FINANCIAL ACCOUNTING AND ANALYSIS

UNIT- 1

Meaning, Nature, Objectives and Functions of Accounting

Financial accountancy (or financial accounting) is the field of
accountancy concerned with the preparation of financial statements for
decision makers, such as stockholders, suppliers, banks, employees,
government agencies, owners and other stakeholders.

Financial capital maintenance can be measured in either nominal

monetary units or units of constant purchasing power. The central need
for financial accounting is to reduce the various principal-agent problems,
by measuring and monitoring the agents' performance and thereafter
reporting the results to interested users.

OBJECTIVES OF FINANCIAL ACCOUNTING

Systematic recording of transactions
Ascertainment of result of above recorded transactions
Ascertainment of the financial position of business
Providing information to the users for rational decision-making
To know the solvency position

NATURE OF FINANCIAL ACCOUNTING

Accounting is a process: A process refers to the method of performing
any specific job step by step according to the objectives, or target.
Accounting is identified as a process as it performs the specific task of
collecting, processing and communicating financial information.

Accounting is an art: Accounting is an art of recording, classifying,

summarizing and finalizing the financial data. The word ‘art’ refers to the
way of performing something.

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Accounting is means and not an end: Accounting finds out the financial
results and position of an entity and the same time, it communicates this
information to its users.

Accounting deals with financial information and transactions

Accounting is an information system: Accounting is recognized and

characterized as a storehouse of information. As a service function, it
collects processes and communicates financial information of any entity.

FUNCTIONS OF ACCOUNTING
Record Keeping
Protecting of properties
Communication of results
Meeting legal requirements

Basic Accounting Terms:

Accounting equation: The accounting equation, the basis for the
double-entry system (see below), is written as follows:
Assets = Liabilities + Stakeholders’ equity
This means that all the assets owned by a company have been financed
from loans from creditors and from equity from investors. “Assets” here
stands for cash, account receivables, inventory, etc., that a company
possesses.
Accounting methods: Companies choose between two methods—
cash accounting or accrual accounting. Under cash basis accounting,
preferred by small businesses, all revenues and expenditures at the time
when payments are actually received or sent are recorded. Under accrual
basis accounting, income is recorded when earned and expenses are
recorded when incurred.

Account receivable: The sum of money owed by your customers after

goods or services have been delivered and/or used.

Account payable: The amount of money you owe creditors, suppliers,

etc., in return for goods and/or services they have delivered.
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Assets (fixed and current): Current assets are assets that will be
used within one year.
For example, cash, inventory, and accounts receivable (see above).
Fixed assets (non-current) may provide benefits to a company for more
than one year—for example, land and machinery.
Balance sheet: A financial report that provides a gist of a company’s
assets and liabilities and owner’s equity at a given time
Capital: A financial asset and its value, such as cash and goods.
Working capital is current assets minus current liabilities. Cash
accounting: See “accounting methods.”
Credit and debit: A credit is an accounting entry that either increases
a liability or equity account, or decreases an asset or expense account. It
is entered on the right in an accounting entry. A debit is an accounting
entry that either increases an asset or expense account, or decreases a
liability or equity account. It is entered on the left in an accounting entry.

Double-entry bookkeeping: Under double-entry bookkeeping, every

transaction is recorded in at least two accounts—as a credit in one
account and as a debit in another.

For example, an automobile repair shop that collects Rs. 10,000 in cash
from a customer enters this amount in the revenue credit side and also in
the cash debit side. If the customer had been given credit, “account
receivable” (see above) would have been used instead of “cash.”

Double-entry bookkeeping: Under double-entry bookkeeping, every

transaction is recorded in at least two accounts—as a credit in one
account and as a debit in another.

For example, an automobile repair shop that collects Rs. 10,000 in cash
from a customer enters this amount in the revenue credit side and also in
the cash debit side. If the customer had been given credit, “account
receivable” (see above) would have been used instead of “cash.” (Also
see “single-entry bookkeeping,” below.) Financial statement: A financial
statement is a document that reveals the financial transactions of a
business or a person. The three most important financial statements for
businesses are the balance sheet, cash flow statement, and profit and loss
statement (all three listed here alphabetically).

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General ledger: A complete record of financial transactions over the

life of a company.

