1 – Introduction to Financial Accounting

Introduction:

Accounting is a business language that describes numerous transactions that occur over a specific period.
Accounting is usually divided into three functions:
1. Recording,
2. Categorizing and
3. Summarising
The term accounting is defined as follows by the American Institute of Certified Public Accountants Association: “Accounting is the process of recording, classifying, and summarising major financial transactions, and then interpreting the results.”

1.1 The Importance of Financial Accounting

A well-known author of Accounting, [Prof. R.R. Gupta, Principal, Poddar College, Nawalgarh (Rajasthan),] wrote in ”First write/record before one delivers goods or renders the services and if there is any disagreement in future, use the writing or record as evidence to resolve the misunderstanding or rectify the error.”
The recording of business transactions is required from the perspective of the owners and any interested parties. People in the second category supply materials, products, and services to businesses, governments, and society. Creditors (suppliers ready to accept payment later) want to know whether the firm can pay them later (solvency of the business). In contrast, the government wants to know whether the company has paid all taxes, fees, etc.

1.2 Accounting Objectives

The primary goal of bookkeeping and accounting is to provide financial data to those interested in the firm. In summary, accounting’s goals are as follows:

1. To keep the business’s records methodically: Accounting’s primary goal is to keep detailed records of all business transactions. Because human memory is minimal and short, remembering all the transactions would be pretty challenging, especially if there were many transactions. As a result, it is critical to accurately record all company transactions to calculate the amount of profit or loss and the organisation’s financial situation on a specific day.

2. Determining the business’s profit or loss: The primary goal of the business is to make a profit. Profits are computed with the assistance of financial accounting. Financial accounting aids in determining a company’s net profit or loss over time. A trade, profit and loss account is prepared after a period to calculate the amount of profit or loss. If the revenue for a period exceeds the expenses incurred to earn that income, the period is said to be profitable; if the costs exceed the revenues for the time, the period is said to be losing. In the event of a profit, management can consider the selling price, output, etc.

3. To demonstrate the company’s financial position: Accounting aims to record the organisation’s financial transactions, determine profit or loss, and present the business’s financial situation. Financial accounting aids in preparing the balance sheet to show the financial condition. The balance sheet is a statement of the company’s assets and liabilities. It also provides information on borrowed and held capital and various assets, such as fixed, current, and miscellaneous assets. A balance sheet represents a company’s financial situation.

4. To disseminate financial information to diverse users: Another goal of accounting is to offer the necessary financial information to various internal and external users. Owners, shareholders, and management are internal consumers of financial statements, whereas debenture holders, creditors, investors, employees, the government, and others are external users of financial statements.

1.3 Accounting Specializations

Accounting’s primary goals are to record company transactions and provide essential financial statement information to internal and external users. Accounting is divided into the following branches to fulfil the goals above:

1. Accounting for Finance: This is the oldest type of accounting. It refers to recording daily financial transactions in a company. The transaction is recorded so that the business’s profit can be calculated after a specific time, and a picture of the business’s financial status can be given.

2. Cost Accounting: As the name implies, this accounting is concerned with determining the cost of a product over a given period. To control costs, a record of raw materials used in manufacturing, wages and labour paid, and other expenses expended on production is kept under this system.

3. Management Accounting: Management accounting provides essential information to management. It involves analyzing and interpreting financial accounting accounts so managers can foresee, plan for the future, and frame policies.

4. Tax Accounting: In tax accounting, accountants create accounts by taxation regulations. Accounts created following taxation provisions may differ from accounts prepared by financial accounting.

5. Inflation Accounting: Financial statements are created using historical costs, which do not accurately portray the business’s financial position or correct profit or loss due to inflation. As a result, the new financial statements are prepared with price level changes in mind under inflation accounting.

6. Accounting for Human Resources: Human Resource Accounting refers to accounting for humans, as humans are now recognised as assets in organisations, just like other physical assets. They are recorded in the books in the same way as other assets. HRA deals with the cost of recruiting, choosing, hiring, training, placing, and developing people on the one hand and the existing economic value of the personnel on the other. HRA uses a variety of approaches to determine a human being’s worth.

