Financial Accounting

Unit-1 Introduction of accounting

Definition of Accounting:The American Accounting Association (AAA) define accounting as follows: "the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information!. According to the American Institute of Certified Public Accountants (AICPA), 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. According to the Accounting Principles Board (APB),
The function of accounting is to provide quantitative information, primarily

of financial nature, about economics entities, that is needed to be useful in making economic decisions.

Nature and scope of accounting:Nature of management accounting:

Managerial personnel are entrusted with authority and responsibility of operating business activities. Management accounting provides information to the personnel are entrusted with authority and responsibility of operating business activities. Management accounting provides information to the managerial personnel at three levels of management viz., top, middle and lower levels of management. It provides the management with the tools for an analysis of its administrative action that can lay suitable emphasis on the possible alternatives in terms of costs, prices and profits. The decisions made by management are based on quantitative information and common sense, foresight, knowledge and experience. Management accounting includes financial accounting information and raw material from several other disciplines such as costing, statistics, mathematics, political science, sociology, psychology, management economics, law etc. With all these data he can ensure

optimum utilization of all the resources including employees by maintaining sound morale of the employees, maximization of output and minimization of inputs, analyze the managerial questions in terms of costs, revenues, profits and growth. It is thus a highly personalized service with the help of which management can explore and exploit business opportunities and take sound and correct decisions. It is not a precise science as it uses its own conventions rather than standardized principles. Therefore the inferences drawn from the facts provided, depends on the skill, judgment and common sense of different management accountants. Thus it is said that management accounting serves as a management information system which enables the effective management of an enterprise.
Scope of management accounting:

Management accounting is a wide and diverse subject. As stated earlier it includes various branches of knowledge such as psychology, sociology, economics, laws, political science, mathematics, statistics, finanacial accounting, cost accounting etc. It is thus very difficult to define its scope, as it is a dynamic and ever growing discipline of knowledge. The important techniques and systems used by management accounting are briefly stated below.
1. Historical cost accounting: Maintenance 2. 3. 4. 5. 6.

7. 8.

9.

of books of cost accounting enables to know the actual costs incurred by the firm. Standard costing: The standard costs laid down by experts are compared with the natural costs in order to know the deviations Marginal costing: The costs are divided into fixed and variable costs which help is making vital decisions. Decision accounting: Decisions are made after studying the impact of decisions in terms of costs, resource, profits, growth etc. Budgetary control: It is a system of controlling the cost with the help of budgets. Control accounting: It includes the techniques such as standard costing, budgetary control, control reports, internal check, internal audit and reports. Revaluation accounting: It is based on current costs to ensure that the investment is intact and profits from investment are kept in mind. Financial planning & policies: It consists of raising the long term and short term finance and invest it on optimum basis and enhance the profitability of the firm. Capital expenditure: The large amounts of future capital expenditure and future profits are analysed to take important decisions.

10. Break even analysis: This

is an important technique which is used to analyse the behavior of costs viz., fixed and marginal costs, indicating the level of activity at which the total costs would equal the total revenue and also the margin of safety. 11. Inter-period comparison: It is a technique of comparing the present performance with the past performance. 12. Techniques of forecasting: Some techniques like decision tree, probability and sensitivity analysis are used by management accountants for forecasting which forms a base for planning. 13. Operations research: It consists of statistical and mathematical techniques that are increasingly used in decision making process. 14. Statistics: The statistical techniques used by management accountant are correlation, regression, probability, time series, standard deviation, linear programming, control charts etc. 15. Other techniques: Other techniques employed are: Financial reporting, data processing, project management and appraisal, management audit, efficiency audit, cost audit, performance budgeting, tax planning, social accounting & audit, human resource accounting, responsibility accounting and divisional performance.

Branches of Accounting:The different branches of financial accounting is as follows i) Financial accounting ii) Cost accounting iii) Management accounting Financial Accounting: It is the original form of accounting. It is mainly confined to the preparation of financial statements for the use of outsiders like creditors, banks and financial institutions etc. The chief purpose of financial accounting is to calculate profit or loss made by the business during the year and exhibit financial position of the business as on a particular date. Cost Accounting: Function of cost accounting is to ascertain the cost of the product and to help the management in the control of cost. Management Accounting or Managerial Accounting: It is accounting for management. i.e., accounting which provides necessary information to the management for discharging its functions. It is the reproduction of financial accounts in such a way as will enable the management to take decisions and to control various business activities.