Journal entry: An entry in the journal that records financial

transactions in the chronological order.

Profit and loss statement (income statement): A financial statement

that summarizes a company’s performance by reviewing revenues, costs
and expenses during a specific period.

Single-entry bookkeeping: Under the single-entry bookkeeping,

mainly used by small or businesses, incomes and expenses are recorded
through daily and monthly summaries of cash receipts and disbursements.
Types of accounting: Financial accounting reports information about
a company’s performance to investors and credits. Management
accounting provides financial data to managers for business development.

BOOKKEEPING & ACCOUNTING

Bookkeeping is an activity that is a small part of accounting and the

Finance Department. Bookkeeping is the process of recording daily
activities of the business, including receipts, payment, purchases, sales
and expenditure. A bookkeeper is usually hired in medium to large
companies that is responsible for recording these transactions.
Bookkeeping is considered as a small part of accounting.
Accounting is the systematic recordation of the financial transactions of
a business. Such recordation can be split into three activities:

 Setting up a system of record keeping

 Tracking transactions within that system of record keeping

 Aggregating the resulting information into a set of financial reports

B Accounting Bookkeeping
a
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collect and present accounting
financial ledgers.

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information.

To see how the To see how the

G company is company is
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l day accounting where the
operations, and money is being
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and utilized.

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T profit and loss
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s general ledger
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and cash book.
statements.

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Revenue is
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acknowledged at
Det when it
the point of sale
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ACCOUNTING & OTHER DISCIPLINE

Relationship of Accounting with Economics

When considering the obviousness of their interconnection what is

understood is that both accounting and economics are concerned with the
effective and efficient utilization of resources, rather, when they are
scarce. Both accounting and economics are meant to maximize the wealth
and so the economists and accountants are consistent with the aspect
that capital should be intact when calculating the income. The income can
be distributed without affecting capital. More importantly, whenever there
is a need for any economical decision making, there is a need for
accounting. Accounting is intended to provide information to the owner of
a business firm, on the other hand, economics is concerned with how the
overall economy works and how single markets function. It can be
understood that accounting provides the information upon which the
economics models are prepared.

Relationship of Accounting with Mathematics

Accounting deals with concrete numbers expressing real sums and

involving operations to create a good set of numbers- going beyond the
numbers- determining financial position of a business house and ensuring
whether or not a business is making money. In doing so, it involves basic
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computational mathematics. Moreover, the basic system of accounting

needs to be changed into an accounting equation which shows Left hand
side- LHS equals Right Hand Side- RHS. In this way, the knowledge of
arithmetic and algebra are prerequisite for accounting computations and
measurements.

Relationship of Accounting with Statistics:

Accounting is not just about the preparation of accounting information, but

it necessitates interpreting and presenting the financial information which
leads to create tables and graphs. The knowledge of creating tables and
graphs is attained through the discipline of statistics. There is another
important factor to consider how accounting is connected with statistics is
that it uses price indices which has to do with creating tables, while the
interpretation involves making absolute and relative comparison by means
of ratio analysis. Thus, for doing all these, the knowledge of statistics is
much needed and so accounting is linked with statistics as well.

Relationship of Accounting with Law:

as it operates within a legal environment and thus all the transactions are
governed on the basis of different acts. Business organizations are
governed by their respective statues that provide many aspects
pertaining to the preparation of accounts. However, it is likely that
accounting influences law and is also influenced by law. In this way,
accounting is also related to law because of many legal aspects and
procedures.

Relationship of Accounting with Management:

Management is administration of business. It involves organizing and

controlling of the affairs of a business or a sector of a business.
Management, in simple terms, getting things done and the methodology
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which is put into practice in order to get the things done or the functions
with their sequence undertaken by a manager is what is said to be
management process which involves: Planning, organizing, directing and
controlling (PODC). Thus, management involves many functions and
application of many disciplines, such as, economics, mathematics,
statistics and computer etc. Accounting professionals are better off with
what they study through their course to understand and use the data for
providing the required accounting information to management for
facilitating in decision making process.