7. Duty Accounting: Responsibility accounting is a management technique that defines accountability based on management’s delegated responsibility levels. A management information and reporting system is implemented to provide proper feedback on the delegated responsibility. Under this method, components of an organisation are formed as responsibility centres and evaluated individually for their performance, each under the authority of a specific person.

1.4 Accounting Functions

Accounting’s primary job is to objectively and consistently document corporate transactions. Aside from this, accounting also performs the following functions:

1. It depicts an honest and fair image of the company’s financial status.
2. It aids in determining the firm’s profit or loss, which is the sole major goal of the business.
3. It aids in future decision-making by various individuals interested in such accounting information.
4. It displays the company’s earning potential.
5. It satisfies all government norms and regulations about accounting information, requiring all firms to prepare their statements following the Indian Companies Act, 1956, as revised to date.

1.5 Accounting Information Users

Internal and external users are the categories of people interested in financial statements.

1. Internal Users: These include (a) shareholders, (b) management, and (c) employees of trade unions, among others.

(a) Shareholders want to know how the company is doing. Financial statements can help them learn about the company’s operational outcomes and financial situation.

(b) Management is eager to make important decisions about fixing selling prices and formulating future policies.

(c) Trade unions and employees are interested in operational outcomes since their bonuses and other benefits are based on the business’s profit. Financial statements also aid in wage/salary negotiations.

2. External Users: External users of financial statements include the following:

(a) Investors: They are interested in a company’s earning capacity, which financial statements can determine. They can also learn about the company’s economic health by reviewing its financial statements.

(b) Creditors, Lenders of Money, and Others: Financial statements can also inform creditors and lenders of money, among others, about the financial soundness of a company. They must notice two things: I the consistency of the income and (ii) the business’s solvency for their investment to be risk-free.

(c) Government: The government develops laws to regulate commercial activity and taxation, among other things. Financial statements aid in the computation of National Income figures.

(d) Taxing authorities: Financial statements contain information on the company’s operating results and financial position. Tax authorities determine the amount of tax based on financial statements. This benefit other taxing bodies, such as sales tax.

(e) Stock exchanges are intended to tax shares and securities. Shares and securities can be purchased and sold through stock exchanges, which provide financial information about each listed company.

3. Consumers: These individuals are interested in obtaining items at a lower cost. As a result, they want to know how to set up a suitable accounting control, which will minimise the cost of manufacturing, resulting in a lower price for consumers. Accounts for interpretation are also of interest to researchers.

4. Scholars of Research: Accounting information, as a reflection of a business organization’s financial performance, is precious to a researcher who wants to research the financial operations of a particular firm. To conduct a study into the financial operations of a specific firm, the research scholar requires detailed accounting information relating to purchases, sales, expenses, cost of materials used, current assets, current liabilities, fixed assets, long-term liabilities, and share-holder funds that are available in the firm’s accounting record.

1.6 Distinctions Between Bookkeeping and Accounting

As previously stated, accounting is finding, measuring, and conveying an organization’s economic information to its users, who use it for decision-making. It identifies a specific entity’s transactions and events. Before understanding the distinction between accounting and bookkeeping, we must first understand the meaning and notion of bookkeeping.

Bookkeeping: Meaning and Definition

Bookkeeping entails keeping a notebook, posting to ledgers, and balancing accounts. The entire subject of bookkeeping is all of the records before the preparation of the trial balance. Thus, bookkeeping may be described as the science and art of accurately and methodically recording transactions in money or money’s worth in a specific set of books regularly so that the actual state of a businessman’s affairs may be reliably discovered. It is vital to highlight that only commercial transactions that can be stated in monetary terms are documented.

The Purposes of Bookkeeping

1. Bookkeeping keeps a permanent record of every transaction.
2. Tracking a company’s resources and capabilities on a specific date can help determine its soundness.
3. Entries relating to a company’s income and expenses make it easier to determine its profit and loss for a specific time.
4. It allows you to create a list of customers and suppliers to calculate the amount received or paid.
5. It is a method that allows evaluating corporate policy in light of prior performance.
6. Records are used to amend business laws, issue licences, assess taxes, etc.

