FA 2 v2(1-4) - FINANCIAL ACCOUNTING PDF

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FINANCIAL ACCOUNTING...

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Financial Account

Advisory Board Chairman Prof. Dr. V.S. Prasad Former Director (NAAC) Former Vice-Chancellor (Dr. B.R. Ambedkar Open University)

Board Members 1. Prof. Dr. Uday Salunkhe! Group Director! Welingkar Institute of Management

2. Dr. B.P. Sabale! Chancellor, D.Y. Patil University, Navi Mumbai! Ex Vice-Chancellor (YCMOU)

3. Prof. Dr. Vijay Khole! Former Vice-Chancellor! (Mumbai University)

4. Prof. Anuradha Deshmukh! Former Director! (YCMOU)

Program Design and Advisory Team Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Mr. Manish Pitke Faculty – Travel and Tourism Management Consultant

Prof. Kanu Doshi Dean – Finance Welingkar Institute of Management, Mumbai

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Prof. Dr. V.H. Iyer Dean – Management Development Programs Welingkar Institute of Management, Mumbai

Mr. Smitesh Bhosale Faculty – Media and Advertising Founder of EVALUENZ

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Prof. Vineel Bhurke Faculty – Rural Management Welingkar Institute of Management, Mumbai

Prof. Venkat lyer Director – Intraspect Development

Dr. Pravin Kumar Agrawal Faculty – Healthcare Management Manager Medical – Air India Ltd.

Prof. Dr. Pradeep Pendse Dean – IT/Business Design Welingkar Institute of Management, Mumbai

Mrs. Margaret Vas Faculty – Hospitality Former Manager-Catering Services – Air India Ltd.

Prof. Sandeep Kelkar Faculty – IT Welingkar Institute of Management, Mumbai

Mr. Anuj Pandey Publisher Management Books Publishing, Mumbai

Prof. Dr. Swapna Pradhan Faculty – Retail Welingkar Institute of Management, Mumbai

Course Editor

Prof. Bijoy B. Bhattacharyya Dean – Banking Welingkar Institute of Management, Mumbai

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Mr. P.M. Bendre Faculty – Operations Former Quality Chief – Bosch Ltd.

Course Coordinators

Mr. Ajay Prabhu Faculty – International Business Corporate Consultant

Ms. Kirti Sampat Assistant Manager – PGDM (HB) Welingkar Institute of Management, Mumbai

Mr. A.S. Pillai Faculty – Services Excellence Ex Senior V.P. (Sify)

Mr. Kishor Tamhankar Manager (Diploma Division) Welingkar Institute of Management, Mumbai

Prof. Dr. P.S. Rao Dean – Quality Systems Welingkar Institute of Management, Mumbai

Prof. Dr. Rajesh Aparnath Head – PGDM (HB) Welingkar Institute of Management, Mumbai

COPYRIGHT © by Prin. L.N. Welingkar Institute of Management Development & Reseach. Printed and Published on behalf of Prin. L.N. Welingkar Institute of Management Develoment & Research, L.N. Road, Matunga (CR), Mumbai - 400 019. ! ALL RIGHTS RESERVED. No part of this work covered by the copyright here on may bereproduced or used in any form or by any means – graphic, electronic or mechanical, including photocopying, recording, taping, web distribution or information storage and rerieval systems – without the written permission of the publisher.

NOT FOR SALE. FOR PRIV VATE CIRCULATION ONLY. 4th Edition ( Jan-2010)

1 Introduction to Financial Accounting Objectives : After completing this chapter, you will be able to understand: • Principles of Accounting. • Financial Statements. • GAAP

Introduction to Financial Accounting

Structure 1.1 Introduction 1.2 Limitations of Accounting 1.3 Scope and Importance 1.4 Concepts and Conventions 1.5 GAAP 1.6 Forms of Organisation 1.7 Summary 1.8 Self Assessment Questions