BRANCHES OF ACCOUNTING

 Financial accounting

It is the original form of accounting. It is mainly confined to the preparation

of financial statements for the use of outsiders like creditors, banks and
financial institutions etc. The chief purpose of financial accounting is to
calculate profit or loss made by the business during the year and exhibit
financial position of the business on a particular date.
 Cost accounting

Function of cost accounting is to ascertain the cost of the product and to

help the management in the control of cost.
 Management accounting

It is accounting for management. i.e., accounting which provides

necessary information to the management for discharging its functions. It
is the reproduction of financial accounts in such a way as will enable the
management to take decisions and to control various business activities.

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Difference between Financial and Cost

Accounting

FINANCIAL COST
ACCOUNTING ACCOUNTING
Aims at safeguarding  Renders information
the interest of the for guidance of the
business, its management for
proprietors and proper planning,
others connected operational control &
with it. decision making.
Financial Accounts  Maintenance of cost
are prepared records are voluntary
according to some and there are no
accepted accounting statutory forms
concepts and regarding their
conventions. presentation.
Reveals the profit of  Reveals the profit
business as a whole made on each
Prepared and product, job or
submitted usually at process.
the end of the  Prepared more frequentl
accounting period. y, sometimes even
Provides information weekly.
useful to outsiders,  Provides
hence high degree of information
accuracy useful to insiders,
degree of accuracy is
less.

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Difference between Management and Financial Accounting

Limitations of Financial Accounting:

1. Recording only monetary items.

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2. Time value of money.

3. Recommendation of alternative methods.

4. Restrain of accounting principles.

5. Recording of past events.

6. Allocation of problem.

7. Maintaining secrecy.

8. Tendency for secret reserves.

9. Importance of form over substance

Accounting Principles and Standards:

Meaning of Accounting Principles

Financial accounting is information that must be processed and reported

objectively. Third parties, who must rely on such information, have a right
to be assured that the data is free from bias and inconsistency, whether
deliberate or not. For this reason, financial accounting relies on certain
standards or guides that are called 'Generally Accepted Accounting
Principles' (GAAP).
Principles derived from tradition, such as the concept of matching. In any
report of financial statements (audit, compilation, review, etc.), the
preparer/auditor must indicate to the reader whether or not the information
contained within the statements complies with GAAP.
🞂 Business entity concept: A business and its owner should be treated
separately as far as their financial transactions are concerned.

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🞂 Money measurement concept: Only business transactions that can be

expressed in terms of money are recorded in accounting, though records
of other types of transactions may be kept separately.
🞂 Dual aspect concept: For every credit, a corresponding debit is made.
The recording of a transaction is complete only with this dual aspect.

🞂 Going concern concept: In accounting, a business is expected to

continue for a fairly long time and carry out its commitments and
obligations. This assumes that the business will not be forced to stop
functioning and liquidate its assets at “fire- sale” prices.

🞂 Cost concept: The fixed assets of a business are recorded on the basis
of their original cost in the first year of accounting. Subsequently, these
assets are recorded minus depreciation. No rise or fall in market price is
taken into account. The concept applies only to fixed assets.

🞂 Accounting year concept: Each business chooses a specific time period

to complete a cycle of the accounting process—for example, monthly,
quarterly, or annually—as per a fiscal or a calendar year.
🞂 Matching concept: This principle dictates that for every entry of revenue
recorded in a given accounting period, an equal expense entry has to be
recorded for correctly calculating profit or loss in a given period.

🞂 Realization concept: According to this concept, profit is recognized only

when it is earned. An advance or fee paid is not considered a profit until
the goods or services have been delivered to the buyer.

Accounting Conventions
There are four main conventions in practice in accounting: conservatism;
consistency; full disclosure; and materiality.

🞂 Conservatism is the convention by which, when two values of a

transaction are available, the lower-value transaction is recorded. By this
convention, profit should never be overestimated, and there should
always be a provision for losses.

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🞂 Consistency prescribes the use of the same accounting principles from

one period of an accounting cycle to the next, so that the same standards
are applied to calculate profit and loss.

🞂 Materiality means that all material facts should be recorded in accounting.

Accountants should record important data and leave out insignificant
information.

🞂 Full disclosure entails the revelation of all information, both favourable and
detrimental to a business enterprise, and which are of material value to
creditors and
debtors.

