Unit -1: Financial Accounting Overview

Meaning of Financial Accounting:

Accounting is the process of recording, classifying, summarizing, analyzing and

interpreting the financial transactions of the business for the benefit of management and
those parties who are interested in business such as shareholders, creditors, bankers,
customers, employees, and government. Thus, it is concerned with financial reporting
and decision making aspects of the business

The term ‘Accounting’ unless otherwise specifically stated always refers to ‘Financial
Accounting’. Financial Accounting is commonly carrying on in the general offices of a
business. It is concerned with revenues, expenses, assets, and liabilities of a business
house. Financial Accounting has the two-fold objective, viz,

 To ascertain the profitability of the business, and

 To know the financial position of the concern.

#Scope of Financial Accounting:

Financial accounting is a useful tool to manage and to external users such as
shareholders, potential owners, creditors, customers, employee, and government. It
provides information regarding the results of its operations and the financial status of the
business.

The following are the functional areas of financial accounting:-

1. Dealing with financial transactions: Accounting as a process deals only with those
transactions which are measurable in terms of money. Anything which cannot be
expressed in monetary terms does not form part of financial accounting however
significant it is.
2. Recording of information: Accounting is an art of recording financial transactions of a
business concern. There is a limitation for human memory. It is not possible to remember
all transactions of the business. Therefore, the information is recorded in a set of books
called Journal and other subsidiary books and it is useful for management in its decision-
making process.
3. Classification of Data: The recorded data is arranged in a manner so as to group the
transactions of similar nature at one place so that full information of these items may be
collected under different heads. This is done in the book called ‘Ledger’. For example,
we may have accounts called ‘Salaries’, ‘Rent’, ‘Interest’, Advertisement’, etc. To verify
the arithmetical accuracy of such accounts, the trial balance is prepared.
4. Making Summaries: The classified information of the trial balance is used to prepare
profit and loss account and balance sheet in a manner useful to the users of accounting
information. The final accounts are prepared to find out operational efficiency and
financial strength of the business.
5. Analyzing: It is the process of establishing the relationship between the items of the
profit and loss account and the balance sheet. The purpose is to identify the financial
strength and weakness of the business. It also provides a basis for interpretation.
6. Interpreting the financial information: It is concerned with explaining the meaning
and significance of the relationships established by the analysis. It should be useful to the
users, so as to enable them to take correct decisions.
7. Communicating the results: The profitability and financial position of the business as
interpreted above are communicated to the interested parties at regular intervals so as to
assist them to make their own conclusions.

#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 for meeting financial
needs. Financial accounting is like a post-mortem 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:-

 It records only quantitative information.

 It records only the historical cost. The impact of future uncertainties has no place in
financial accounting.
 It does not take into account price level changes.
 It provides information about the whole concern. Product-wise, process-wise,
department-wise or information of any other line of activity cannot be obtained separately
from the financial accounting.
 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.
 As there is no technique for comparing the actual performance with that of the budgeted
targets, it is not possible to evaluate the performance of the business.
 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.
 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.
 Does it not reveal which departments are performing well? Which ones are incurring
losses and how much is the loss in each case?
 It does not provide the cost of products manufactured
 There are no means provided by financial accounting to reduce the wastage.
 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.
 It is not helpful to the management in taking strategic decisions like replacement of
assets, an introduction of new products, discontinuation of an existing line, expansion of
capacity, etc.
 It provides ample scope for manipulation like overvaluation or undervaluation. This
possibility of manipulation reduces the reliability.
 It is technical in nature. A person not conversant with accounting has little utility of the
financial accounts.

Nature of Financial Accounting:

 Contents: The end product of the financial accounting process is the financial statements
that communicate useful information to decision-makers. The financial statements reflect
a combination of recorded facts, accounting conventions and personal judgments of the
preparers. There are three primary financial statements for a profit-making entity in India,
viz., the Income Statement (statement of revenues, expenses, and profit), and the Balance
Sheet (like the statement of assets, liabilities and owner’s equity) and cash flow
statement. The accounting information generated by financial accounting is quantitative,
formal, structured, numerical and past-oriented material.
 Accounting System: The accounting system includes the various techniques and
procedures used by the accountant (preparer) in measuring, describing and
communicating financial data to users. Journals, ledgers and other accounting techniques
used in processing financial accounting information depend upon the concept of the
double-entry system. This technique includes generally accepted accounting principles
(GAAP). The standard of generally accepted accounting principles includes not only
broad guidelines of general application but also detailed practices and procedures.
 Measurement Unit: Financial accounting is primarily concerned with the measurement
of economic resources and obligations and changes in them. Financial accounting
measures in terms of monetary units of a society in which it operates. For example, the
common denominator or yardstick used for accounting measurement is the rupee in India
and dollar in the U.S.A. The assumption is that the rupee or the dollar is a useful
measuring unit.
 Users of Financial Accounting Information: Financial accounting information is
intended primarily to serve external users. Some users have the direct interest in the
reported information. Examples of such users are owners, creditors, potential owners,
suppliers, management, tax authorities, employees, customers. Some users need financial
accounting information to help those who have the direct interest in a business enterprise.