Introduction to Financial Accounting

1.1! INTRODUCTION Why Financial Accounting? What is common to all these Individuals? i) Ms. Sudha Narayan Murthy (Infosys) - The Wealthiest Woman in ii)Mr. K P Singh (DLF Group) - The Wealthiest Man in India iii)Ms. Perween Warsi (S&A Foods – Samosa Queen) - The Wealth Woman Outside India iv)Mr. Laxmi N. Mittal (Mittal Steel) - The Wealthiest Indian Outside v) Mr. Bill Gates (Microsoft) - The Wealthiest Man in USA vi)Mr. Warren Buffett (Berkshire Hathaway) - The Second Wealthies They are all very Rich & Famous. But above all, they hold Equity Sh companies indicated against their names and which are listed on re stock exchanges. How do we determine that they are Wealthy? We can determine their wealth by counting, by accounting, by recor valuing all their worldly wealth, their assets, their estates, their prop possessions and financial liabilities, if any. Accounting all incomes, expenses, assets & liabilities in Monetary T Rupees) is the sole determinant of all economic activities of all busi industry, trade, commerce, also of fashion designers; software gian moghuls and even NGOs (CRY, Lijjat Papad). Accounting helps recording all financial transactions enabling of: I. Trial Balance

Introduction to Financial Accounting

Financial statements have their use to several segments of the are called Stakeholders: 1. Shareholders 2. Investment Advisors, Analysts 3. Creditors, Vendors, Suppliers 4. Labour (Workers & Employees) 5. Government (Local, State, Central) 6. Researchers (Faculty) 7. Students of Finance In any business, there are Purchases, Production, Sales, Loans, St Creditors, Bank Balance, Profits & Losses. Unless you produce goo services, you can’t sell and unless you sell, you can’t have profit. Bu can be made at a profit all the time. There can be sales at a loss als important for a business? Sales or Profit? Ideally Profitable Sales! Basic Principles of Accounting: Accounting is a Science (Recording) as well as an Art (Interpreting) only financial transactions and records only Historical Costs (Not M These are recorded and prepared as an ongoing concern basis (no (Capital & Revenue) (Matching concept). It expects on a year to yea Consistency (depreciation, stock valuation). Accounting is governed of Conservative basis (provide for unrealized losses; but ignore unr profits). Accounts are prepared in a manner that the Business is sep the owner (hence owner’s capital is liability) (Business entity).

1.2! LIMITATIONS OF ACCOUNTING

Introduction to Financial Accounting

1.3! SCOPE & IMPORTANCE Accounting can be defined as an information system which measur and communicates financial information to decision makers. Decisio be divided into two broad categories: external and internal. In financ we are concerned with external decision makers such as business potential owners, creditors, etc. A financial accounting system provi summarised and categorised information about the company’s perfo state of affairs mainly for external decision makers. A management system provides much richer, detailed information meant to aid a fir decision makers. In practice, these are not separate systems but ar integrated financial and management accounting system. Internal d makers are the managers who plan, organize and run the business questions like:

• Is the available cash sufficient to pay bills? (A company can surviv without profits, but not too long without cash.) • What is the cost of manufacturing each unit of product? • Can we afford to give employee payraises this year? • What product line is most profitable? External decision-makers include Investors, Creditors and Others li authorities, Regulatory agencies, Customers, Labour unions and Ec planners. They ask questions like: • Is the company earning satisfactory income? • How does the company compare in size and profitability with com • Will the company be able to pay its debts when they become due?

Introduction to Financial Accounting

There are various kinds of enterprises such as for-profit, non-profit, etc. In our study of accounting we will concentrate on for-profit busi operate as companies. We will touch on other forms of business str including sole proprietorships and partnerships, but our emphasis w accounting for companies. For-profit businesses have two primary g follows: 1. Profitability – will the company earn sufficient net income to pay expenses and provide profits to the owners. 2. Liquidity – will the company generate sufficient cash to pay its b become due.

A third objective pursued by many of the better companies is Growt and profitability. Financial accounting is governed by rules or guidelines collectively Generally Accepted Accounting Principles (GAAP). Many of these a by law of the country. However, some have considerable persuasive they are not mandatory. As we begin to study accounting we will be introduced to these principles and concepts. Some of the basic prin concepts are:

1.4! CONCEPTS AND CONVENTIONS What are Accounting Concepts ? Accounting concepts means the rules or the principles that govern a They are fundamental acounting rules that must be followed by all c They provide the basis for other principles such as accounting conv policies. Accounting concepts means the necessary assumptions o accounting is based We can say concepts are like the grammer for

