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8/7/2019 Financial Accounting part I
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Financial and Management Accounting Unit 1
Page No.: 1
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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Self Assessment Questions 2:
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.
Self Assessment Questions 3:
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.
Self Assessment Questions 4:
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.
Self Assessment Questions 5:
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.
Self Assessment Questions 6:
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.,
Self Assessment Questions 7:
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.
Self Assessment Questions 8:
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
Self Assessment Questions 1:
1. Fra Luca Pacioli2. Cost Accounting
3. 14th Century
Self Assessment Questions 2:
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
Self Assessment Questions 3:
1. Recording business transactions as per accounting principles
2. Accounting is the discipline of measuring, communicating and
interpreting financial activities.
3. Profession, accountants.
Self Assessment Questions 4:
1. Journal
2. No, because this is not financial in nature.
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Self Assessment Questions 5:
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.
Self Assessment Questions 6:
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.
Self Assessment Questions 7:
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.
Self Assessment Questions 8:
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