INTRODUCTION TO FINANCIAL
ACCOUNTING AND ITS TERMS
JKSSB PANCHAYAT ACCOUNT ASSISTANT

PANCHAYAT ACCOUNT ASSISTANT STUDY MATERIAL

INTRODUCTION TO FINANCIAL ACCOUNTING AND ITS TERMS JKSSB

➢ Accounting

Accounting is the art of recording, classifying and summarising the economic information 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.

➢ Functions of Accounting

1) Identifying:

The first step in accounting is to determine what to record, i.e., to identify the financial events which are to be recorded in the books of accounts. It involves observing all business activities and selecting those events or transactions which can be considered as financial transactions.

2) Recording: A transaction will be recorded in the books of accounts only it is considered as an economic event and can be measured in terms of money. Once the economic events are identified and measured in economic terms they will be recorded in the books of accounts in monetary terms and in chronological order.

3) Classifying: Once the financial transactions are recorded in journal or subsidiary books, all the financial transactions are classified by grouping the transactions of one nature at one place in a separate room.

4) Summarising: It is concerned with presentation of data and it begins with balance of ledger accounts and the preparation of trial balance with the help of such balances. 5) Communication: The main purpose of accounting is to communicate the financial information the users who analyse them as per their individual requirements. Providing financial information to its users is a regular process.

➢ Objectives of Accounting

1) To keep systematic and complete records of financial transactions in the books of accounts according to specified principles and rules to avoid the possibility of omission and fraud.

2) To ascertain the profit earned or loss incurred during a particular accounting period which further help in knowing the financial performance of a business.

3) To ascertain the financial position of the business by the means of financial statement i.e. balance sheet which shows assets on one side and Capital & Liabilities on the other side.

4) To provide useful accounting information to users like owners, investors, creditors, banks, employees and government authorities etc who analyze them as per their requirements.

5) To provide financial information to the management which help in decision making, budgeting and forecasting.

6) To prevent frauds by maintaining regular and systematic accounting records.

➢ Advantages of Accounting

1) It provides information which is useful to management for making economic decisions.

2) It helps owners to compare one year’s results with those of other years to locate the factors which leads to changes.

3) It provides information about the financial position of the business by means of balance sheet which shows assets on one side and Capital & Liabilities on the other side.

4) It helps in keeping systematic and complete records of business transactions in the books of accounts according to specified principles and rules, which is accepted by the Courts as evidence.

5) It helps a firm in the assessment of its correct tax Liabilities such as income tax, sales tax, VAT, excise duty etc.

6) Properly maintained accounts help a business entity in determining its proper purchase Price.

➢ Limitations of Accounting

1) It is historical in nature; it does not reflect the current worth of a business. Moreover, the

figures given in financial statements ignore the effects of changes in price level.

2) It contains only those information’s which can be expressed in terms of money. It ignores qualitative elements such as efficiency of management, quality of staff, customer’s satisfactions etc. 3) It may be affected by window dressing i.e. manipulation in accounts to present a more favorable position of a business firm than its actual position.

4) It is not free from personal bias and personal judgment of the people dealing with it. For example, different people have different opinions regarding life of asset for calculating depreciation, provision for doubtful debts etc.

5) It is based on various concepts and conventions which may hamper the disclosure of realistic financial position of a business firm. For example, assets in balance sheet are shown at their cost and not at their market value which could be realised on their sale.

➢ Book Keeping - The Basis of Accounting

Book keeping is the record-making phase of accounting which is concerned with the recording of financial transactions and events relating to business in a significant and orderly manner. Book Keeping should not be confused with accounting. Book keeping is the recording phase while accounting is concerned with the summarizing phase of an accounting system. The distinction between the two are as under. Accounting Book Keeping

1) It is the summarizing phase of an accounting system.

1) It is the recording phase of an accounting system.

2) It is a Secondary Stage which begins where the Book keeping process ends.

2) It is a primary stage and basis for accounting.

3) It is analytical in nature and required special skill or knowledge.

3) It is routine in nature and does not require any special skill or knowledge

4) It is done by senior staff called accountants.