GAAP (GENERALLY ACCEPTED ACCOUNTING PRINCIPLES)

MEANING OF GAAP

Generally accepted accounting Principles (GAAP) are a common

set of Accounting Principles, standards and procedures that companies
must follow when they compile their financial statements. GAAP is a
combination of authoritative standards (set by policy boards) and the
commonly accepted ways of recording and reporting accounting
information. GAAP improves the clarity of the communication of financial
information.

GAAP is meant to ensure a minimum level of consistency in a

company's financial statements, which makes it easier for investors to
analyze and extract useful information. GAAP also facilitates the cross
comparison of financial information across different companies.

RELEVANCE OF GAAP

 Consistency

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Generally accepted accounting principles provide a consistent basis to

measure business activity. As business becomes more global and
technologically advanced, GAAP provides a framework to analyze new
types of transactions. The Emerging Issues Task Force, a subcommittee
of the Financial Accounting Standards Board, is charged with determining
the accounting treatment for new issues that arise. Without a systematic
method of determining how to account for new transactions, business
owners would be forced to make a best guess at how to account for new
types of transactions. Differences in these approaches could cause the
same economic transaction at two different businesses to be recorded in
different manners.

 Comparability

The proliferation of the Internet makes obtaining financial information

about companies easier than ever before. However, without generally
accepted accounting principles, this information would not all that useful.
By standardizing accounting techniques and treatments, generally
accepted accounting principles allow small-business owners to compare
companies

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 Benchmarking

Companies use generally accepted accounting principles to compare

their performance with that of other companies and industry
averages. This process, called benchmarking, can be used to
compare the smallest businesses with large multinationals. While
small- business owners should exercise caution before acting on
these comparisons, it can be useful to know how some of your
business metrics stack up against your larger competitors. Further,
during times of economic recession, benchmarking can help you
determine where your company's declines in sales or other metrics
fall in relation to other companies.

 External Reporting

Whether it is a loan officer, a tax collector or a potential investor,

external parties need to be able to assess the financial health and
performance of your company. Generally accepted accounting
principles allow these parties to use standardized procedures to come
to these conclusions.

Accounting Equation:
Accounting equation is referred to as the relationship between assets,
liabilities and capital of a business. The accounting equation is one of
the most important equations in accounting and is used for
preparing balance sheet. It can be represented by the following
equation:

A=C+L

where ,

A = Assets

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C = Capital (Owner’s equity)

L = Liabilities

The accounting equation can be also be represented as :

Assets = Liabilities + Capital (Owner’s equity)

This equation can be used to find the value of Capital and Liabilities

Capital = Assets – Liabilities

Or

Liabilities = Assets – Capital

The accounting equation sometimes is also referred to as the balance

sheet equation since the accounting equation shows the fundamental
relationship between the assets, liabilities and capital which are
regarded as the most components of a balance sheet.

The accounting equation states that at any given point in time, the
resources of the business entity (assets) must be equal to the claims
of those who have provided finance for those resources.

The claims can be either from proprietors (known as capital) and from
outsiders (known as liabilities).

The accounting equation is all about the equality of the assets and
liabilities side with each other.

Key Points of Balance Sheet Equation:

Though Balance sheet equation gives the investors and shareholders
a rough idea about the financial status of the company. Few things
that should be kept in mind are stated below:

 The report of the Balance Sheet does not always give the true and
exact status of the company’s finance
 Each transaction recorded in the financial statements should be
mentioned in the Balance sheet

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 If one aspect of the Balance sheet is impacted the other aspect should
also be influenced
Related link: Balance Sheet vs Cash Flow Statement

Example:
ABC starts a food truck business. He puts ₹ 50,000 as a capital fund.
He further loans ₹ 25,000 from a local credit vendor. Now, he has a
total of ₹ 75,000, he then purchases a fully furnished truck for ₹
45,000.

Below is the ABC balance sheet for December 2017.

In the above example, the total assets are equivalent to the total
liabilities + owner’s equity.

Overview of Depreciation:

What Is Depreciation?

Depreciation is an accounting practice used to spread the cost of a

tangible or physical asset over its useful life. Depreciation represents
how much of the asset's value has been used up in any given time
period. Companies depreciate assets for both tax and accounting
purposes and have several different methods to choose from.