Users or Role of the Financial Accounting:

The most basic objective of financial accounting is the preparation of general purpose
financial statements, which are financial statements meant for use by stakeholders
external to the entity, who do not have any other means of getting such information, i.e.
people other than the management. These stakeholders include:

 Investors and Financial Analysis: Investors need the information to estimate the
intrinsic value of the entity and to decide whether to buy, hold or sell the entity’s shares.
Equity research analysts use financial statements to conduct their research on earnings
expectations and price targets.
 Working as Employee groups: Employees and their representative groups are interested
in information about the solvency and profitability of their employers to decide about
their careers, assess their bargaining power and set a target wage for themselves.
 Lead as Lenders: Lenders are interested in information that enables them to determine
whether their loans and the interest earned on them will be paid when due.
 Suppliers and other trade creditors: Suppliers and other creditors are interested in
information that enables them to determine whether amounts owing to them will be paid
when due and whether the demand from the company is going to increase, decrease or
stay constant.
 One of the Customers: Customers want to know whether their supplier is going to
continue as an entity, especially when they have a long-term involvement with that
supplier. For example, Apple is interested in the long-term viability of Intel because
Apple uses Intel processors in its computers and if Intel ceases operations at once, Apple
will suffer difficulties in meeting its own demand and will lose revenue.
 His also Governments and their agencies: Governments and their agencies are
interested in financial accounting information for a range of purposes. For example, the
tax collecting authorities, such as IRS in the USA, are interested in calculating the taxable
income of the tax-paying entities and finding their tax payable. Antitrust authorities, such
as the Federal Trade Commission, are interested in finding out whether an entity is
engaged in monopolization. The governments themselves are interested in the efficient
allocation of resources and they need financial accounting information of different
sectors and industries to decide on federal and state budget allocation, etc. The bureaus of
statistics are interested in calculating national income, employment, and other measures.
 Also as Public: the public is interested in an entity’s contribution to the communities in
which it operates, its corporate social responsibility updates, its environmental track
record, etc.

Definition of Management Accounting

Management Accounting, also known as Managerial Accounting is the accounting for
managers which helps the management of the organisation to formulate policies and
forecasting, planning and controlling the day to day business operations of the
organisation. Both the quantitative and qualitative information are captured and analysed
by the management accounting.

The functional area of management accounting is not limited to providing a financial or

cost information only. Instead, it extracts the relevant and material information from
financial and cost accounting to assist the management in budgeting, setting goals,
decision making, etc. The accounting can be done as per the requirement of the
management, i.e. weekly, monthly, quarterly, etc. and there is no format set on the basis
of which it is to be reported.

Key Differences Between Financial Accounting and Management

Accounting

The following points explain the major differences between financial accounting and
managerial accounting:

1. Financial Accounting is the branch of accounting which keeps track of all the financial
information of the entity. Management Accounting is that branch of accounting which
records and reports both the financial and nonfinancial information of an entity.
2. Users of financial accounting are both the internal management of the company and the
external parties while the users of the management accounting are only the internal
management.
3. Financial accounting is to be publicly reported whereas the Management Accounting is
for the use of the organisation and hence it is very confidential.
4. Only monetary information is contained in financial accounting. As against this,
management accounting contains both monetary and non-monetary information such as
the number of workers, the quantity of raw material used and sold, etc.
5. Financial Accounting is done in the prescribed format, whereas there is no prescribed
format for the Management Accounting.
6. Financial Accounting focuses on providing information about the functioning of the
entity’s business to its users, whereas Management Accounting focuses on providing
information to help them in evaluating the performance and devising plans for the future.
7. The Financial Accounting is mainly done for a specific period, which is usually one year.
On the other hand, the management accounting is done as per the needs of the
management say quarterly, half yearly, etc.
8. Financial accounting is a must for any company for auditing purposes. On the contrary,
management accounting is voluntary, as no editing is done.
9. Financial accounting information is required to be published and audited by statutory
auditors. Unlike, management accounting, which does not require information to be
published and audited, as they are for internal use only.

Accounting Concepts and Conventions

In drawing up accounting statements, whether they are external “financial accounts” or
internally-focused “management accounts”, a clear objective has to be that the accounts
fairly reflect the true “substance” of the business and the results of its operation.

The theory of accounting has, therefore, developed the concept of a “true and fair view”.
The true and fair view is applied in ensuring and assessing whether accounts do indeed
portray accurately the business’ activities.

To support the application of the “true and fair view”, accounting has adopted certain
concepts and conventions which help to ensure that accounting information is presented
accurately and consistently.

Accounting Conventions
The most commonly encountered convention is the “historical cost convention”. This
requires transactions to be recorded at the price ruling at the time, and for assets to be
valued at their original cost.

Under the “historical cost convention”, therefore, no account is taken of changing prices
in the economy.