4) It is done by junior staff called bookkeepers

5) It gives the complete picture of the financial conditions of the business unit.

5) It does not give the complete picture of the financial conditions of the business unit.

➢ Types of accounting information

Accounting information can be categorized into following:

1) Information relating to profit or loss i.e. income statement, shows the net profit of business operations of a firm during a particular accounting period.

2) Information relating to Financial position i.e. Balance Sheet. It shows assets on one side and Capital & Liabilities on the other side. Schedules and notes forming part of balance sheet and income statement to give details of various items shown in both of them.

1) Financial Accounting:

It is that subfield/Branch of accounting which is concerned with recording of business transactions of financial nature in a systematic manner, to ascertain the profit or loss of the accounting period and to present the financial position of the Business.

2) Cost Accounting: It is that Subfield/Branch of accounting which is concerned with ascertainment of total cost and per unit cost of goods or services produced/ provided by a business firm.

3) Management Accounting: It is that subfield/Branch of accounting which is concerned with presenting the accounting information in such a manner that help the management in planning and controlling the operations of a business and in better decision making.

➢ Qualitative Characteristics of Accounting Information

1) Reliability: Means the information must be based on facts and be verified through source documents by anyone. It must be free from bias and errors.

2) Relevance: To be relevant, information must be available in time and must influence the decisions of users by helping them to form prediction about the outcomes.

3) Understandability: The information should be presented in such a manner that users can understand it well.

4) Comparability: The information should be disclosed in such a manner that it can be compared with previous year’s figures of business itself and other firm’s data. Accounting information is useful for interested users only if it poses the following characteristics:

ACCOUNTING TERMS

➢ Assets

Assets are valuable and economic resources of an enterprise useful in its operations.

Assets can be broadly classified as:

1) Current Assets: Current Assets are those assets which are held for short period and can

be converted into cash within one year. For example: Debtors, stock etc.

2) Non-Current Assets: Non-Current Assets are those assets which are hold for long period and used for normal business operation. For example: Land, Building, Machinery etc.

They are further classified into:

a) Tangible Assets: Tangible Assets are those assets which have physical existence

and can be seen and touched. For Example: Furniture, Machinery etc.

b) Intangible Assets: Intangible Assets are those assets which have no physical existence and can be felt by operation. For example: Goodwill, Patent, Trade mark etc.

➢ Liabilities

Liabilities are obligations or debts that an enterprise has to pay after some time in the

future. Liabilities can be classified as:

1) Current Liabilities: Current Liabilities are obligations or debts that are payable within a

period of one year. For Example: Creditors, Bill Payable etc.

2) Non-Current Liabilities: Non-Current Liabilities are those obligations or debts that are payable after a period of one year. Example: Bank Loan, Debentures etc.

➢ Receipts

A written acknowledgment of having received, or taken into one's possession, a specified amount of money, goods, etc. receipts, the amount or quantity received. the act of receiving or the state of being received. Receipts can be classified as:

1) Revenue Receipts: Revenue Receipts are those receipts which are occurred by normal

operation of business like money received by sale of business products.

2) Capital Receipts: Capital Receipts are those receipts which are occurred by other than business operations like money received by sale of fixed assets.

➢ Expenses

Costs incurred by a business for earning revenue are known as expenses. For example:

Rent, Wages, Salaries, Interest etc.

➢ Expenditure

Spending money or incurring a liability for acquiring assets, goods or services is called

expenditure. The expenditure is classified as:

1) Revenue Expenditure: It is the amount spent to purchase goods and services that are used during an accounting period is called revenue expenditure. For Example: Rent,

interest, etc.

2) Capital Expenditure: If benefit of expenditure is received for more than one year, it is

called capital expenditure. Example: Purchase of Machinery.

3) Deferred Revenue Expenditure: There are certain expenditures which are revenue in nature but benefit of which is derived over number of years. For Example: Huge Advertisement Expenditure.

➢ Business Transaction

An Economic activity that affects financial position of the business and can be measured in terms of money e.g., expenses etc.

