position of the business- Balance Sheet- Recovery from Debtors, payment to creditors, Balance cash, Closing Stock, Fixed Assets, etc.
To provide information to various parties

Limitations of Accounting
Influenced by Personal Judgments Based on Accounting Concepts Conventions Incomplete Information Omission of Qualitative Information Based on Historical Costs Affected by Window Dressing Unsuitable for Forecasting

and

BASIC ACCOUNTING TERMS

Assets
Fixed assets Are held for continuous use in the business for purpose of producing goods and are not meant for resale E.g..-Land and Building, Plant and Machinery
Current assets Are meant for sale or easily convertible into cash within one year E.g..- Cash, Debtors, Stock

 Liabilities Long Term Liabilities- Those which fall due for payment after more than one year E.g..- Long term loans, Debentures Current Liabilities Those which have to paid within one year E.g..- Bills payable, Creditors

 Capital Amount invested by the proprietor in a business enterprise. It is also known as Owners Equity or Net Worth or Net Assets Expenses Cost incurred in producing and selling the goods and providing services for the purpose of generating revenue

Revenue Amount received from the sale of goods and providing services on a regular basis. It is related with day to day affairs of the business

Income = Revenue less Expenses

Capital Expenditure Expenditure incurred in acquiring or increasing the value of a fixed asset - Balance Sheet Revenue Expenditure The full benefit of this expenditure is received during one accounting period - Dr. in Trading and Profit & Loss A/c

 DebtorsThose persons or firms to whom goods have been sold or services rendered on credit and payment has not been received from them

CreditorsThose persons or firms from whom goods have been purchased or services procured on credit and payment has not been made to them

STOCK

Stock of raw material

Stock of Work In-Progress

Stock of Finished Goods

 Stock of Raw Material Unused raw material purchased for using them in products manufactured Stock of Work-in-progress Such goods need further processing for converting into finished products Stock of Finished Goods Goods which have been completely processed & are ready for sale but lying unsold

 Purchases Purchases of goods in which the business deals or acquiring raw material for conversion into finished goods and then sale Purchase Returns Purchased goods are returned. Also known as Returns outwards

 Sales Goods which are purchased for resale purposes. It also includes revenues from services provided to customers. It includes both cash and credit sales Sale Returns Sold goods returned back. Also known as Return Inwards

Discount

Trade Discount

Cash Discount

 Trade Discount Discount allowed by a seller to its customers on a fixed percentage on the list price. It is not recorded in the books of accounts as it is deducted in the invoice
Cash Discount Discount allowed to the customers for making prompt payment. This transaction is to recorded in the books of Accounts.

 Drawing Cash or value of goods withdrawn by the owner for personal use or any private payments made out of business funds

Kinds of Accounting Principles

ACCOUNTING CONCEPTS

ACCOUNTING CONVENTIONS

ACCOUNTING CONCEPTS
Business Entity Concept Money Measurement Concept Going Concern Concept Accounting Period Concept Historical Cost Concept

Dual Aspect Concept Revenue Recognition Concept Matching Concept Accrual Concept Objectivity Concept

ACCOUNTING CONVENTIONS
Convention of full disclosure Convention of Consistency Convention of Conservatism Convention of Materiality

Business Entity Concept

Business is treated as a unit separate and distinct from its owners, creditors, managers and others. i.e. the owner of the business is always considered as distinct and separate from the business. For E.g. Harshpreet Traders Ltd. borrowed money and invested in business. When lenders asked Harshpreet to return the invested money, Harshpreet responded by stating that he invested them into business and it went bankrupt. Thus, he cant be personally held liable for loss in business as they are separate legal entities.

Money Measurement Concept

Only those transactions and events are recorded in accounting which are capable of being expressed in terms of money. An event, even though it may be very important for the business will not be recorded in the books unless it can be measured in terms of money. For E.g. It does not record the beginning of the strike.

Going Concern Concept

It is assumed that the business will continue to exist for a long period in the future. It is because of this concept that the outside parties enter into long term contracts with the enterprise. For E.g. Batuk Maharaj is a well known astrologer. One day, Batuk predicted that the world is going to end in 2009.The Chief Financial Officer of the well known company, Ms Aishwarya, has a strong belief in his predictions. The Accountant, Ms. Avani decided to show in her accounts by taking business having a finite duration. Is she correct? OF COURSE NOT. Business has eternal life.

