1 introduction to financial accounting

INTRODUCTION TO
FINANCIAL
ACCOUNTING
1

TOPICS COVERED
• Meaning of Accounting
• Difference between Book Keeping and Accounting
• Is accounting an art or science
• Objectives of Financial Accounting
• Branches of Accounting
• Nature of Accounts with examples
• Double Entry System and its rules with examples
• Accounting Concepts
• Accounting Conventions
• Uses of Financial Accounting
• Users of Accounting Information
• Advantages of Accounting
• Limitations of Financial Accounting
• Important Terms for Reference
2

Meaning of Accounting
• Art of recording and classifying the business transactions and
events which includes – receipt and payment of cash,
purchase and sale of goods on credit etc
• The transactions must be in monetary terms
• Art of making summaries, analysis and interpretation of
business transactions
• Communication to the external and internal stakeholders for
decision making
3

Difference between Book
Keeping and Accounting
BASIS FOR COMPARISON BOOKKEEPING ACCOUNTING
Meaning Bookkeeping is an activity of recording
the financial transactions of the
company in a systematic manner.
Accounting is an orderly recording and
reporting of the financial affairs of an
organization for a particular period.
What is it? It is the subset of accounting. It is regarded as the language of
business.
Decision Making On the basis of bookkeeping records,
decisions cannot be taken.
Decisions can be taken on the basis of
accounting records
Preparation of Financial Statements Not done in the bookkeeping process Part of Accounting Process
Tools Journal and Ledgers Balance Sheet, Profit & Loss Account
and Cash Flow Statement
Methods / Sub-fields Single Entry System of Bookkeeping
and Double Entry System of
Bookkeeping
Financial Accounting, Cost Accounting,
Management Accounting, Human
Resource Accounting, Social
Responsibility Accounting.
Determination of Financial Position Bookkeeping does not reflect the
financial position of an organization.
Accounting clearly shows the financial
position of the entity.
4

Accounting as science and art
• As science
- An accountant finalizes the economic results by identifying,
analyzing, classifying using the method of double-entry
bookkeeping accounting system.
- So, Accounting is a science that includes comprises of rules,
principles, concepts, conventions and standards in science.
• As Art
- it presents the financial findings by following and
implementing a universally accepted method (GAAP).
- the established rules and principles of accountingis applied in
bookkeeping process of and economic entity
5

Objectives of Financial
Accounting
• To know the results of business – via profit and loss account or
income and expenditure account
• To ascertain the financial position of the business – the extent of
assets and liabilities at any point of time through preparation of
balance sheet
• To ensure control over the assets – important in prevention of
frauds, misappropriation and losses
• To facilitate proper management of cash – surplus fund can be used
in profitable ventures and deficiency of cash can be overcome by
preparing for funds from bankers etc
• To provide requisite information – information to the govt and tax
authorities with great ease, as and when needed 6

Branches of Accounting
7
Basis Financial
Accounting
CostAccounting Management
Accounting
Objects Record transactions
& determine
financial
position & profit or
loss.
Ascertainment, allocation,
accumulation and
accounting for cost
To assist the
management in
decision-making &
policy formulation.
Nature Concerned with
historical data.
Concerned with both past
and present
recorded(historical in
nature).
Deals with
projection of data for
the future (futuristic
in nature)
Principle
Followed
Governed by
GAAP
Certain principles
followed for recording
costs.
No set principles are
followed in it.
Data
used
Qualitative aspects
are not recorded
Only quantitative aspect is
recorded.
Uses both
quantitative and
qualitative concepts.

Branches of Accounting
8
Basis Financial
Accounting
CostAccounting Management
Accounting
Reporting
frequency
Generally at end
of year
As & when desired by
management
As & when desired by
management
Publication Published in case
of companies
NOT published NOT published
Information
recorded
Monetary
transactions
ONLY
Both monetary
non-monetary
information.
and Both monetary
non-monetary
information
and
Forms
Account
of Accounts are
prepared to meet
the legal
requirements.
These are generally
kept Voluntarily to
meet the requirements
of the management.
These are generally
kept Voluntarily to
meet the requirements
of the management.