Introduction to Financial Accounting

1 ENTITY CONCEPT. 2 GOING CONCERN CONCEPT. 3 MONEY MEASUREMENT CONCEPT. 4 HISTORICAL COST CONCEPT. 5 ACCRUAL CONCEPT. 6 ACCOUNTING PERIOD CONCEPT. 7 MATCHING COST AND REVENUE CONCEPT. 8 DUAL ASPECT CONCEPT. 9 COST ATTACH CONCEPT 10 VERIFIABLE OBJECTIVE EVIDENCE CONCEPT. 1 ENTITY CONCEPT: According to this concept, the business is different from the person business. The business has a separate identity or personality which from the persons or entities in the business such as proprietors, par managers or the employees. Therefore, we find that all accounting note of the transactions between the owner and the business. The o treated as outsiders for the purpose of recording transactions. The e is applicable to all forms of business such as sole trader, partnershi Company, Co-operative societies. The transactions relating to the business only are recorded. The pe transactions of the proprietor are not recorded in business. Similarly transaction between the organisation and the proprietor is also reco The Capital is shown as a liability in accounts according to the conc the capital is the money the business has to refund to the proprietor

Introduction to Financial Accounting

2 GOING CONCERN CONCEPT: Normally the business is viewed as an ongoing concern. It means t is that the business will exist for a long period of time to come. It wil wound up immediately. It is assumed that the businessman has no close the business. There is no need to close the business as well. According to this concept, the business has permanent life, it will co very long period of time . It will not be closed at the end of the year. It is because of this concept, assets are not valued at their market v price. They are always shown at cost less depreciation. The various purchased will be used for a very long period of time. They are not p selling them at the end of the year. 3 MONEY MEASUREMENT CONCEPT: According to this concept, only such transactions are recorded whic expressed in terms of money. Therefore, those transactions and eve cannot be put in terms of money will not be recorded in the books o Such events may be very important, but still it will not be recorded i accounts. The advantage of this concept is that money provides a c So the different facts of business can be expressed in terms of num be added or substracted. Thus, only monetary matters are recorded. Non-monetary matters s death of a manager, strikes of workers, resignation of an employee recorded. This is because these cannot be expressed in terms of m This concept is also known as Monetary Unit Concept or Monetary Concept.

Introduction to Financial Accounting

It does not mean that the asset will always be shown at cost. It only cost becomes the basis for all subsequent accounting for the asset. may be depreciated at the end of each year and the value may be r The cost concept brings objectivity in the preparation and presentat statements. For example: if a plot of land is purchased for Rs.200,000, it will be the books as Rs.200,000 only even though the present market valu may be Rs.500,000. 5 ACCRUAL CONCEPT: This concept is the recognition of income and cost as they are earn It is not as money is received or expenses are paid. In simple words this concept we have to record the expenses for the given period sa even if the said expense is paid or not. For example: we record outstanding expenses at the end of the yea have not paid the expense. But it has accrued. In the same way we for income accrued, even though it is not received. Thus under this concept, revenues and expenses relating to a partic considered. Therefore, expenses paid in advance is excluded, but e outstanding is included. Similarly, income received in advance is ex income receivable is included in the books of accounts. 6 ACCOUNTING PERIOD CONCEPT: This concept is also known as Periodicity Concept. According to thi calculation of profit or loss made cannot be postponed indefinitely o business is closed. Therefore the accounting period is to be sepera ti i di ll It i ithi thi i d h

Introduction to Financial Accounting

business. This concept assumes that the profitability of a business c measured reliably by periodic profit or loss accounts and that the re cost can be properly matched. The accounting period selected should be sufficiently long enough t representative and short enough to provide current information.

7 MATCHING COST AND REVENUE CONCEPT: It means the expenses and revenue have to be matched to determi a particular period. This is one of the most important concept of acc Once the revenue is recognised, then the problem is to identify the cost which have been incurred to earn the revenue. In order to dete income or profit for a accounting period, these costs and expenses deducted from the revenue earned. This concept is related to Accounting Period Concept. Once the acc period is determined, then within that period the revenue and its rela matched. According to this concept, the accountant is concerned with the det revenue for a particular period and then assigning to such revenue, or charges which are incurred to earn such revenue. Thus, the expe in a said accounting period are matched against the revenue earne

8 DUAL ASPECT CONCEPT: According to this concept, every transaction has two aspects. This i double entry book-keeping system. Every entry must have minimum According to Dual Aspect concept, every transaction has two aspec below:

Introduction to Financial Accounting

In the same way : e It increases one liability and increases another liability. f It increases one liability and decreases one asset. g It decreases one liability and increases another liability. h It decreases one liability and decreases one asset. 9 COST ATTACH CONCEPT: This concept is also known as Cost Merge Concept. In order to prod goods or article it is necessary to purchase raw-materials, and there it to get the finished goods. In this process, the services of various f required. These factors are also called the Factors of Production. S labour cost, power, overhead expenses. These costs have a capac attach when they are brought together. So we add material cost, lab other overhead costs to get the final product cost. Only when the m converted into a final product it gets value and utility. 10 VERIFIABLE OBJECTIVE EVIDENCE CONCEPT: According to this concept, all accounting transactions should have d proof. These documents may be purchase orders, delivery challan, vouchers, pass book, cheque books, correspondence, agreements supporting documents form the basis for accounting entries. These evidence which help the auditors to verify the books of accounts. ACCOUNTING CONVENTIONS Conventions are the customs or traditions which help the preparatio

Introduction to Financial Accounting

stock valuation, methods of accounting etc. 1 CONVENTION OF DISCLOSURE: This means that accounts must be prepared honestly. They must gi information.The accounting statements must give full and fair inform proprietors, creditors, investors and others. This convention is more case of a big business like the Joint Stock Companies. This is beca owners and the managers are different. The shares of the companie traded in the stock exchanges. So the investors must get full inform Companies' Act, 1956 requires that the accounts of the company m and fair view of the state of affairs of the company and it must be ce auditors. The Act also prescribes the form in which the profit and los and the Balance Sheet must be presented. 2 CONVENTION OF MATERIALITY: The accountant must give importance to material details and ignore details. If this is not done, the accountants will be over burdened wi details.An item is material if the knowledge of it will influence decisi to help decide on matters of investment. Therefore, while preparing important matters are kept and the unimportant matters are left out merged with other items. For example : an amount of Rs.1,000 is material in a total amount o But the same amount of Rs.1,000 is not material in a total amount o 10,00,000.

This convention puts a check on unnecessary disclosure in the fina accounts The financial statements should not be unnecessarily bulk

Introduction to Financial Accounting

3 CONVENTION OF CONSISTENCY: This convention indicates that the procedure selected by the compa followed consistently every year. The financial statements will be co if the procedure is followed consistently. There are several methods of charging depreciation, such as Straig Method or Written Down Value Method etc. Once the company dec one particular method, then it must follow the same method year aft same way, there are different methods of valuation of stock such as or Average price etc. The company may adopt any of the methods o stock, but it must be followed consistently. However, this convention does not mean the company must be very Whenever it is desirable, the company may change the accounting This should be done only when there is an improvement in procedu introduce a new procedure. When a change is introduced, the comp make a disclosure of the changes made. Similarly, the procedure sh changed very often.

4 CONVENTION OF CONSERVATISM: This is one of the oldest conventions of accountancy.In olden days, Sheet was considered as one of the most important documents. It e valuation of assets. Conservatism in short means the policy of playing safe. According t convention while preparing accounts we must not take into account unless they are realised. However, we must provide for all anticipat Sometimes, this convention is criticised on the grounds that it provid creation of secret reserves and it is against the convention of disclo

Introduction to Financial Accounting

The primary agency responsible for GAAP in India is the Accounting Board of The Institute of Chartered Accountants of India (www.icai.o US, the equivalent is the Financial Accounting Standards Board (FA Securities Exchange Board of India (SEBI) oversees companies wh are publicly traded, while the Company Law Board (CLB) oversees norms in general for all companies in India. In the US, there is a sin called the Securities Exchange Commission (SEC). In short, the GA rules; the ICAI makes the rules and SEBI and CLB enforce the rule

A basic tool used by accountants to explain business transactions is accounting equation. It can be expressed variously as: Resources = Equities Assets = Liabilities and Owner's Equity Assets = Liabilities and Shareholders' Equity Assets = Rs. 10 Lakhs Liabilities = Rs. 7 Lakhs

Capital = Assets - Liabilities (In the above example, assets are Rs. 10 lakhs and liabilities are R Hence, capital is Rs. 3 lakhs)

Shareholders' Equity consists of two parts:...