Financial and Management Accounting

Unit 1

Unit 1
Structure: 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 Introductions Objectives Evolution Self Assessment Questions 1 Need Self Assessment Questions 2

Financial Accounting An Introduction

Meaning of Accountancy, book keeping and Accounting Self Assessment Questions 3 Characteristics Self Assessment Questions 4 Functions and objectives of accounting Self Assessment Questions 5 Difference between book keeping and accounting, accountancy Self Assessment Questions 6 Financial accounting and management accounting Self Assessment Questions 7 Basic terms Self Assessment Question 8

1.10 Summary Terminal Questions Answer to SAQs and TQs

1.1 Introduction
Accounting is a branch of knowledge, concerned with recording classifying, analyzing and reporting financial information to owners, bankers, creditors, government and host of stakeholders regarding the financial performance of organizations - business or bon-business entities. Over a period of time, accounting has assumed a status of a science and an art. In order to achieve uniformity globally, international standards have also emerged in accounting. In this Unit, the historical perspective of Accounting, its meaning, functions and basic terms used in the subject are discussed.
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Learning Objectives: After studying this unit, you should be able to understand the following

1. To expose the students with meaning, need and purpose of accounting. 2. To know the functions Accounting. 3. To understand the difference between Financial Accounting and Management Accounting. 4. To acquaint with the basic terminology used in the subject.
1.2 Evolution of Financial Accounting
Any branch of knowledge does not emerge all of a sudden. Knowledge is a product of continuous intellectual exercise and the changes in the environmental and social demands. Accounting is an ancient art. Michael Russel in his article Evolution of Accounting points out that as early as 8500 B.C, accounting was existing. Archeologists have found clay tokens as old as 8500 BC in Mesopotamia which were usually cones, disks, spheres and pellets. These tokens correspond to such commodities like sheep, clothing or bread. They were used in the Middle West in keeping records. Similarly in ancient civilizations like China, Babylonia, Greece and Egypt, record keeping was in practice in the same manner as stated above. During 3600 BC in Babylonia payment of salaries was recorded in clay tablets. The rulers of these civilizations kept track of labour and material costs by using accounting methods. In an article published by John R. Alexander on History of Accounting, he stated that an improved system of book keeping known as double entry book keeping was introduced in 14th century and the following seven key ingredients were responsible for the creation of double entry book keeping. Private property: The power to change ownership, because book keeping is concerned with recording the facts about property and property rights Capital: Wealth productively employed, because otherwise commerce would be trivial and credit would not exist Commerce: The interchange of goods on a widespread level, because purely local trading in small volume would not create the sort of press of business needed to spur the creation of an organized system to replace the existing hodgepodge of record keeping Credit: The present use of future goods, because there would have been little impetus to record transactions completed on the spot.

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Writing: A mechanism for making a permanent record in a common language given the limits of human memory.

Money: The common denominator for exchange, since there is no need for book keeping except as it reduces transactions to a set of monetary values.

Arithmetic: A means of computing the monetary details of the deal.

Double entry records first came out during 1340 A.D. in Genoa. In 1494, the first systematic record keeping was formulated by Fra Luca Pacioli a Franciscan monk and one of the most celebrated mathematicians to this day. Pacioli is considered as the father of accounting. Michael Russel, in his article states that industrial revolution, which brought paradigm changes in the working and business transactions paved way to the specialized field of accounting called cost accounting in order to meet the need for the analysis of various costs. Mean while, corporate form of organisation came into being which made it necessary to report financial information to the owners (shareholders) by the management. Virtually management and ownership got separated and to instill confidence of the shareholders, managers had to submit reports, as prepared on the basis of accounting information. Welsch and Anthony, in their book Fundamentals of Financial Accounting, comment that the growth of business organizations in size, particularly publicly held corporations, has brought pressure from stock holders, potential investors, creditors, government agencies, and the public at large, for increased financial disclosure. The publics right to know more about organizations that directly or indirectly affect them (whether or not they are shareholders) is being increasingly, recognized as essential. An open society is one that has a high degree of freedom at the individual level and typically evidences an effective commitment to measuring the quality of life attained. These characteristics make it essential that the members of the society be provided adequate, understandable, and dependable financial information from the major institutions that comprise it. So accountants have a greater responsibility of not only being accurate but also transparent to the possible extent. At present, there have been tremendous advancements in accounting to meet the needs brought about by information technology. Work is done faster, more accurate, and more dependable by using computers. Business can be transacted without even facing one another and accounting has become so customer friendly that records and reports are generated instantaneously to all parties concerned. Self Assessment Questions 1:
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1. __________ is the father of Accounting. 2. A new accounting system called _______ emerged during industrial revolution. 3. Double Entry book keeping was introduced during ___________ century.

