Reading Material

UNIT 01

Introduction to Financial Accounting

TOPIC-1

1. Meaning of Financial Accounting

Financial Accounting is a branch of accounting that involves the process of

recording, summarizing, and reporting the multitude of transactions resulting
from business operations over a period of time. These transactions are
summarized in the form of financial statements – including the income
statement, balance sheet, and cash flow statement – that reflect the financial
performance and position of a business.

Definition:

According to the American Institute of Certified Public Accountants

(AICPA),

"Financial Accounting is the art of recording, classifying and summarizing 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."

2. Importance of Financial Accounting

1. Systematic Record Keeping: Maintains chronological records of all financial
transactions.
2. Financial Performance Evaluation: Helps evaluate business performance
through income statements.
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3. Financial Position Analysis: Shows the position of assets, liabilities, and
equity.
4. Legal Compliance: Ensures compliance with laws and regulations.
5. Decision-Making: Assists management and stakeholders in making informed
decisions.
6. Communication to Stakeholders: Communicates results to investors,
creditors, regulators, and others.
7. Basis for Taxation: Provides information required for determining taxable
income.
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3. Scope of Financial Accounting

Financial accounting is concerned with:
 Recording of financial transactions.
 Classifying transactions into various accounts.
 Summarizing data to prepare financial statements.
 Analyzing and interpreting results for stakeholders.
 Communicating information to users like investors, creditors, and
government agencies.
It includes:
 Preparation of income statement (Profit and Loss Account)
 Preparation of balance sheet
 Cash flow statement and statement of changes in equity
 Notes to accounts and disclosure requirements
 Handling of adjustments and closing entries
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4. Limitations of Financial Accounting
Despite its usefulness, financial accounting has several limitations:
1. Historical in Nature: Based on past transactions; does not reflect real-time
data.
2. Ignores Non-Monetary Aspects: Factors like employee satisfaction or brand
value are not recorded.
3. Use of Estimates: Many items like depreciation or provisions involve
estimates and assumptions.
4. Subject to Manipulation: Window dressing can distort true financial
performance.
5. Not Forward-Looking: Doesn’t provide future projections or budgets.
6. Lacks Timeliness: Financial reports are usually published periodically (e.g.,
quarterly/yearly), not in real-time.

5. Bookkeeping vs. Accounting

Feature Bookkeeping Accounting

Recording +
Systematic recording
classifying +
Meaning of financial
summarizing +
transactions
analyzing

Maintain accurate Provide financial

Objective record of all insights for decision-
transactions making

Skills Analytical and

Clerical skills
Required interpretative skills

Decision Does not aid decision- Provides a basis for

Support making decision-making

End Trial Balance Financial Statements

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Feature Bookkeeping Accounting
Product (P&L, Balance Sheet,
etc.)

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6. Accounting Principles
Accounting principles are a set of rules and guidelines followed for proper
accounting and reporting of financial transactions. These principles are
divided into:
a. Accounting Concepts (Fundamental Assumptions)

1. Business Entity Concept: The business is treated as a separate entity from its
owner(s).
2. Money Measurement Concept: Only transactions measurable in monetary
terms are recorded.
3. Going Concern Concept: Assumes that the business will continue
indefinitely.
4. Accounting Period Concept: The life of the business is divided into time
periods for reporting (e.g., quarterly, annually).
5. Cost Concept: Assets are recorded at their historical cost, not current market
value.
6. Dual Aspect Concept: Every transaction has a dual effect – debit and credit.
7. Revenue Recognition Concept: Revenue is recognized when it is earned, not
necessarily when received.
8. Matching Concept: Expenses are matched with the revenues of the same
period.
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9. Accrual Concept: Revenues and expenses are recognized when they occur,
not when cash is exchanged.

b. Accounting Conventions (Practices Based on Custom or Usage)

1. Convention of Consistency: Same accounting methods are followed from
period to period.
2. Convention of Full Disclosure: All significant information should be
disclosed in financial statements.
3. Convention of Conservatism (Prudence): Anticipate no profits but provide
for all possible losses.
4. Convention of Materiality: Only material (significant) items should be
reported.

7. Accounting as an Information System

Definition:
Accounting is not just a method of recording transactions; it serves as a
comprehensive information system that collects, processes, and
communicates financial data.

Key Functions:
 Data Collection: Recording financial transactions
 Processing: Classifying and summarizing into reports
 Output: Producing financial statements
 Communication: Disseminating information to internal and external users
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Users of Accounting Information:

 Internal: Management, employees
 External: Investors, creditors, tax authorities, regulatory bodies
Why it's an Information System:
 Transforms raw financial data into useful reports
 Aids planning, controlling, and decision-making
 Provides a basis for forecasting and strategy

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Financial Accounting Topics

1. Users of Accounting Information

Accounting provides vital information to a wide range of users. These users
are broadly classified into internal and external users:
A. Internal Users
These users are directly involved in managing the organization.
1. Owners: Want to know the profitability and financial position of the business.
2. Management: Uses accounting data for planning, controlling, and decision-
making.
3. Employees: Interested in job security, bonuses, and retirement benefits.
B. External Users
These are individuals or entities not directly involved in the business
operations.
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1. Investors and Shareholders: Assess company’s profitability and future
growth to decide on investment.
2. Creditors and Lenders: Evaluate creditworthiness and financial stability
before lending.
3. Government and Regulatory Authorities: Use information for taxation,
regulation, and compliance purposes.
4. Customers: Large customers may want to assess the financial health of
suppliers.
5. Suppliers: Assess the company’s ability to pay for goods or services on credit.
6. Public and Media: Interested in economic contributions like employment and
CSR.
7. Analysts and Financial Advisors: Use information to provide investment
recommendations.