NATURE OF ACCOUNTS
9
Personal Account Real Account Nominal Account
The elements or accounts
which represent persons
and organisations.
which represent tangible or
intangible aspects or helps
the organisation to earn
profit
which represent expenses,
losses, incomes, gains.
• Mrs. Vimla a/c -
representing Mrs. Vimla
a person.
• M/s Bharat & Co a/c -
representing M/s Bharat
& Co, an organisation.
• Capital a/c -
representing the owner
of the business, a person
or organisation.
• Bank a/c - representing
Bank, an organisation.
• Cash a/c - representing
cash which is tangible.
• Goods/Stock a/c -
representing Stock
which is tangible.
• Furniture a/c -
representing Furniture
which is tangible.
• Goodwill
• Salaries a/c -
representing
expenditure on account
of salaries, an expense.
• Interest received a/c -
representing income on
account of interest, an
income.
• Loss on sale of Asset a/c
- representing the loss
incurred on sale of
assets, a loss.

NATURE OF ACCOUNTS -
EXAMPLES
• Started Business with a Capital of 1,00,000.
Since capital in the form of cash is being brought into the business,
capital increases by 1,00,000 and cash increases by 1,00,000
10
Capital a/c
↓
Person
↓
Personal a/c
Cash a/c
↓
Tangible Aspect (Asset)
↓
Real a/c

EXAMPLES
• Bought Furniture for cash 25,000
Since Furniture is being bought by paying cash, the value of Furniture
increases by 25,000 and the cash available with the business would
reduce by 25,000.
11
Furniture a/c
↓
↓
Real a/c
Cash a/c
↓
↓
Real a/c

EXAMPLES
• Bought Goods for cash 25,000 from M/s Roxy Brothers.
Since goods are bought by paying cash, the value of Goods increases by
25,000 and the cash available with the business would reduce by
25,000.
12
Goods/Stock a/c
↓
↓
Real a/c
Cash a/c
↓
↓
Real a/c
*Vendor name is irrelevant in cash purchases

EXAMPLES
• Bought Goods from Mr. Shyam Rao on credit for 10,000.
Since goods are bought on credit, the value of Goods increases by
10,000. The liabilities of the business would increase by 10,000. This
liability is indicated by an element identified by the name of the vendor
who gave the goods on credit i.e. Mr. Shyam Rao.
13
Goods/Stock a/c
↓
↓
Real a/c
Mr. Shyam Rao a/c
↓
Person
↓
Personal a/c

EXAMPLES
• Sold Goods for cash 20,000 to Mr. Peter
Since goods are sold by taking cash, the value of Goods decrease by
20,000 and the cash available with the business would increase by
20,000.
14
Goods/Stock a/c
↓
↓
Real a/c
Cash a/c
↓
↓
Real a/c
*Buyer name is irrelevant

EXAMPLES
• Sold Goods on credit to M/s Bharat & Co., for 10,000.
Since goods are sold on credit, the value of Goods decreases by 10,000.
A new asset in the form of a debtor (those who owe us) is created. The
new asset is indicated by an element identified by the name of the
organisation which purchased the goods on credit i.e. M/s Bharat & Co.
15
Goods/Stock a/c
↓
↓
Real a/c
M/s Bharat & Co. a/c
↓
Person
↓
Personal a/c

Double Entry System
• Every transaction involves two parties or accounts – one
account gives the benefit and the other receives it. It is called
dual entity of transaction
• The process of keeping account accepting this dual entity i.e.
debiting one account for a definite amount of money and
crediting the other account for the same amount is called
double entry system.
• Therefore, for every debit there is a corresponding credit for
equal amount of money and for every credit there is a
corresponding debit for equal amount of money; i.e. for every
transaction one account is debited for the amount of
transaction and the other account is credited for the equal
amount of money.
16

Rules of Double Entry
Type of Account Debit Credit
Personal Account Receiver Giver
Real Account What comes in What goes out
Nominal Account Expense and losses Incomes and gains
17

Rules of Double Entry -
Examples
• Commenced business with a capital of 2,00,000.
18
Capital a/c
↓
Person
↓
Personal a/c
↓
Giving benefit
↓
Credit
[Credit the benefit giver]
Cash a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit
[Debit what comes in]