1.3 Need
Economic activities are carried on by trading and non-trading organizations, the former with profit motive and the latter with a focus on service. Business is prominently carried on under different forms of organizations, namely sole trading, partnership, Hindu undivided family firms (HUF), cooperative societies and companies. Having invested capital in the business, one has to find out at the end of a particular period whether the business has yielded any profit or loss; any assets are created; the liabilities payable; total expenses incurred; total revenues generated and so on and so forth. Innumerable business transactions might have taken place during the period and remembering all transactions is humanly impossible, let alone finding the results of the transactions. Even to put them in a computer, it requires a systematic approach to record, classify, analyse and report the financial data to the stake holders of a business enterprise. Precisely for this purpose, financial accounting is needed. Proprietor/s in case of sole trading and partnership firms, members in case of cooperative institutions, shareholders in case of companies, suppliers, customers, tax authorities, banking institutions, lenders, borrowers, employees, government agencies and general public are the various parties interested in the financial information of a business enterprise and each one them is interested in different aspects of the business. Accounting information has to be supplied in a prescribed manner to these parties and this information is contained in the form of different statements such as trading account, profit and loss account, balance sheet, cash flow statement, fund flow statement, statement of investments and so on. While a proprietor/ partner/member/shareholder is interested in profit and loss account and balance sheet, bankers are interested in cash and fund flow statements in addition to P&L account and balance sheet, government is interested in the amount of tax collections, employees are interested in P&L account, customers, in total sales, suppliers in cash statements, security analysts in the ratio analysis of various financial parameters of the business organization. Financial accounting fulfills the aspirations of the above parties regarding the enterprise. Thus Accounting has emerged for two purposes, namely to record all business transactions since one can not remember them and communicate the results of financial data to all interested parties.

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Self Assessment Questions 2: 1. What are the two purposes of accounting? 2. Shareholders of a company are interested in ______ and _______ of a business. 3. Bankers are interested in _________ and _______ besides P&L A/C and balance sheet.

1.4 Meaning of Accountancy, Book-keeping and Accounting

Book-keeping, accounting and accountancy are the terms used in the science of financial accounting. Book-keeping means recording of business transactions in the books of accounts in accordance with the principles of accounting. Book keeping is an adjunct for accounting. Day to day transactions are entered in a systematic manner to facilitate the preparation of profit and loss account, balance sheet and other statements containing information about debtors, creditors, tax payment etc., For the purpose of recording the financial data, debit and credit principles are adopted so that cross checking is made possible, summary of each account is known at the end of an accounting period. Accounting on the other hand is the discipline of measuring, communicating and interpreting financial activities and it is widely referred to as language of business. Way back in 1941, the definition for the word Accounting was given by the Committee on Terminology of the American Institute of Chartered Public Accountants, (AICPA)thus, accounting is an art of recording, classifying and summarizing in a significant manner and terms of money transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. The American Accounting Association (AAA) in 1966 provided the following definition: Accounting is the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information In 1970, the AICPA emphasized accounting with reference to the concept of information.. Accounting is treated as a service activity. The function of accounting is to provide quantitative information, primarily financial in nature, and about economic activities, that is intended to be useful in making economic decisions. Accountancy is the profession and the practitioners of accountancy are called accountants. Therefore book keeping is the basic activity of recording, accounting is the analysis and reporting function and accountancy is the profession of carrying the above activities. Self Assessment Questions 3:
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1. What is book keeping? 2. Define Accounting. 3. Accountancy is a __________ and the practitioners of accountancy are __________ .