Accounting Period Concept

The entire life of the firm is divided into time intervals for the measurement of the profits of the business. Twelve month period is usually adopted for this purpose. According to the Income Tax Law, a business has compulsorily to adopt financial year beginning on 1st April and ending on 31st March in the next calendar year, as its accounting period.

Historical Cost Concept

An asset is ordinarily recorded in the books of accounts at the price at which it was acquired. This cost becomes the basis of all subsequent accounting for the asset and as this cost relates to the past, it is referred to as historical cost. For E.g. If a business entity purchases a building for a particular price, it will be recorded in the books at that price only. Subsequent increase or decrease would not be recorded in the books of accounts.

Dual Aspect Concept

According to this concept, every transaction affects at least two accounts. If one account is debited, any other account must be credited. The system of recording transactions based on this concept is called as Double Entry System. It is because of this principle that the two sides of Balance Sheet are always equal.

Revenue Recognition Concept

Concept of revenue recognition determines the time in which the revenue is realized. It should be remembered that revenue recognition is not related with the receipt of cash. Revenue is deemed to be realized when the ownership of the goods is transferred to the purchaser. For E.g. If a firm gets an order of goods on 1st Jan, supplies on 20th and receives cash on 1st April, the revenue will be deemed to have been earned on 20th Jan, as ownership of goods was transferred on that day.

Matching Concept
For matching costs with revenue, first revenues should be recognized and then costs incurred for generating that revenue should be recognized. When an item of revenue is included in the profit and loss account, all expenses incurred on it, whether paid or not should be shown as expenses in the profit and loss account. Similarly, incomes receivables must be added in revenues and incomes received in advance must be deducted from revenues.

Accrual Concept
In this concept revenues is recorded when sales are made or services are rendered & it is immaterial whether cash is received or not. Similarly expenses are recorded in the accounting period in which they assist in earning the revenues whether the cash is paid for them or not. Thus, to ascertain the true profit or loss for an accounting period all expenses and incomes relating to the accounting period are recorded whether actual cash has been paid or received or not.

Objectivity Concept
The accounting transaction should be recorded in an objective manner, free from the personal bias of either the management or the accountant who prepares the accounts. It is possible when each transaction is supported by verifiable documents. Objectivity is one of the reasons for adopting the Historical Cost as the basis of recording accounting transaction because cost actually paid for an asset can be verified from the documents.

Convention of Full Disclosure

This principle requires that all significant information relating to the economic affairs of the enterprise should be completely disclosed. i.e. there should be sufficient disclosure of information which is of material interest to the users of financial statements. Disclosing of material facts does not mean leaking out the secrets of the business but disclosing sufficient information which is of material interest to the users of financial statements.

Convention of Consistency
The Accounting principles and methods should be consistent from one year to another. They should not be changed from one year to year, in order to enable the management to compare the Profit & Loss Account and Balance Sheet of different periods and draw important conclusions about the working of the enterprise. The nature of the effect of change of method and justification for the change must be stated clearly by way of footnotes to enable the users of financial statements to be aware of the change.

Convention of Conservatism
All anticipated losses should be recorded in the books of accounts, but all anticipated or unrealized gains should be ignored. Provision is made for all known liabilities and losses even though amount cannot be determined with certainty For E.g.- Closing stock is valued at cost or realizable value whichever is less Provision for doubtful debts is created in anticipation of actual bad debts

Convention of Materiality
It is an exception to the convention of full disclosure. According to this convention, items having an insignificant effect or being irrelevant to the user need not be disclosed. These unimportant items are either left out or are merged with other items. An item should be regarded as material if there is reason to believe that knowledge of it would influence decision of informed investor.

ACCOUNT
An account is a record of all business transactions relating to a particular person or item. In accounting we keep a separate record of each individual asset, liability, expense or income. The place where such a record is maintained is termed as an Account. All accounts are divided into two sides. The left hand side of the account is called Debit side and the right side of an account is called the credit side. Debit is written as Dr. and credit is written as Cr. An Account is abbreviated as A/c.

Rules of Debit and Credit

Following rules of debit or credit in respect of various categories of accounts are as : Assets Account When there is an increase in the amount of an asset, such an increase is recorded on the debit side of the asset account and if there is a reduction in the amount of an asset, such reduction is recorded on the credit side of the asset account.