Role of Accounting in modern Organisation:Accounting is an age-old profession. In old days of accounting, the main function of an accountant was to maintain the records of the business. However over the years, the role of an accountant has undergone a sea change. With the inception of joint stock company form of an organization, the profession of accountancy has come to be recognized as one of the lucrative professions. Accountants can be broadly divided into two categories namely, Accountants in public practice and Accountants in employment. Accountants in public practice (practicing chartered accountants) are members of the Institutes of Chartered Accountants of India. The accountant renders valuable service to the society in the following manner:
1. Writing up Accounts for Preparing Financial Statements: Professional

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accountants offer services for writing up accounts and preparing financial statements. By maintaining proper books of accounts and records he assists management to a great extent in the field of planning, decisionmaking and controlling. A systematic record also enables the business to compare one years results with those of other years. Audit of Accounts: Conducting of audit is one of the most important functions of a professional accountant where his specialized training, skills and judgement are most often called into play. Audit satisfies the users of financial statements that the accounting information contained in these statements is true and reliable and that accounts have been prepared in accordance with the accounting standards. It, thus, adds credibility to financial statements prepared by the business. He also points out the shortcoming and suggests ways to overcome them. Role as Management Accountant: A management accountant helps the management in planning and control of organizational activities and their performance evaluation. Help to government, Revenue Department and Tax Payer: Chartered accountant plays an important role in ensuring that the Government gets its proper share of taxes and at the same time the tax payer is not exploited. Chartered accountant is instrumental in preparing the financial statements of the enterprise. He also prepares the returns for tax purposes. He also appears before the tax authorities on behalf of the taxpayer. He also does the work of certification of documents in many cases. Role as Cost Accountant: As a cost accountant, he maintains the costing records and ascertains the cost of product or service. He provides costing information introduces cost control and cost reduction methods and assists the management in fixing appropriate selling prices.

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Role in Merger, Liquidation, etc: The services or advice of chartered

accountants are frequently sought in the formation, merger or liquidation of limited companies. They are called upon to undertake investigation for achieving greater efficiency in management and find out the reasons for increase of decrease in profits. They act as executors and trustees under a will or trust deed to carry out the administration of the estate or settlements.

Importance of accounting:The importance of accounting is to provide meaningful information about a business enterprise to those persons who are directly of indirectly interested in the performance and financial position of a business enterprise. Such persons may include owners, creditors, investors, employee, government, public, research scholars and the managers. 1. OWNERS: The owners of a business furnish capital to be used for the purpose of business. They are interested to know whether the business has earned a profit or loss during particular period and also its financial condition on a particular date. They want accounting reports in order to have an appraisal of past performance and also for an assessment of future prospects. 2. CREDITORS: The creditors include supplier of goods and supplies, bankers and other lenders of money. They are interested in the financial stability of the concern before making loans of granting credit. They look to the ability of the business to pay interest and amount as and when it becomes due for payment. They also look to the trends of earnings a it ultimately affects the solvency of concern. 3. INVESTORS: Investors look not only the earning capacity of business but also its financial strength and solvency before deciding whether to subscribe of not for the shares in a company. They are interested in steady and good return on their capital, the safety of their capital and appreciation in the value of the shares. 4. EMPLOYEES: Employees are interested in earning capacity of a concern as their salaries, bonus and pension schemes are dependent on this factor. They have a permanent stake in the business and in order to have and assurance of steady employment they are very much interested in the stability of the organization. 5. GOVERNMENT: Government is interested in accounting statements and reports in order to see the performance of particular unit, its cost structure and income in order to impose tax and excise duty. 6. PUBLIC: The public as consumers is interested in accounting statements in order to know whether control is exercised on production, selling and distribution expenses in order to reduce the prices of goods they buy.