1.5 Characteristics of Accounting

From the above definitions of Accounting, one can list out the characteristics of accounting: 1. Accounting is an art and science: Recording and maintenance of accounts of various transactions needs special skill and knowledge. Reading and interpreting the results, obtained by the accounting system requires experience. From this angle, accounting is an art. Accountants are endowed with this special skill and aptitude and it is difficult to acquire proficiency in this art. It is like a doctor who diagnoses and prescribes medicines just by looking to the medical reports, an accountant on a gaze of the financial reports can find out the financial health of an enterprise and suggests measures to improve the financial position. Accounting is also a science, not like physics or chemistry, but it is an exacting science. Accounting is governed by definite principles, rules, concepts, conventions and policies. A systematic and scientific approach is adopted to classify, record, analyse and interpret the accounting information. 2. Accounting involves a process of identifying, classifying and recording financial information, expressed in terms of money. All financial transactions are expressed in terms of money. Incomes, expenses, acquisition of assets, payment of liabilities, capital of shareholders etc., are stated in money terms and all transactions are broadly classified as related to definite heads of account, namely personal, real and nominal. After classification, they are recorded in the books of original entry as per the accounting principles. The book of original entry is called Journal. From Journal, the transactions are summarized under each head of relevant account and posting takes place to a book called ledger. At the end of a particular accounting period, the gist or the net balance of all ledger accounts is aggregated to prepare a trail balance. From trial balance, it is possible to prepare trading, profit and loss accounts and balance sheet. 3. Events of non financial nature can not be recorded, even though such events may have an impact on the operational results of the enterprise. For instance financial manager and production manager of a concern do not have good relationship and owing to this the production process is affected and subsequently the profitability. This event of non financial nature can not be reflected in accounts.

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4. Accounting is an information system. The results of analysis and interpretation are communicated to the management and other interested parties. Internal control is effectively exercised and accountability is ensured through accounting information. 5. It helps in taking managerial decisions. Self Assessment Questions 4: 1. The book of original entry is called __________ . 2. Profitability of an enterprise is affected if the finance manager and production manager do not agree each other. Does this picture in accounts?

1.6 Functions and Objectives of Accounting

From the above paragraphs, it can be concluded that accounting involves the following functions and objectives. a) Systematic recording of all business events or transactions and subsequent posting to ledger to finally prepare financial statements profit and loss account and balance sheet. b) Reporting the results to management, shareholders, creditors, bankers, investors, stock brokers, stock exchanges, employees, governments etc., c) Satisfying the statutory requirements, especially of Registrar of Companies, SEBI (Securities Exchange Board of India) in case the company is listed, tax authorities (sales tax, excise, customs, income tax) and government in order to protect the interest of general public. d) Protecting the properties of business by recording them on the date of acquisition and showing their accounts in the balance sheet. e) It helps for internal control by holding the concerned persons responsible for any errors, lapses or under performance. Equally it helps to identify the strong areas of excellent performance and subsequently pin point the individuals or departments to be rewarded or appreciated. f) Accounting is a tool for effective planning. Current years financial performance becomes the basis for future predictions and estimations. Since it is tool for planning, it also acts as tool for controlling. Preparation of budgets, cost analysis, tax planning, auditing are some of the functions of accounting. Self Assessment Questions 5: 1. State any two functions of accounting. 2. Name the different parties to whom accounting information has to be reported?

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1.7 Differences between Book Keeping and Accounting

As already said, book keeping is a system of recording the day to day transactions in the books of enterprise. Accounting enjoys wider scope and includes not only book keeping but also analysis, interpretation and reporting of financial information. The later part of accounting is the core function of accounting. Now - a-days, owing to information technology, ready made packages like Tally are available, which facilitate entry of transactions and preparation of ledger accounts are made easy. In case of large industrial enterprises and multi national corporations, regular journal entries are not recorded owing to very large number of transactions taking place day in and day out. On the other hand subsidiary books such as cash book, sales book, purchases book, bills receivable book are prepared and ledger accounts are drawn from them. The differences between book keeping and accounting are as under: Book keeping It is a process of recording the transactions in books of accounts Adopt principles of accounting for recording Book keeping is an adjunct to accounting The objective is to prepare final accounts and balance sheet at the end of accounting period Accounting It includes recording, communicating analyzing and

Analysing and interpreting requires skill, knowledge and experience Accounting starts when book keeping ends The objective is to inquire and find out the reasons for financial results and communicate the results to all stakeholders in a manner they understand.