2. Accounting Standards (AS): General Accounting Standards in India

Accounting Standards (AS) are written policy documents issued by
regulatory bodies like the Institute of Chartered Accountants of India
(ICAI), to ensure transparency, consistency, and comparability in the
preparation and presentation of financial statements.
Legal Authority in India:
 Under the Companies Act, 2013, compliance with Accounting Standards is
mandatory.
 ICAI issues AS through the Accounting Standards Board (ASB).
Objectives of Accounting Standards:
1. Standardize accounting policies.
2. Ensure transparency and comparability.
3. Prevent manipulation and ensure faithful representation.
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4. Improve reliability of financial information.
Examples of Common Accounting Standards (Not exhaustive):

AS
Title Scope
No.

Disclosure of Requires disclosure of

AS-1
Accounting Policies significant accounting policies.

Valuation of Deals with the determination of

AS-2
Inventories cost and net realizable value.

Depreciation (Now merged with AS-10)

AS-6
Accounting Dealt with depreciation policy.

Revenue Timing and criteria for

AS-9
Recognition recognizing revenue.

AS- Property, Plant & Accounting treatment for fixed

10 Equipment assets.

AS- Related Party Requires disclosure of related

18 Disclosures party transactions.

Note: For companies following Indian Accounting Standards (Ind AS), these
are converged with IFRS.

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3. Bases of Accounting – Cash vs Accrual

Accounting records can be maintained using either the Cash Basis or the
Accrual Basis.
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A. Cash Basis of Accounting:
 Revenue is recorded when cash is received.
 Expenses are recorded when cash is paid.
 Simpler and commonly used in small businesses or by individuals.
Advantages:
 Simple to implement.
 Reflects actual cash flow.
Limitations:
 Ignores outstanding payables/receivables.
 Does not give a true picture of financial health.
B. Accrual Basis of Accounting:
 Revenues are recorded when earned, regardless of cash receipt.
 Expenses are recorded when incurred, regardless of payment.
Advantages:
 Provides a more accurate and realistic picture of financial performance.
 Matches revenues with related expenses (Matching Principle).
Limitations:
 More complex.
 May not reflect actual cash position.
Accrual basis is mandatory under Indian GAAP for companies.
TOPIC-6
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4. Classification of Income, Expenditure & Receipts
Understanding these classifications is crucial for accurate financial reporting.
A. Income
1. Revenue Income:
o Income from regular business operations (e.g., sales, service income).
o Recurring in nature.
2. Capital Income:
o Arises from non-operating sources (e.g., sale of fixed assets, share capital
raised).
o Non-recurring.
B. Expenditure
1. Revenue Expenditure:
o Incurred for day-to-day operations.
o Benefits last within the accounting period.
o E.g., rent, wages, utility bills.
2. Capital Expenditure:
o Incurred to acquire or improve long-term assets.
o Provides benefit over multiple periods.
o E.g., purchase of machinery, land, buildings.
C. Receipts
1. Revenue Receipts:
o Inflows from regular business activities.
o E.g., sales, commission, interest received.
2. Capital Receipts:
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o Inflows from sources other than business operations.
o E.g., loan taken, issue of shares.
Revenue items affect Profit & Loss A/c, while Capital items are shown in
the Balance Sheet.

5. Accounting Equation
The Accounting Equation is the foundation of double-entry accounting and
shows the relationship between assets, liabilities, and capital.
Basic Equation:

Assets = Liabilities + Owner’s Equity (Capital)

Meaning:
 Assets: What the business owns (cash, inventory, machinery).
 Liabilities: What the business owes to others (loans, creditors).
 Owner’s Equity: The owner’s claim or interest in the business (capital +
retained earnings).
Example:
Suppose a business is started with ₹1, 00,000 capital and takes a loan of
₹50,000:
Assets = Liabilities + Capital
₹1, 50,000 = ₹50,000 + ₹1, 00,000
Extended Equation:
To reflect income and expenses:
Assets = Liabilities + Capital + (Revenues - Expenses)
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Dual Aspect Concept:
Every transaction has a dual effect (debit & credit) ensuring the accounting
equation remains balanced.
Transaction Example:
 Buy furniture for ₹10,000 cash:
o Asset (Furniture) ↑ ₹10,000
o Asset (Cash) ↓ ₹10,000
o Total Assets = No change → Equation still balances.

Overview Table:

Concept Key Takeaways

Users of Accounting Internal (owners, mgmt.), External

Info (investors, govt, creditors)

Accounting Issued by ICAI; ensure consistency and

Standards (AS) transparency

Cash Basis Simple, records cash inflows/outflows only

Records when earned/incurred; follows

Accrual Basis
matching principle

Income Types Revenue vs Capital

Expenditure Types Revenue, Capital, Deferred

Revenue (sales), Capital (loans,

Receipts
investments)

Assets = Liabilities + Capital (+ Revenue –

Accounting Equation
Expenses)