➢ Account

Account refers to a summarized record of relevant transactions of particular head at one place. All accounts are divided into two sides. The left side of an account is called debit side and the right side of an account is called credit side.

➢ Capital

Amount invested by the owner in the firm is known as capital. It may be brought in the form of cash or assets by the owner.

➢ Drawings

The money or goods or both withdrawn by owner from business for personal use, is known as drawings. Example: Purchase of car for wife by withdrawing money from Business.

➢ Profit

The excess of revenues over its related expenses during an accounting year is profit. Profit = Revenue – Expenses.

➢ Gain

A non-recurring profit from events or transactions incidental to business such as sale of

fixed assets, appreciation in the value of an asset etc.

➢ Loss

The excess of expenses of a period over its related revenues is termed as loss. Loss = Expenses – Revenue.

➢ Goods

The products in which the business deal in. The items that are purchased for the purpose of resale and not for use in the business are called goods.

➢ Purchases

The term purchased is used only for the goods procured by a business for resale. In case of trading concerns it is purchase of final goods and in manufacturing concern it is purchase of raw materials. Purchases may be cash purchases or credit purchases.

➢ Purchase Return

When purchased goods are returned to the suppliers, these are known as purchase return.

➢ Sales

Sales are total revenues from goods sold or services provided to customers. Sales may be cash sales or credit sales.

➢ Sales Return

When sold goods are returned from customer due to any reason is known as sales return.

➢ Debtors

Debtors are persons and/or other entities to whom business has sold goods and services on credit and amount has not received yet. These are assets of the business.

➢ Creditors

If the business buys goods/services on credit and amount is still to be paid to the persons and/or other entities, these are called creditors. These are liabilities for the business.

➢ Bill Receivable

Bill Receivable is an accounting term of Bill of Exchange. A Bill of Exchange is Bill Receivable for seller at time of credit sale.

➢ Bill Payable

Bill Payable is also an accounting term of Bill of Exchange. A Bill of Exchange is Bill Payable for purchaser at time of credit purchase.

➢ Discount

Discount is the rebate given by the seller to the buyer. It can be classified as:

1) Trade Discount: The purpose of this discount is to persuade the buyer to buy more goods. It is offered at an agreed percentage of list price at the time of selling goods. This discount is not recorded in the accounting books as it is deducted in the invoice/cash memo. 2) Cash Discount: The objective of providing cash discount is to encourage the debtors to pay the dues promptly. This discount is recorded in the accounting books.

➢ Income

Income is a wider term, which includes profit also. Income means increase in the wealth of the enterprise over a period of time.

➢ Stock

The goods available with the business for sale on a particular date is known as stock.

➢ Cost

Cost refers to expenditures incurred in acquiring manufacturing and processing goods to make it saleable.

➢ Voucher

The documentary evidence in support of a transaction is known as voucher. For example, if we buy goods for cash we get cash memo, if we buy goods on credit, we get an invoice, when we make a payment we get a receipt.

➢ Double Entry System of Book-keeping

Double Entry System of Book-keeping refers to a system of accounting under which both the aspects (i.e. debit or credit) of every transaction are recorded in the accounts involved. The individual record of person or thing or an item of income or an expense is called an account. Every debit has equal amount of credit. So the total of all debits must be equal to the total of all credits.

ACCOUNTING PRINCIPLES

➢ Introduction To maintain uniformity in recording transactions and preparing financial statements, accountants should follow Generally Accepted Accounting Principles.

➢ Accounting Principles Accounting principles are the rules of action or conduct adopted by accountants universally while recording accounting transactions. GAAP refers to the rules or guidelines adopted for recording and reporting of business transactions, in order to bring uniformity in the preparation and presentation of financial statements. These principles

are classified into two categories:

1) Accounting Concepts:

They are the basic assumptions within which accounting operates.

2) Accounting Conventions:

These are the outcome of the accounting practices or principles being followed over a long period of time.

• Features of accounting principles

(1) Accounting principles are manmade.

(2) Accounting principles are flexible in nature.

(3) Accounting principles are generally accepted.

• Necessity of accounting principles

Accounting information is meaningful and useful for users if the accounting records and financial statements are prepared following generally accepted accounting information in standard forms which are understood.