Examples
• Bought Furniture for cash 20,000.
19
Furniture a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit
Cash a/c
↓
↓
Real a/c
↓
Going out
↓
Credit
[Credit what goes out]

Examples
• Paid Rent to the shop owner Mr. Murugan 5,000.
20
Rent Paid a/c
↓
Expenditure
↓
Nominal a/c
↓
Expense
↓
Debit
[Debit all expenses/losses]
Cash a/c
↓
↓
Real a/c
↓
Going out
↓
Credit

Examples
• Paid cash into bank 1,50,000
21
Bank a/c
↓
Organisation
↓
Personal a/c
↓
Receiver
↓
Debit
[Debit the benefit receiver]
Cash a/c
↓
↓
Real a/c
↓
Going out
↓
Credit

Examples
• Bought Goods for cash 10,000 from M/s Shamir Jain & Co.,
22
Goods/Stock a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit
Cash a/c
↓
↓
Real a/c
↓
Going out
↓
Credit

Examples
• Bought Goods on credit from M/s Ramdas & Bros. for 10,000.
23
M/s Ramdas & Bros. a/c
↓
Organisation
↓
Personal a/c
↓
Giver
↓
Credit
Goods/Stock a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit

Examples
• Sold goods for cash 12,000 to Mr. Naryan Tiwari.
24
Cash a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit
Goods/Stock a/c
↓
↓
Real a/c
↓
Going out
↓
Credit

Examples
• Bought Machinery from M/s Boolani Machinery and paid by
cheque 25,000.
25
Bank a/c
↓
Organisation
↓
Personal a/c
↓
Giver
↓
Credit
Machinery a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit

Examples
• Sold goods on credit to Mr. Natekar for 8,000.
26
Mr. Natekar a/c
↓
Person
↓
Personal a/c
↓
Receiver
↓
Debit
[Debit the benefit reciever]
Goods/Stock a/c
↓
↓
Real a/c
↓
Going out
↓
Credit

Examples
• Paid weekly wages to workers 5,000
27
Wages Paid a/c
↓
Expenditure
↓
Nominal a/c
↓
Expense
↓
Debit
[Debit all expenses/losses]
Cash a/c
↓
↓
Real a/c
↓
Going out
↓
Credit

Examples
• Paid M/s Ramdas and Brothers by cheque 5,000.
28
M/s Ramdas & Bros. a/c
↓
Organisation
↓
Personal a/c
↓
Receiver
↓
Debit
[Debit the benefit reciever]
Bank a/c
↓
Organisation
↓
Personal a/c
↓
Giver
↓
Credit

Examples
• Received from Mr. Natekar 2,000
29
Cash a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit
Mr. Natekar a/c
↓
Person
↓
Personal a/c
↓
Giver
↓
Credit

Examples
• Received commission from M/s Orion Traders for giving a
trade lead 500.
30
Commission Received a/c
↓
Income
↓
Nominal a/c
↓
Income
↓
Credit
[Credit all incomes/gains]
Cash a/c
↓
↓
Real a/c
↓
Coming in
↓
Debit

Journal Entry
• A daily written records of transactions
Format
31

Journal Entry - Example
33
Journal Entry

Accounting Concepts
• Business Entity Concept
- Business is established to achieve an economic goal
- Accounting Equation –
(Assets = Liabilities + Capital)
• Money Measuring Concept
- All the events and transactions are recorded in the terms of
money
- Does not take care of the effects of inflation because it
assumes stable value for measuring
40

Accounting Concepts
• Going Concern Concept
- It assumes that business will exist for a longer period of time
- It supports the concept of valuing the assets at historical cost or
replacement cost
• Dual Aspect Concept
- Every transaction has two aspects – giving certain benefits and
receiving certain benefits
• Periodicity Concept
- Business is segmented into different periods (accounting periods)
and accordingly the result of each period is ascertained e.g. Income
statement (profit and loss), balance sheet (financial position) 41

Accounting Concepts
• Historical Cost Concept
- Transactions are recorded wrt the respective amounts
involved.
- Does not take in account the inflation rate and depreciation
rates
• Matching Concept
- All the costs should be associated to a particular period should
be compared with revenues associated with that period to
obtain net income
- It necessitates adjustments for outstanding expenses, prepaid
expenses, etc 42

