Summary Accounts_Revision_Notes

PART - A : FINANCIAL ACCOUNTING-I

UNIT – I: THEORETICAL FRAME WORK

CHAPTER-1
INTRODUCTION TO ACCOUNTING

Revision Notes
 Introduction : Accounting is the language of business which helps in recording the business transactions in
chronological order in the books of accounts. It records only financial transactions related to the business.
 Accounting : According to American Institute of Certified Public Accountants – ‘‘Accounting is the art of recording,
classifying and summarising 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 result thereof.
 Accounting Process :
(i) Recording of financial transactions in the Journal (Journalizing).
(ii) Recording in the Ledger (Posting to Ledger).
(iii) Summarising the Activities/Transactions.
(iv) Analysis and Interpretation.
(v) Communicating the results.
 Objectives of Accounting : Following are the important objectives or purposes of Accounting :
(i) Maintaining Records.
(ii) Estimating Profit or Loss.
(iii) Presenting the financial position.
(iv) Providing useful information to users.
 Advantages of Accounting
(i) Availability of information.
(ii) Identifies strength and weaknesses of business.
(iii) Enables comparison between time periods and similar companies.
(iv) Evidence in the court of law.
(v) Payment of tax.
(vi) Helps in realisation of debts.
 Limitations of Accounting
(i) Financial accounting is not absolutely exact.
(ii) Financial accounting does not show the exact worth of business.
(iii) Problem of window dressing.
(iv) Worthless assets are often shown in the balance sheet.
(v) No effect of inflationary trends.
(vi) Qualitative factors are ignored.
 Branches of Accounting :
(i) Financial accounting
(ii) Cost accounting
(iii) Management accounting
 Types of Accounting Information:
Accounting information refers to the financial statements generated through the process of Book Keeping, use
of which helps the users to arrive at decisions. The financial statements so generated are the Income Statement,
i.e., Profit and Loss Account and the Position Statement, i.e., Balance Sheet. The accounting information can be
categorised into three types:
(i) Information Relating to Profit or Surplus: The Income Statement makes available the accounting information
about the profit earned or loss incurred as a result of business operations or otherwise during an accounting
period.
(ii) Information Relating to Financial Position: The Position Statement, i.e., the Balance Sheet provides the
information about the financial position of the entity. It provides information about the assets owned by the
entity, amounts receivable and the cash and bank balances held by it. These are represented in the liabilities
by the amounts owed by the entity towards loans, creditors and amounts payable, and capital.

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(iii) Information about Cash Flow: Cash Flow Statement is a statement that shows both inflow and outflow of
cash during a specific period. It is of immense use as many decisions such as payment of liabilities, payment
of dividend and expansion of business, etc., are based on availability of cash.
 Users of Accounting Information
Users of Accounting Information may be categorized into Internal Users and External Users
Internal Users
(i) Owner: To know about return of their investment, financial health of their business/company.
(ii) Management: To evaluate the performance to take various decisions.
(iii) Employees: To know profitability so as to claim higher wages and bonus.
External Users
(i) Investors: To ensure safety and growth of their investments and future of the business.
(ii) Creditors: To assess the financial capability i.e., ability of business to pay its debts.
(iii) Lenders: To assess repaying capacity and credit worthiness of the business.
(iv) Tax authorities: To assess the taxes due, true and fair disclosure of accounting information.
(v) Others: Customers, researchers, etc., may seek different information for different reasons.
 Qualitative characteristics of accounting information are explained as:
(i) Reliability : It means that the user can rely on the accounting information. All accounting information is
verifiable and can be verified from the source document (voucher), viz. cash memos, bills, etc.
Hence, the available information should be free from any errors and unbiased.
(ii) Relevance : It means that essential and appropriate information should be easily and timely available and any
irrelevant information should be avoided. The users of accounting information need relevant information for
decision-making, planning and predicting the future conditions.
(iii) Understandability : Accounting information should be presented in such a way that every user is able to
interpret the information without any difficulty in a meaningful and appropriate manner.
(iv) Comparability : It is the most important quality of accounting information. Comparability means accounting
information of a current year can be compared with that of the previous years. Comparability enables intra-
firm and inter-firm comparison. This assists in assessing the outcomes of various policies and programmes
adopted in different time horizons by the same or different businesses. Further, it helps to ascertain the
growth and progress of the business over time and in comparison to other businesses.
 Role of Accounting in Business : The role of accounting has been changing for centuries with the changes in
economic development and increasing societal demands. It describes and analyses a mass of data of an enterprise
through measurement, classification and summarisation, and reduces those data into reports and statements,
which show the financial condition and results of operations of that enterprise. Hence, it is regarded as a language
of business. It also performs the service activity by providing quantitative financial information that helps the
users in various ways.
Accounting as an information system provides financial information to the stakeholders of the business:
management, investors and creditors. Accounting measures and summarizes the activities of the company and
communicates the results to management and other interested parties. However, accounting information relates
to the past transactions and is quantitative and financial in nature, it does not provide qualitative and non-
financial information. These limitations of accounting must be kept in view while making use of the accounting
information.
Basic Accounting Terms
 Entity : Entity means a reality that has a definite individual existence. Business entity means a specifically
identifiable business enterprise like Big Bazaar, ITC Limited, Tanishq etc. An accounting system is always devised
for a specific business entity (also called accounting entity).
 Business Transaction : It is an activity that involves exchange of money or money’s worth between parties and
brings about a change in the financial position like purchase of goods, payment for transport, payment of wages,
salaries, sale of goods, collection of money, etc. Transactions can be broadly classified into cash transactions and
credit transactions depending on when the payment is made. If the payment is done immediately it is a cash
transaction and if the payment is postponed to a future date, it is a credit transaction.
 Asset : The properties owned by a business and its claims against are collectively called assets. Assets are classified
into:
(i) Non-current Assets : These assets are meant for long term use with the aim of generating profits/incomes.
(ii) Current Assets : Current assets are the assets which keep on circulating from business-to-business, party-to-
party. These assets are not held for permanent use. They just come into the possession of the business during
normal course of business. More and more assets are added each day from one side and sold out or exchanged
from the other side, which makes their balance always fluctuating. These assets can be converted into cash
within one accounting year.
Examples : cash, debtors, stock of goods, etc.