• Types of Accounting Principles

1) Accounting Entity or Business Entity Principle:

An entity has a separate existence from its owner. According to this principle, business is treated as an entity, which is separate and distinct from its owner. Therefore, transactions are recorded and analyzed, and the financial statements are prepared from the point of view of business and not the owner. The owner is treated as a creditor (Internal liability) for his investment in the business, i.e. to the extent of capital invested by him. Interest on capital is treated as an expense like any other business expense. His private expenses are treated as drawings leading to reductions in capital.

2) Money Measurement Principle:

According to this principle, only those transactions that are measured in money or can be expressed in terms of money are recorded in the books of accounts of the enterprise. Non-monetary events like death of any employee/Manager, strikes, disputes etc., are not recorded at all, even though these also affect the business operations significantly.

3) Accounting Period Principle:

According to this principle, the life of an enterprise is divided into smaller periods so that its performance can be measured at regular intervals. These smaller periods are called accounting periods. Accounting period is defined as the interval of time, at the end of which the profit and loss account and the balance sheet are prepared, so that the performance is measured at regular intervals and decisions can be taken at the appropriate time. Accounting period is usually a period of one year, which may be a financial year or a calendar year.

4) Full Disclosure Principle:

According to this principle, apart from legal requirements, all significant and material information related to the economic affairs of the entity should be completely disclosed in its financial statements and the accompanying notes to accounts. The financial statements should act as a means of conveying and not concealing the information. Disclosure of information will result in better understanding and the parties may be able to take sound decisions on the basis of the information provided.

5) Materiality Principle:

According to this principle, only those items or information should be disclosed that have a material effect and are relevant to the users. Disclosure of all material facts is compulsory but it does not imply that even those figures which are irrelevant are to be included in the financial statements. Whether an item is material or not depends on its nature. So, an item having an insignificant effect or being irrelevant to user need not be disclosed separately, it may be merged with other item. If the knowledge about any information is likely to affect the user’s decision, it is termed as material Information.

6) Prudence or Conservatism Principle:

According to this principle, prospective profit should not be recorded but all prospective losses should immediately be recorded. The objective of this principle is not to overstate the profit of the enterprise in any case and this concept ensures that a realistic picture of the company is portrayed. When different equally acceptable alternative methods are available, the method having the least favorable immediate effect on profit should be adopted.

7) Cost Principle or Historical cost concept:

According to this Principle, an asset is recorded in the books of accounts at its original cost comprising of the cost of acquisition and all the expenditure incurred for making the assets ready to use. This cost becomes the basis of all subsequent accounting transactions for the asset. Since the acquisition cost relates to the past, it is referred to as the Historical cost.

8) Matching Principle:

According to this principle, all expenses incurred by an enterprise during an accounting period are matched with the revenues recognized during the same period. The matching principle facilitates the ascertainment of the amount of profit earned or loss incurred in a particular period by deducting the related expenses from the revenue recognized in that period. It is not relevant when the payment was made or received. This concept should be followed to have a true and fair view of the financial position of the company.

9) Dual Aspect Principle:

According to this principle, every business transaction has two aspects - a debit and a credit of equal amount. In other words, for every debit there is a credit of equal amount in one or more accounts and vice-versa. The system of recording transactions on the basis of this principle is known as “Double Entry System”. Due to this principle, the two sides of the Balance Sheet are always equal and the following accounting equation will always hold good at any point of time. Assets = Liabilities + Capital Example: Ram started business with cash Rs. 1,00,000. It increases cash in assets side and capital in liabilities- side by Rs. 1,00,000. Assets Rs. 1,00,000 = Liabilities + Capital Rs. 1,00,000.

10) Revenue Recognition Concept:

This principle is concerned with the revenue being recognised in the Income Statement of an enterprise. Revenue is the grass inflow of cash, receivables or other considerations arising in the course of ordinary activities of an enterprise from the sale of goods, rendering of services and use of enterprise resources by others yielding interests, royalties and dividends. It excludes the amount collected on behalf of third parties such as certain taxes. Revenue is recognised in the period in which it is earned irrespective of the fact whether it is received or not during that period.