KEY TAKEAWAYS

 Depreciation allows businesses to spread the cost of physical assets

(such as a piece of machinery or a fleet of cars) over a period of years
for accounting and tax purposes.

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 There are several different depreciation methods, including straight-

line and various forms of accelerated depreciation.
 Some methods of accounting for depreciation require that the
business estimate the "salvage value" of the asset at the end of its
useful life.

Depreciation Overview
Assets like machinery and equipment are expensive. Instead of
realizing the entire cost of an asset in year one, companies can use
depreciation to spread out the cost and match depreciation expenses
to related revenues in the same reporting period. This allows the
company to write off an asset's value over a period of time, notably
its useful life.

Companies take depreciation regularly so they can move their assets'

costs from their balance sheets to their income statements. When a
company buys an asset, it records the transaction as a debit to
increase an asset account on the balance sheet and a credit to reduce
cash (or increase accounts payable), which is also on the balance
sheet. Neither journal entry affects the income statement, where
revenues and expenses are reported.

At the end of an accounting period, an accountant books depreciation

for all capitalized assets that are not yet fully depreciated.
The journal entry consists of a:

 Debit to depreciation expense, which flows through to the income

statement
 Credit to accumulated depreciation, which is reported on the balance
sheet

Depreciation in Accounting

In accounting terms, depreciation is considered a non-cash charge

because it doesn't represent an actual cash outflow. The entire cash
outlay might be paid initially when an asset is purchased, but the
expense is recorded incrementally for financial reporting purposes.
That's because assets provide a benefit to the company over an
extended period of time. But the depreciation charges still reduce a
company's earnings, which is helpful for tax purposes.4

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The matching principle under generally accepted accounting

principles (GAAP) is an accrual accounting concept that dictates
that expenses must be matched to the same period in which the
related revenue is generated. Depreciation helps to tie the cost of an
asset with the benefit of its use over time. In other words, the
incremental expense associated with using up the asset is also
recorded for the asset that is put to use each year and
generates revenue.

The total amount depreciated each year, which is represented as a

percentage, is called the depreciation rate. For example, if a company
had $100,000 in total depreciation over the asset's expected life, and
the annual depreciation was $15,000, the rate would be 15% per year.

Types of Depreciation With Calculation Examples

There are a number of methods that accountants can use to
depreciate capital assets. They include straight-line, declining
balance, double-declining balance, sum-of-the-years' digits, and unit
of production. We've highlighted some of the basic principles of each
method below, along with examples to show how they're calculated.

1. Straight-Line Method:
The straight-line method is the most basic way to record depreciation.
It reports an equal depreciation expense each year throughout the
entire useful life of the asset until the asset is depreciated down to its
salvage value.

Let's assume that a company buys a machine at a cost of $5,000.

The company decides that the machine has a useful life of five years
and a salvage value of $1,000. Based on these assumptions, the
depreciable amount is $4,000 ($5,000 cost - $1,000 salvage value).

The annual depreciation using the straight-line method is calculated

by dividing the depreciable amount by the total number of years. In
this case, it comes to $800 per year ($4,000 / 5 years). This results in
an annual depreciation rate of 20% ($800 / $4,000).

2. Diminishing Balance Method:

The declining balance method is an accelerated depreciation method
that begins with the asset's book, rather than salvage, value. Because
an asset's carrying value is higher in earlier years (before it has begun
to be depreciated), the same percentage causes a larger depreciation
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expense amount in earlier years, then declines each year thereafter.

This is the formula:

Declining Balance Depreciation = Book Value x (1/Useful Life)

Using the straight-line example above, the machine costs $5,000 and
has a useful life of five years. In year one, depreciation would be
$1,000 ($5,000 x 1/5 =$1,000).

In year two it would be ($5,000-$1,000) x 1/5, or $800. In year three,

($5,000-$1,000-$800) x 1/5, or $640, and so forth.

Why Are Assets Depreciated Over Time?

New assets are typically more valuable than older ones for a number
of reasons. Depreciation measures the value an asset loses over
time—directly from ongoing use through wear and tear and indirectly
from the introduction of new product models and factors like inflation.
Writing off only a portion of the cost each year, rather than all at once,
also allows businesses to report higher net income in the year of
purchase than they would otherwise.

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