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They can also judge whether the economic resources of the concern are benefit of the common man or not. RESEARCH SCHOLAR: Such persons are interested in accounting statements and reports in order to get data for proving their thesis on which they are working and hence to complete their research projects. MANAGERS: The managers of an enterprise nees accounting information for planning, control, evaluation of performance and decision-making. Their main responsibility is to operate the business so al to obtain maximum return on capital employed without causing any harm to the interest of the shareholders.

Objectives & Principles of accounting: To keep systematic records To protect business properties To ascertain the operational profit or loss To ascertain the financial position of a business To assist in rational decision making

Limitations Of Financial Accounting:

Financial accounting is concerned with the preparation of final accounts. The business has become so complex that mere final accounts are not sufficient in meeting financial needs. Financial accounting is like a postmortem report. At the most it can reveal what has happened so far, but it cannot exercise any control over the past happenings. The limitations of financial accounting are as follows:1. It records only quantitative information. 2. It records only the historical cost. The impact of future uncertainties has no place in financial accounting. 3. It does not take into account price level changes. 4. It provides information about the whole concern. Product-wise, processwise, department-wise or information of any other line of activity cannot be obtained separately from the financial accounting. 5. Cost figures are not known in advance. Therefore, it is not possible to fix the price in advance. It does not provide information to increase or reduce the selling price. 6. As there is no technique for comparing the actual performance with that of the budgeted targets, it is not possible to evaluate performance of the business. 7. It does not tell about the optimum or otherwise of the quantum of profit made and does not provide the ways and means to increase the profits.

8. In case of loss, whether loss can be reduced or converted into profit by means of cost control and cost reduction? Financial accounting does not answer this question. 9. It does not reveal which departments are performing well? Which ones are incurring losses and how much is the loss in each case? 10. It does not provide the cost of products manufactured 11. There is no means provided by financial accounting to reduce the wastage. 12. Can the expenses be reduced which results in the reduction of product cost and if so, to what extent and how? No answer to these questions. 13. It is not helpful to the management in taking strategic decisions like replacement of assets, introduction of new products, discontinuation of an existing line, expansion of capacity, etc. 14. It provides ample scope for manipulation like overvaluation or undervaluation. This possibility of manipulation reduces the reliability. 15. It is technical in nature. A person not conversant with accounting has little utility of the financial accounts.

GAAP:-

Generally Accepted Accounting Principles (GAAP) refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as Accounting Standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing, and in the preparation of financial statements.

Accounting concepts :- In order to make the accounting language convey

the same meaning to all people & to make it more meaningful, most of the accountants have agreed on a number of concepts which are usually followed for preparing the financial statements. These concepts provide a foundation for accounting process. No enterprise can prepare its financial statements without considering these concepts. o Business / separate entity concept

o o o o o o o o o o o

Going concern Money measurement concept Cost / historical cost concept Dual aspect concept Accounting period concept Going concern concept Revenue recognition/realization concept Periodic matching of cost and revenue / matching concept Realization accrual concept Objectivity concept Timeliness Cost benefit principle

1. Business / separate entity concept:

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Business is treated as separate & distinct from its members Separate set of books are prepared. Proprietor is treated as creditor of the business. For other business of proprietor different books are prepared.

Going concern concept : Business will continue for a long period. As per this concept, fixed assets are recorded at their original cost & depreciation is charged on these assets. Because of this concept, outside parties enter into long term contracts with the enterprise.

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Money measurement concept: Transactions of monetary nature are recorded. Transactions of qualitative nature, even though of great importance to business are not considered.

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Cost / historical cost concept: Assets are recorded at their original price. This cost serves the basis for further accounting treatment of the asset.

 Acquisition cost relates to the past i.e. it is known as historical cost.

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Dual aspect concept: Every transaction recorded in books affects at least two accounts. If one is debited then the other one is credited with same amount. This system of recording is known as DOUBLE ENTRY SYSTEM. ASSETS = LIABILITIES + CAPITAL

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Accounting period concept: Entire life of the firm is divided into time intervals for ascertaining the profits/losses are known as accounting periods. Accounting period is of two types- financial year(1st Apr to 31st March) & calendar year(1st Jan to 31st Dec).

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Periodic matching of cost and revenue/cost concept:All the revenue of a particular period will be matched with the cost of that period for determining the net profits of that period. Accordingly, for matching costs with revenue, first revenue should be recognised & then costs incurred for generating that revenue should be recognised.