 Liabilities Accounts

When there is an increase in the amount of liability, such an increase will be recorded on the credit side of the liability account. On the contrary, if there is reduction in the amount of liability, it will be recorded on the debit side of the liability account.

Capital Account
An increase in the capital is recorded on the credit side and the decrease in the capital is recorded on the debit side. Revenue or Income Account All increases in the gains and incomes are recorded on the credit side as it leads to the increase in the capital. On the contrary, if there is reduction in any income, the account will be debited as it leads to decrease in the capital

Losses or Expenses Account All increases in the losses and expenses are recorded on the debit side of the concerned expenses account as it leads to decrease in the capital. On the contrary, the reduction in the expenses is recorded on the credit side

 The above rules maybe summarized as: 1. Debit the increase in the asset and credit decrease in the asset 2. Credit the increase in the liabilities and debit decrease in the liabilities 3. Credit the increase in the capital and debit decrease in the capital 4. Credit the increase in the incomes and debit decrease in the incomes 5. Debit the increase in the expenses and credit decrease in the expenses.

the the the the the

JOURNAL
Journal is a book of original entry in which the transactions are recorded first of all, as and when they take place. The journal provides a date-wise record of all the transactions with details of the accounts debited and credited, according to the double entry system of bookkeeping and the amount of each transaction. Each entry is followed by a brief explanation of the transaction which is called Narration.

Format of Journal
Journal
Date Particulars Ledg Amo er unt folio Dr. 1 2 3 4 Amo unt Cr. 5

1. Date In the first col., the date of the transaction is entered. The yr. and the mth. is written only once till they change. 2. Particulars Each transaction affects two accounts out of which one account is debited and the other is credited. After each entry a brief explanation with the necessary details is given. 3. Ledger Folio or L.F. All entries from the journal are later posted into the ledger accounts. The folio no. of the ledger account where the posting has been made from the journal is recorded in the L.F. Column.

4. Amount amount written. 5. Amount amount written.

Dr. In the fourth column, the of the account being debited is Cr. In the fifth column, the of the account being credited is

Double Entry System

Every business transaction has a two fold effect and that it affects two accounts in opposite directions and if a complete record were to be made of each such transaction, it would be necessary to debit one account and credit another account. It is this recording of the two-fold effect of every transaction that has given rise to the term Double Entry System.

Classification of Accounts
Accounts

Personal Account

Impersonal Account

Real Accounts

Nominal Accounts

1. Personal Accounts The accounts which relate to an individual, firm, company or an institution are called personal accounts. For E.g.- Account of Mohan, Capital Account of the proprietor, Account of XYZ Ltd, etc.

Rule Debit the Receiver and Credit the Giver

Types of Personal Accounts

Personal Accounts

Natural Personal A/cs

Artificial Personal Accounts

Representative Personal Accounts

a. Natural Personal Accounts Accounts of Natural Persons means the accounts of human beings. For E.g.- Proprietors Capital Account, Mohans Account, Etc,. b. Artificial Personal Accounts These accounts do not have physical existence as human beings but they work as personal accounts. For E.g.- Firms A/c, Ltd. Co.s A/c, Accounts of Clubs, etc.

c. Representative Personal Accounts- When an account represents a particular person or a group of persons, it is termed as a Representative personal account. For E.g.- Salaries for the month of December are unpaid and put under one common title Salaries Outstanding Account.

2. Real Accounts The accounts of all those things whose value can be measured in terms of money and which are the properties of the business are termed as Real Accounts. For E.g.- Cash A/c, Furniture A/c, Etc.
Rule Debit what comes and Credit what goes out.

Types of Real Accounts

Real Accounts

Tangible Real Accounts

Intangible Real Accounts

a. Tangible Real Accounts These are the accounts of those things which can be touched, felt, measured, etc. For E.g. Cash A/c, Land A/c, etc,. b. Intangible Real Accounts These accounts represents such things which cannot be touched, but of course, their value can be measured in terms of money. For E.g. Goodwill A/c, Copyrights A/c, etc.

3. Nominal Accounts These accounts include the accounts of all expenses and incomes. For E.g. Salaries account, Discount received, etc. Rule Debit the expenses and losses and Credit incomes and gains.