Accounting Concepts
• Realisation Concept
- Recognises revenue when sale is made
• Accrual Concept
- Revenue is recognised on its realisation
- Cost is recognised when it is incurred and not when the
payment is made
• Objective Evidence Concept
- Accounting must be based on objective evidence – every
transaction should be supported by verifiable document and
free from biasness
43

Accounting Conventions
• Conservatism
- Revenues and profits are not anticipated. Only realized profits
with reasonable certainty are recognized in the profit and loss
account
- However, provision is made for all known expenses and losses
whether the amount is known for certain or just an estimation
- This treatment minimizes the reported profits and the
valuation of assets
44

• Consistency
- Companies should choose the most suitable accounting
methods and treatments, and consistently apply them in
every period
- Changes are permitted only when the new method is
considered better and can reflect the true and fair view of the
financial position of the company
- The change and its effect on profits should be disclosed in the
financial statements
45

• Disclosure
- Financial statements should be prepared to reflect a true and
fair view of the financial position and performance of the
enterprise
- All material and relevant information must be disclosed in the
financial statements
46

Uses of Financial Accounting
• Ascertaining the operation profit or loss
• Ascertaining the financial position of the business
• Keeping systematic records
• Protecting and controlling business properties
• Facilitating rational decision-making
• Planning and control operations.
• Compliance with the legal requirements
• Making information available to various groups and users at a
particular time.
• Evidence in court in case of dispute
• Substitute of memory
• Settlement of taxation liability
• Comparative study
• Sale of business
• The amount ,size and causes of increase or decrease of capital 47

Users of Accounting
Information – Internal
• Owners
- They provide funds for the operations of a business
- Interested in knowing how profitably the business operations have
been carried out and how the capital is deployed in the form of
assets and liabilities
• Management
- As the management is answerable to the owners, they need up to
date information which helps them in various facets of management
like planning, decision making and controlling
• Employees
- They need this information to analyse the which firm they are
serving and how the bonus and incentives would be paid to them 48

Users of Accounting
Information - External
• Prospective Investors
- they are the potential investors
- By reviewing the past and present performance of the business, they
decide to invest their money
• Creditors
- Included supplier of goods and services on credit and others lending
money
- their welfare is closely related to the progress of the business as they
can analyse the paying off capacity of the business
• Government
- Its needs information for taxation and other purposes e.g. sales tax,
income tax, excise duty etc.
• Consumers
- To analyse the exercise better control over cost of production and this
inturn improves the image and reputation of the business
• Research Scholars
- To analyze the financial operations
49

Advantages of Accounting
1. Complete and Systematic Record:
Accounting is based on generally accepted principles and a scientific way of presentation of
business transactions in books of accounts. As such, accounting is a complete and systematic
recording of all business transactions. The limitations of humans, that they can not keep all
transactions in mind, is overcome by accounting because each and every business transaction
can be recorded and analyzed through same.
2. Determination of Selling Price:
The main function of the management is decision making. Accounting helps and guides the
management to take decisions in respect of determining selling price, deduction of cost,
increase in sales etc.
3. Valuation of the Business:
In case of sale of business or conversion of one business into another, true and fair value of
the business is calculated. Through accounting, the correct picture can be depicted in Balance
Sheet and as such the purchase price can be determined. Balance Sheet shows the value of
assets & liabilities of the business which can be used to calculate its net worth.
50

4. Helps in Raising Loan:
For further expansion, business must have sufficient funds. Sometimes, due to paucity of
funds business cannot do well. In those cases further funds can be raised by taking loan from
some financial institutions like banks, IDBI, ICICI etc. These financial institutions lend money on
the basis of profitability and soundness of the business enterprise. The profitability and
soundness can be measured by the Trading and Profit & Loss Account and Balance Sheet, the
final results of books of accounts.
5. Evidence in Court of Law:
The business transactions are recorded in the books of accounts supported by authenticated
documents viz. vouchers etc. Thus, the accounts can be used as an evidence in the court of
law.
6. In Compliance of Law:
Every business has to deal with various government departments like income tax, sales tax,
custom and excise etc. Various periodic returns are to be filed with these departments.
Accounting helps in preparation and filing of such returns.
51