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Realisation/accrual concept:In this concept revenue is recorded when sales are made or services are rendered & it is immaterial whether cash is received or not. Same with the expenses i.e. they are recorded in the accounting period in which they assist in earning the revenues whether the cash is paid for them or not. For taxation purposes financial year is adopted as prescribed by the Govt. Companies having their shares listed on stock exchange publishes their quarterly results.

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Revenue recognition/realisation concept :Revenue means the addition to the capital as a result of business operations. Revenue is realised on three basis-:

1. Basis of cash 2. Basis of sale 3. Basis of production

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Objectivity concept:-

Accounting transactions should be recorded in an objective manner, free from the personal bias of either management or the accountant who prepares the accounts. It is possible only when each transaction is supported by verifiable documents & vouchers such as cash memos, invoices.

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Timeliness: This principle states that the information should be provided to the users at right time for the purpose of decision making. Delay in providing accounts serves no usefulness for the users for decision making.

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Cost benefit principle: This principle states that the cost incurred in applying the principles should be less than the profits derived from the

Accounting conventions:- An accounting convention may be defined as a

custom or generally accepted practice which is adopted either by general agreement or common consent among accountants.
1.

Convention of full disclosure. Convention of consistency. Convention of conservatism. Convention of materiality.

Convention of conservatism: All anticipated losses should be recorded but all anticipated gains should be ignored. It is a policy of playing safe.

 Provisions is made for all losses even though the amount cannot be determined with certainity
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Convention of full disclosure: Information relating to the economic affairs of the enterprise should be completely disclosed which are of material interest to the users. Proforma & contents of balance sheet & P&L a/c are prescribed by Companies Act. It does not mean that leaking out the secrets of the business.

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Convention of consistency: Accounting method should remain consistent year by year. This facilitates comparison in both directions i.e. intra firm & inter firm. This does not mean that a firm cannot change the accounting methods according to the changed circumstances of the business.

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Convention of materiality:According to American Accounting Association, An item should be regarded as material if there is reason to believe that knowledge of it would influence decision of informed investor. It is an exception to the convention of full disclosure. Items having an insignificant effect to the user need not to be disclosed.

Accounting standards issued by institute of chartered accountants of India:

AS-1:Disclosure Of Accounting Policies (Mandatory 1.4.1991) AS-2:Valuation Of Inventories(Mandatory 1.4.1999) AS-3:Cash Flow Statements( Mandatory 1.4.2001) AS-4:Contingencies And Events Occuring After Balance Sheet Date (Mandatory 1.4.1995) AS-5:Prior Period And Extraordinary Items And Changes In Accounting Estimates(Mandatory 1.4.1996) AS-6:Depreciation Accounting(Mandatory 1.4.1995) AS-7:Accounting For Construction Contract(Mandatory 1.4.2003)

AS-8:Accounting For (Mandatory 1.4.1991)

Research

And

Development

AS-9: Revenue Recognition (Mandatory 1.4.1991) AS-10: Accounting For Fixed Assets(Mandatory 1.4.1991) AS-11: Accounting For Effects Of Changes In Foreign Exchange Rates(Mandatory 1.4.1991) AS-12:Accounting For Government Grants(Mandatory 1.4.2004) AS-13:Accounting For Investments (Mandatory 1.4.1995) AS-14:Accounting For Amalgamations (Mandatory 1.4.1994) AS-15:Accounting For Retirement Benefits In The Financial Statements Of Employers (Mandatory 1.4.1995) AS-16:Borrowing Costs(Mandatory 1.4.2000) AS-17:Segment Reporting(Mandatory 1.4.2001) AS-18:Related Party Disclosures(Mandatory 1.4.2001) AS-19:Leases(Mandatory 1.4.2001) AS-20:Earnings Per Share(Mandatory 1.4.2001) AS-21:Consolidated Financial Statements(Mandatory 1.4.2001) AS-22:Accounting For Taxes On Income (Mandatory 1.4.2001) AS-23:Accounting For Investments Statements(Mandatory 1.4.2002) In Consolidated Financial