Self Assessment Questions 6: 1. When book keeping ends, ________________ commences. 2. State two differences between book keeping and accounting.

1.8 Financial Accounting and Management Accounting

Financial accounting is the preparation and communication of financial information to outsiders such as creditors, bankers, government, customers and so on. Another objective of financial accounting is to give complete picture of the enterprise to shareholders. Management accounting on the other hand aims at preparing and reporting the financial data to the management on regular basis. Management is entrusted with the responsibility of taking appropriate decisions, planning, performance evaluation, control, management of costs, cost determination etc., For

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both financial accounting and management accounting the financial data is the same and the reports prepared in financial accounting are also used in management accounting But the following are major differences between Financial accounting and Management accounting.

Financial accounting The primary users of financial accounting information are shareholders, creditors, government authorities, employees etc., Accounting information is always expressed in terms of money

Management accounting Top, middle and lower level managers use the information for planning and decision making Management accounting may adopt any measurement unit like labour hours, machine hours or product units for the purpose of analysis Reports are prepared on continuous basis, monthly or weekly or even daily Management accounting is oriented towards future Management accounting makes use of other disciplines like economics, management, information system, operation research etc.,

Financial data is presented for a definite period, say one year or a quarter Financial accounting focuses on historical data

Financial accounting is a discipline by itself and has its own principles, policies and conventions Self Assessment Questions 7:

1. Management accounting is concerned with _____________. 2. State any two differences between Financial accounting and Management accounting.

1.9 Basic Terms

To understand the subject, proper understanding of the following terms is essential. 1. Transaction: It is transfer of money or goods or service from one person or account to another person or account. For example, purchase of goods, sale of goods, payment of cash towards rent, receipt of cash towards interest on loans given, cash brought in as capital dividend paid to share holders etc are all transactions. There are cash transactions, credit transactions and paper transactions. In all cash transactions, cash is paid or received immediately. Ex: Rama paid cash Rs.10000 for purchase of goods. Krishna sells goods for cash Rs1000.Credit transaction is one where there is a promise to pay/receive cash at a future date. EX: Rama purchases goods from Gopal and promises to pay cash one month after the date. Paper transaction is one where there is no cash inflow or outflow but

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adjustment is made in the records only. Bad debts of previous year are written off; depreciation provided on fixed assets etc., 2. Capital: Funds brought in to start business, by the owner/s. In the case of a company, capital is collected by issue of shares. Capital used to purchase fixed assets is called fixed capital and that capital used for day to day affairs of business is known as working capital. From business point of view, Capital is a liability. 3. Assets: Every enterprise has assets. Land and buildings, plant and machinery, furniture and fixtures, cash in hand and at bank, debtors and stock etc., are regarded as assets, by the use of which business is carried on. Assets may be fixed, current, liquid or fictitious. Fixed assets are those which are held for use in the production or supply of goods and services. Ex: plant and machinery, which is used fairly for long period. Current assets are those which are held or receivable within a year or within the operating cycle of the business. They are intended to be converted into cash within a short period of time. Ex: Stock in trade, debtors, bills receivable, cash at bank etc., Liquid assets are those which can be easily converted into cash and for instance, cash in hand, cash at bank, marketable investments etc., Fictitious assets are in the form of such expenses which could not be written off during the period of their incidence. For example, promotional expenses of a company which could not be treated as expenditure in the year of incidence are shown as fictitious asset. 4. Liability: Obligation to be fulfilled in future with respect to payment towards acquisition of an asset or performance of a service. Current liability is that obligation which has to be satisfied within a year. For example, payment to be made sundry creditors for the goods supplied by them on credit; bills payable accepted by the businessman; overdraft raised by the businessman in a bank etc. 5. Goods: Commodities or articles purchased for resale are called goods. Furniture items dealt by a furniture dealer constitute goods for that business. If rice dealer purchases furniture, not for resale but for use, it is called purchase of asset and the same furniture becomes asset. Rice for rice dealer is goods, because he purchases only for resale. 6. Trade: Purchase and sale of goods is called trade. 7. Purchases: It refers to goods bought in exchange for cash or credit. In case of credit purchase, goods are received against a promise to pay the price for the same at a future date.