7. Inter-Firm or Intra-Firm Comparison:
• Trading and Profit & Loss Account shows net profit earned or net loss sustained by the
business. If the accounts are maintained properly, records relating to various expenses,
sales, gross profit and net profit etc. can be compared.
• As such, accounting helps in inter- firm and intra-firm comparison. Comparison of accounts
of two different enterprises for the same year is known as inter-firm comparison and
comparison of two different periods for the same business enterprise is known as intra-firm
comparison. The performance of the business enterprise is then compared with the
predetermined goals and shortcomings, if any, can be rectified accordingly.
8. Facilitates Audit:
Depending upon the size, nature and type of business, certification of books of accounts,
known as audit, is mandatory. Audit certificate issued by the auditor on the accounts is a clean
chit to organization which proves that there are no irregularities in the organization.
9. Effective Management:
Accounting facilitates proper feed back to the management. As such, it helps the management
in planning as well as control of different activities of the business enterprise. It also helps the
management to evaluate the performance of the business enterprise and takes timely action
to remove the shortcomings in the management.
52

Limitations of Financial
Accounting
• Records only monetary transactions
• Effects of price level accounting is not considered
• No realistic information due to concepts and convention
followed
• Personal bias of accountant affects the accounting statements
• Permits alternative treatment – Lack of uniformity in
accounting principles
• Historical in Nature – records only the past transactions and
no guidance of future
• Does not record the effect of various govt regulations
53

Important Terms for Reference
54

Business Transaction
• Any exchange of money or money’s worth as goods
and services between two parties is called a
business transaction
• An event which can be expressed in terms of
money May relate to purchase and sale of goods,
receipt and
• payment of cash and rendering of services by one
party to another.
• Transactions may be:
I. Cash transaction: When payment is made immediately
II. Credit transaction :When payment is
postponed to a future date 55

Assets
It is any physical thing or right owned which has money
value.
56
• These are resources owned by the business which are
expected to give benefits in the future.
• Assets may be fixed assets or current assets
• Assets include:
– Land - tangible
– Building - Tangible
– Equipment – Tangible
– Goodwill – Intangible
– Brand - Intangible

Liability
• These are amounts owed by the enterprise to
the outsiders i.e. to all others except the owner
• These are claims of outsiders on assets of the
firm.
57

Capital (Owner’s Equity)
• It is the claim of owners on the assets of an
enterprise.
• It is the excess of assets over liabilities i.e. it is
what’s left of the assets after liabilities have been
deducted.
• Also known as networth
58

Revenue
59
• They are amounts received from
customers for:
– sales of products or
– performance of services or
– in return of use of the firm’s assets by outsiders.
• Revenues include the following
– Sales proceeds
– fees for performance of services
– rent
– interest

Expense
• An expense is the amount incurred in the
process of earning revenue.
• They are amounts that have been paid or will be
paid later for costs that have been incurred to
earn revenue.
• Include:
– salaries and wages
– Utilities payments
– supplies used
– advertising 60

Income
• It is excess of revenue over expense
• It is the favorable change in owner’s equity which results
from operations i.e. it is an inflow of assets or decrease in
liabilities resulting in increase in capital.
61

Trade Debtor (Account
Receivable)
• A debtor is a person who owes money.
• The amount due from a debtor as per books of account
is called book debt or Accounts Receivable.
• A trade debtor is a person who owes money as a result
of purchase of goods or services on credit
62

Trade Creditor (Accounts
Payable)
• A creditor person to whom money is owing or payable.
• A trade creditor is a person who owes to whom money is
owing or payable as a result of purchase of goods or services
on credit
• Accounts Payable is a liability that results from the
purchase of goods or services on account (on credit)
63

Expenditure
• Takes place when an asset or service is acquired.
• Include both payment of a sum
immediately and a promise to pay it at a future date.
• An expense is an expenditure whose benefit finishes or is enjoyed
immediately such as salaries, rent, etc.
• An expenditure which will provide benefits in the future is
considered as an asset
• A loss is an expenditure without any
benefitto the concern 64

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