The other conventions you will encounter in a set of accounts can be summarised as
follows:
Monetary measurement

Accountants do not account for items unless they can be quantified in monetary terms.
Items that are not accounted for (unless someone is prepared to pay something for them)
include things like workforce skill, morale, market leadership, brand recognition, quality
of management etc.

Separate Entity

This convention seeks to ensure that private transactions and matters relating to the
owners of a business are segregated from transactions that relate to the business.

Realisation

With this convention, accounts recognise transactions (and any profits arising from them)
at the point of sale or transfer of legal ownership – rather than just when cash actually
changes hands. For example, a company that makes a sale to a customer can recognise
that sale when the transaction is legal – at the point of contract. The actual payment due
from the customer may not arise until several weeks (or months) later – if the customer
has been granted some credit terms.

Materiality

An important convention. As we can see from the application of accounting standards

and accounting policies, the preparation of accounts involves a high degree of judgement.
Where decisions are required about the appropriateness of a particular accounting
judgement, the “materiality” convention suggests that this should only be an issue if the
judgement is “significant” or “material” to a user of the accounts. The concept of
“materiality” is an important issue for auditors of financial accounts.

Accounting Concepts
Four important accounting concepts underpin the preparation of any set of accounts:

Going Concern
Accountants assume, unless there is evidence to the contrary, that a company is not going
broke. This has important implications for the valuation of assets and liabilities.

Consistency

Transactions and valuation methods are treated the same way from year to year, or period
to period. Users of accounts can, therefore, make more meaningful comparisons of
financial performance from year to year. Where accounting policies are changed,
companies are required to disclose this fact and explain the impact of any change.

Prudence

Profits are not recognised until a sale has been completed. In addition, a cautious view is
taken for future problems and costs of the business (the are “provided for” in the
accounts” as soon as their is a reasonable chance that such costs will be incurred in the
future.

Matching (or “Accruals”)

Income should be properly “matched” with the expenses of a given accounting period.

Key Characteristics of Accounting Information

There is general agreement that, before it can be regarded as useful in satisfying the needs
of various user groups, accounting information should satisfy the following criteria:

Understandability

This implies the expression, with clarity, of accounting information in such a way that it
will be understandable to users – who are generally assumed to have a reasonable
knowledge of business and economic activities

Relevance

This implies that, to be useful, accounting information must assist a user to form, confirm
or maybe revise a view – usually in the context of making a decision (e.g. should I invest,
should I lend money to this business? Should I work for this business?)
Consistency

This implies consistent treatment of similar items and application of accounting policies

Comparability

This implies the ability for users to be able to compare similar companies in the same
industry group and to make comparisons of performance over time. Much of the work
that goes into setting accounting standards is based around the need for comparability.

Reliability

This implies that the accounting information that is presented is truthful, accurate,
complete (nothing significant missed out) and capable of being verified (e.g. by a
potential investor).

Objectivity

This implies that accounting information is prepared and reported in a “neutral” way. In
other words, it is not biased towards a particular user group or vested interest

Accounting Standards in India

Accounting standards codify the generally accepted accounting principles. They lay
down the norms of accounting policies and practices by way of codes or guidelines to
direct as to how the items appearing in the financial statements should be dealt with in the
books of account and shown in the financial statements and annual reports. They present
the general principles to be put to application using professional judgment.

The main purpose of accounting standards is to provide information to the user as to the
basis on which the accounts have been prepared. They make the financial statements of
different business units or the financial statements of the same business unit comparable.
In the absence of accounting standards, comparison of different financial statements may
lead to misleading conclusions. Accounting standards bring about uniformity of
assumptions, rules and policies adopted in financial reporting and thus they ensure
consistency and comparability in the data published by the business enterprises.
Accounting Standards in India:
Realizing that there was a need of accounting standards in India and keeping in view the
international developments in the field of accounting, the Council of the Institute of
Chartered Accountants of India constituted the Accounting Standards Board (ASB) in
April, 1977. The Accounting Standards Board is performing the function of formulating
the accounting standards. While doing so, it takes into account the applicable laws,
customs, usages and business environment. It gives adequate representation to all the
interested parties; the Board consists of representatives of industries, Central Board of
Direct Taxes and the Comptroller and Auditor General of India.

The Institute of Chartered Accountants of India has so far issued thirty two
accounting standards. They are as follows:

The IASC and the ICAI, both, consider Going Concern, Accrual and Consistency as
fundamental. In other words, it will be assumed, without the fact having to be stated, that
the financial statements have been drawn up on accrual basis, without any change in the
accounting policies and without there being any necessity or intention to liquidate or
wind up the firm or a substantial part of it.

The going concern assumption is very important; only on its basis can fixed assets be
stated at cost less depreciation and their realizable value can be ignored. Also, some
liabilities (such as gratuities, retrenchment compensation) arise only when the firm is
liquidated. These can be ignored as long as the firm is a going concern. One can see that
if the going concern assumption is not valid, the financial statements as ordinarily drawn
up, will not be true at all. AS I issued by the ICAI in November, 1979 is given below.
The standard has become mandatory with effect from 1.4.1991.