11) Verifiable Objective concept:

This concept holds that accounting should be free from personal bias. This means that all business transactions should be supported by business documents like cash memo, invoices, sales bills etc.

➢ Fundamental Accounting Assumptions

1) Going Concern Assumption:

This concept assumes that an enterprise has an indefinite life or existence. It is assumed that the business does not have an intention to liquidate or to scale down its operations significantly. This concept is instrumental for the company in:

1. making a distinction between capital expenditure and revenue expenditure.

2. Classification of assets and liabilities into current and non-current.

3. providing depreciation charged on fixed assets and appearance in the Balance Sheet at book value, without having reference to their market value.

4. It may be noted that if there are good reasons to believe that the business, or some part of it, is going to be liquidated or that it will cease to operate (say within a year or two), then the resources could be reported at their current values (or liquidation values).

2) Consistency Assumption:

According to this assumption, accounting practices once selected and adopted, should be applied consistently year after year. This will ensure a meaningful study of the performance of the business for a number of years. Consistency assumption does not mean that particular practices, once adopted, cannot be changed. The only requirement is that when a change is desirable, it should be fully disclosed in the financial statements along with its effect on income statement and Balance Sheet. Any accounting practice may be changed if the law or Accounting standard requires so, to make the financial information more meaningful and transparent.

3) Accrual Assumption:

As per Accrual assumption, all revenues and costs are recognized when they are earned or incurred. This concept applies equally to revenues and expenses. It is immaterial, whether the cash is received or paid at the time of transaction or on a later date.

➢ Bases of Accounting

There are two bases of ascertaining profit or loss, namely:

1) Cash basis

Under this, entries in the books of accounts are made when cash id received or paid and not when the receipt or payment becomes due. For example, if salary Rs. 7,000 of January 2010 paid in February 2010 it would be recorded in the books of accounts only in February, 2010.

2) Accrual basis

Under this however, revenues and costs are recognized in the period in which they occur rather when they are paid. It means it record the effect of transaction is taken into book in the when they are earned rather than in the period in which cash is actually received or paid by the enterprise. It is more appropriate basis for calculation of profits as expenses are matched against revenue earned in the relation thereto. For example, raw materials consumed are matched against the cost of goods sold for the accounting period.

➢ Difference between accrual basis of accounting and cash basis of accounting Basis Accrual Basis of Accounting Cash Basis of accounting

1) Recording of Transactions Both cash and credit transactions are recorded. Only cash transactions are recorded.

2) Profit or Loss . Profit or Loss is ascertained correctly due to complete Correct profit/loss is not ascertained because it records

3) Distinction between Capital and Revenue items .This method makes a distinction between capital and revenue items. This method does not make a distinction between capital and revenue items.

4) Legal position

This basis is recognized under the companies Act.This basis is not recognized under

the companies Act or any other act.

➢ Accounting Standards (AS)

“A mode of conduct imposed on an accountant by custom, law and a professional body.” – By Kohler • Concept of Accounting Standards Accounting standards are written statements, issued from time-to-time by institutions of accounting professionals, specifying uniform rules and practices for drawing the financial Statements.

• Nature of accounting standards

1) Accounting standards are guidelines which provide the framework credible financial statement can be produced.

2) According to change in business environment accounting standards are being changed or revised from time to time.

3) To bring uniformity in accounting practices and to ensure consistency and comparability is the main objective of accounting standards.

4) Where the alternative accounting practice is available, an enterprise is free to adopt. So accounting standards are flexible.

5) Accounting standards are amendatory in nature.

• Objectives of Accounting Standards

1) Accounting standards are required to bring uniformity in accounting practices and policies by proposing standard treatment in preparation of financial statements.

2) To improve reliability of the financial statements: Statements prepared by using accounting standards are reliable for various users, because these standards create a sense of confidence among the users.

3) To prevent frauds and manipulation by codifying the accounting methods and practices.

4) To help Auditors: Accounting standards provide uniformity in accounting practices, so it helps auditors to audit the books of accounts.