AS-24:Discontinuing Operations(Mandatory 1.4.2004) AS-25:Interim Financial Reporting(Mandatory 1.4.2002) AS-26:Intangible Assets(Mandatory 1.4.2003) AS-27:Financial Reporting Of Interest In Joint Ventures(Mandatory 1.4.2002) AS-28:Impairment Of Assets (Mandatory 1.4.2004)

AS-29:Provisions Contigent (Mandatory 1.4.2004)

Assets

And

Acontigent

Liabilities

SHARES:- A share is one unit into which the total share capital is divided. Share capital of the company can be explained as a fund or sum with which a company is formed to carry on the business and which is raised by the issue of shares. Shares are the marketable instruments issued companies in order to raise the required capital. by the

These are very popular investments which are traded every day in the stock market and the value of the share at the end of the day decides the value of the firm. The shares which are issued by companies are of two types: Equity Shares Preference Shares Equity Shares: Equity Shares are issued and are traded everyday in the stock market. Equity share holders only get dividend after preference shareholders & debenture holders. The returns on the equity shares are not at all fixed. It depends on the amount of profits made by the company. The board of directors decides on how much of the dividends will be given to equity share holders. Share holders can accept to it or reject the offer during the annual general meeting. Equity shareholders have the right to vote on any resolution placed before the company.

The Equity share is a common name, some of the types of equity shares are: Blue Chip Shares Income Shares Growth shares Cyclical Shares Defensive shares Speculative shares

ADVANTAGES High Return Easily Transferable. These can be easily liquidated. Right to vote Right to choose the board of directors. Equity share holders have the right to oppose any of the decisions taken by the board of directors. DISADVANTAGES High Risk In worst cases less privilege given to equity share holders PREFRENCE SHARE :These are other type of shares. The preference shares are market instrument issued by the companies to raise the capital. Preference shares have the characteristics of both equity shares and debentures. Fixed rate of dividends are paid to the preference share holder as in case of debentures, irrespective of the profits earned company is liable to pay interest to preference share holders. Preference shares are divided into: Cumulative & Non cumulative shares Redeemable & Non-redeemable Convertible & Non-convertible shares Participating and non-participating ADVANTAGES

 These yield fixed rate of returns Its a hybrid instrument having some of the characteristics of debentures and equity shares.

DISADVANTAGES They do not provide the investor with any of the voting rights. If the company gets huge profits then they wont get any extra bonus.

ISSUE OF SHARES : Detail of a Company & Shares in Prospectus. 90 % application is necessary If access application received then company issue shares by pro rata basis full amount can be called up by company at the time of application or it can be paid up in installments also (calls) share of the company may be issued in any of the following three ways: 1. At par; 2. At premium; and 3. At discount. Issue of shares for consideration other than cash (For example: issue of shares to vendors, to promoters etc.) Forfeiture of shares Buy Back of Shares Right Shares Redemption of preference shares/ Debenture

DEBENTURES : Instrument of debt executed by the company A certificate of loan Company pays pre specified percentage of interest Part of the company's capital structure Debentures are generally secured against the companys assets

 Convertible debentures can be either fully or partly converted into Shares Convertible debentures may carry a lower rate of interest TYPES OF DEBENTURES:

Security Point of View i. ii. Secured Debentures Unsecured Debentures

Tenure Point of View i. ii. Redeemable Debentures Perpetual Debentures

Mode of Redemption Point of View i. ii. Convertible Debentures Non-Convertible Debentures

Coupon Rate Point of View ADVANTAGES 1. Control of company is not surrendered to debenture holders because they do not have any voting rights. 2. Interest on debenture is an allowable expenditure under income tax act, hence incidence of tax on the company is decreased. 3. Debenture can be redeemed when company has surplus funds. DISADVANTAGES 1. Cost of raising capital through debentures is high of high stamps duty. 2. Common people cannot buy debenture as they are of high denominations.

3. They are not meant for companies earning greater than the rate of interest which they are paying on the debentures. AMALGAMATION:- "blending together of two or more undertakings into
one undertaking, the shareholders of each blending company, becoming, substantially, the shareholders of the blended undertakings. There may be amalgamations, either by transfer of two or more undertakings to a new company, or to the transfer of one or more companies to an existing company.