The following table explains the  differences between bookkeeping and accounting:

1.7 Accounting Terminology Basics

Accounting terminology refers to the terms that are commonly used in day-to-day business. As a result, it is critical to understand all of the terms. Some of the terms that are frequently used are as follows:

1. Capital is the sum of money the business owner has invested. It is also referred to as owners’ equity or net worth. It is equal to the total assets minus the total liabilities. In other words, capital is the excess of assets over liabilities. Because a business is considered a separate entity, any capital invested by the owner is viewed as a liability for the business. This can be demonstrated algebraically:

Capital equals total assets minus total liabilities.

2. Assets: Assets are the things or valuable properties the company uses in its operations. In other words, an asset is anything that benefits the firm. According to Finny and Miller, “Assets are future economic benefits—the rights that an organisation or individual owns or controls,” Kohler’s Dictionary for Accountants defines an asset as “any owned physical property (tangible) or right (intangible) having economic value to the owner.” By definition, assets are “physical goods or intangible rights controlled by a firm and carrying likely future benefits,” according to the Institute of Chartered Accountants of India. As a result of the preceding definitions, it is evident that an asset must have future economic benefit and must be held by an enterprise. Fixed assets and current assets are the two basic categories of assets:

a. Fixed assets, such as land and buildings, plant and machinery, and furniture, are purchased to operate a business and not for resale.
b. Current assets are assets held for a short period to be converted into cash or resold, such as unsold goods, debtors, bills receivable, bank balances, etc.

3. Liability: It is defined as currently existing commitments that a commercial enterprise must meet at some point in the future. “Liabilities are debts, amounts owed to creditors,” write Finny and Miller. In other words, liabilities are obligations that do not involve capital (the business owner’s contribution). Liabilities are “probable future sacrifices of economic benefits arising from the present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events,” according to F.A.S.B. Stanford (1980). In contrast, the Accounting Principles Board (APB) defines liabilities as “economic obligations of an enterprise recognised and measured by generally accepted accounting principles.” As a result of the preceding definitions, it is clear that liability is a legal obligation to pay for a transaction that has already occurred. Liabilities may be grouped into three sorts, namely:

a. Short-term liabilities are obligations payable within one year. Examples are creditors, bills payable, and an overdraft from a bank.
b. Long-term liabilities are obligations payable after one year, such as debentures and bonds issued by the corporation.
c. Contingent liability is a liability that arises only if an uncertain event occurs. If it happens, the contingent responsibility exists. There is no liability if it does not occur. Such liabilities are not included in the balance sheet but are mentioned in a footnote. Examples of such liabilities include (i) liability for discounted bills and (ii) claims against the firm that are not recognised as debts.

4. Debtors: Debtors are people who owe money to a business in exchange for getting goods or services on credit. An enterprise’s balance sheet shows the total balance outstanding at the end of a specific date as an asset. Debtors are also referred to as accounts receivable.

5. Creditors: The creditors are the people or businesses to whom the firm owes money for goods or services.

6. Revenue: A company’s revenue is the money it receives from selling a good or providing services to customers. Income examples are sales, commissions, interest, dividends, rent, and royalties. It is the sum added to capital as a result of company operations.

7. Equity: Normally, equity refers to ownership or a percentage of ownership in a corporation or valuable assets.

8. Bills of Exchange: A written order from one person (the payor) to another, signed by the person giving it, requiring the person to whom it is addressed to pay a certain sum of money on demand or at some fixed future date, to either the person identified as the payee or to any person presenting the bill of exchange.

9. Income: The financial gain (earned or unearned) accrued over a specific period.

10. Expenditure: A payment or the incurrence of an obligation to pay for an item or service supplied in the future.

11. Profit and Loss Account: The second section of Trading and Profit & Loss Account is Profit & Loss Account. The trading account displays the gross profit and the difference between sales and costs. As a result, gross profit cannot be viewed as net profit when a business owner wishes to determine how much net profit he has produced from operating operations during a given period. For this purpose, a Profit & Loss Account includes all of the business’s operating and non-operating earnings and losses. All expenses and losses are declared on the debit side (left-hand side), and all income is disclosed on the credit side (right-hand side). The excess of credit over debit is called net profit, whereas the excess over credit is called net loss.

12. Goods: A broad term for the goods in which the business trades; that is, only those articles purchased for resale for profit are referred to as goods.

13. Drawings: The quantity of money or the value of things the proprietor takes for personal or household use. It is typically deducted from capital.