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 Liability : Liabilities are claims of creditors against the business. They are the claims on the assets or wealth of the
business. For example, when a company borrows money it gets assets in the form of cash and at the same time it
accepts a liability named as loan. Liabilities can be classified into the following categories :
(i) Current Liabilities : These are liabilities to be paid off within a short period, usually less than one year. These
are usually paid off by current assets. Current portion of long-term liabilities are also considered as current
liabilities.
Examples: bank overdraft, trade creditors, outstanding expenses, etc.
(ii) Non-current Liabilities : As the name indicates, non-current liabilities are paid off after a long period. All
liabilities maturing after one year are considered as non-current liabilities. These liabilities can be settled
either by payment of cash or by delivery of fixed assets or by conversion of liabilities into equity.
Examples : mortgage loans and debentures.
(iii) Contingent Liabilities : Contingent liabilities are not actual liabilities. They are probable liabilities which are
dependent on the happening of a certain contingency. For example, a claim against the business in court is
a contingent liability. If the court decides against the business the claim becomes a real liability to pay. Other
examples of contingent liabilities are loan guaranteed by the business, bills receivable discounted with the
bank, etc.
 Capital : Capital is normally understood as the owner’s investment in a business. The owner’s investment does
not mean the exact amount he puts in to start the business. The capital of the owner will increase when he makes
profit. It will decrease when he incurs a loss. If he takes out money or goods for personal use, we call it drawings.
Owner’s capital will reduce when he makes drawings. Infact capital is excess of total assets of the business over
the liabilities. In other words, capital is the net worth of the business.
On the basis of assets owned by the company, capital can be divided into fixed capital or working capital.
The amount invested in the fixed assets of the business is known as fixed capital.
Working capital is the value of current assets over current liabilities.
Working Capital = Current Assets – Current liabilities
 Drawings : Drawing is the withdrawal of cash or goods by the owner for personal use. In accounting this is
considered as negative capital.
 Revenue : Revenue is the increase in current assets without a corresponding increase in liability or owner’s
investment. According to the Financial Accounting Standard Board (FASB) revenue is “inflow or other enhancements
of assets to an entity from delivering or producing goods, rendering services or other activities that constitute the entity’s
ongoing major or central operations.”
 Goods : Articles purchased for sale or for use in the manufacturing of other products as raw material are known
as ‘Goods’. For example : furniture will be the goods for the firm dealing in furniture but it will be an asset for the
firm dealing in stationery.
 Stock/Inventories : The term ’stock’ includes goods lying unsold on a particular date. The stock may be of two
types :
(i) Opening stock; and (ii) Closing stock.
The term ‘Opening stock’ means goods lying unsold at the beginning of the accounting period whereas the
term ‘Closing stock’ represents the goods lying unsold at the end of the accounting period. These can be further
classified into :
(a) Raw materials : Goods that have been purchased and have not yet been put through the manufacturing
process.
(b) Work-in-progress : Goods that have entered in the manufacturing process, but are not completed.
(c) Finished goods : Those that have completed the manufacturing process, but remain unsold.
 Purchases : The term ‘Purchases’ is used only for the purchases of goods which are purchased with the purpose
of resale or to be converted into products dealt with by the firm.
Purchases of assets are not purchases in accounting terminology as these are not meant for sale.
 Sales : The term ‘Sales’ is used only for the sale of goods which are purchased with the purpose of resale. The
term ‘sales’ includes both cash sales and credit sales.
In accounting terminology, sale of assets are not sales. Sales should be of a regular nature.
 Debtors : The term ‘Debtors’ represents those persons or firms to whom goods have been sold on credit and the
payment has not been received from them.
 Creditors : A person or firm to whom an amount is owed by the business is called a ‘Creditor’. For Example
Mohan is a creditor of the firm if the goods are purchased from him on credit.
Creditors may also be creditors for expenses. It happens when certain expenses such as salaries, rent, wages,
interest, etc., remain due during the accounting period.
 Profit : Profits refer to the excess of ‘Sales’ over ‘Cost of Goods Sold’. It arises from continuous business operations.
 Income : The term ‘income’ is synonymous with the term ‘Profit’. It may be defined as excess of total revenues
over the total expenses of the business. It is a favourable difference between the revenues and the expenses.