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8. Sales: Goods sold to customers either for cash or for credit are regarded as sales. In case of cash sales, cash is received immediately and in case of credit sales, cash will be received at a future date. 9. Sole trader: A single individual carrying on business with or without the help of his kith and kin is called sole trader. 10. Partnership: It is a relationship between partners to contribute capital to start business, agree to distribute profits and losses in an agreed proportion and the business being carried on by all or any one acting for all. Partnership firm refers to business where as the partnership refers to relationship caused by agreement. 11. Joint Stock Company: It is an organization, for which the capital is contributed by shareholders to carry on business and it is registered under Companies Act and it has a legal entity, having perpetual existence and a common seal. 12. Debtor: Debtor is a person who owes some thing to business. A person to whom goods are sold on credit becomes a trade debtor to the business. 13. Creditor: A creditor is a person to whom the business owes some thing. For example, a person from whom goods are purchased on credit and amount is yet to be paid is called a trade creditor. 14. Stock: Total goods kept on hand by a trader or industrial enterprise on a given date. It represents unsold part of goods. Self Assessment Questions 8: 1. A company is registered under ___________ . 2. A partnership is ___________ among partners. 3. Rama & Co., owned by Govind. Is it a firm or sole trader? 4. If A purchases goods from B, A is ___________ to B and B is _________ to A. 5. X co Ltd., sold goods to Y Co Ltd and Y Co gave a cheque payable after one month. Is it a cash sale or credit sale? 6. Mr. P brings furniture worth Rs.10000 and goods worth Rs.200000 into his business. Is it capital? Terminal Questions 1. Briefly describe the meaning of accountancy, book-keeping and accounting. 2. Write the differences between accounting and book-keeping.

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3. Brief describe the need and evolution of accounting. 4. State the meaning of the folling terms a. Transaction b. Assets c. Joint stock company d. Goods e. Trade. Answer for Self Assessment Questions Self Assessment Questions 1: 1. Fra Luca Pacioli 2. Cost Accounting 3. 14th Century Self Assessment Questions 2: 1. Record all business transactions and communicate the results to interested parties. 2. Profit and loss and balance sheet 3. Cash flow and fund flow statements Self Assessment Questions 3: 1. Recording business transactions as per accounting principles 2. Accounting is the discipline of measuring, communicating and interpreting financial activities. 3. Profession, accountants. Self Assessment Questions 4: 1. Journal 2. No, because this is not financial in nature. Self Assessment Questions 5: 1. Systematic recording, reporting, Satisfying statutory requirements, protecting the properties, internal control, tool for effective planning (Any two). 2. Shareholders, creditors, bankers, brokers, debtors, customers, suppliers, Government etc. Self Assessment Questions 6: 1. Accounting

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2. Book keeping is a process of recording but accounting is not only recording but also analyzing and communicating; book keeping requires the knowledge of accounting principles but

accounting requires not only knowledge but also skill and experience. Self Assessment Questions 7: 1. Taking decisions, planning, evaluating and controlling 2. FA considers historical data and MA focuses on future; FA is a discipline by itself but MA makes use of other disciplines like economics, information system etc. Self Assessment Questions 8: 1. Companies Act, 2. An agreement 3. Sole Trading concern 4. Debtor, Creditor 5. Credit sale 6. Yes, it is capital. Answer for Terminal Questions: 1. Refer to unit 1.2 2. Refer to unit 1.6 3. Refer to unit 1.1 4. Refer to unit 1.8

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