Chapter-1

The nature and functions of financial accounting

Financial accounting may be defined as the process of designing and operating an information system for collecting, measuring and recording an enterprises transactions, and summarizing and communicating the results of these transactions to users to facilitate making financial economic decisions. The first part of this definition, relating to collecting and recording transactions, refers to double-entry bookkeeping, which consists of maintaining a record of the nature and money value of the transactions of an enterprise. In many organizations this may be done using a computer. The second part of the definition, relating to communicating the results, refers to preparing final accounts and statements from the books of account (or any other system of recording), showing the profit earned during a given period and the financial state of affairs of a business at the end of that period.

FA as IS.

Business transactions

Decision makers

Data

Information

Tracking and recording of data

Processing of data

Reporting

The recording and control of business transactions

This includes records of the following: 1 The amount of cash and cheques received, for what and from whom. 2 The amount of cash and cheques paid, for what and to whom. Records of money received and paid are kept so that the enterprise knows how much money it has at any time. 3 Assets, expenses and goods purchased on credit. This is so that the enterprise knows to whom it owes money and how much. These are referred to as creditors. 4 Assets and goods sold on credit. This is so that the enterprise knows who owes it money and how much. These are referred to as debtors.

The accountant has been traditionally regarded as the holder of the purse strings and responsible for safeguarding the assets of the enterprise. The control aspect of this function includes ensuring that the correct amounts are paid to those entitled to them at the appropriate time, collecting the enterprises debts when due, safeguarding against fraud and misappropriation of assets such as goods or cash. The latter function is often referred to as internal control.

To maintain accuracy in recording

Double-entry bookkeeping is generally regarded as the most accurate method of bookkeeping, primarily because each transaction is entered in the books twice. This duplication, referred to as a form of internal check, highlights any errors.

To meet the requirements of the law

The law, in the form of the Companies Acts, states that companies must keep proper records of their transactions and send their shareholders a set of annual final accounts. There is also tax legislation that requires sole traders and partnerships to provide the Inland Revenue with details of their income and expenditure. The self assessment procedure used by the Inland Revenue allows traders to deduct various expenses from their income in arriving.

To present final accounts to the owners of the business

These comprise a profit and loss account showing the amount of profit and thus the financial performance of a business for a given period, and a balance sheet showing its financial position at the end of that period. The latter will include the following items: 1 The amount of cash and money at the bank. 2 Other assets that the business owns, such as goods for resale, vehicles and machinery. 3 Debtors and creditors. 4 The amount of capital that has been invested in the business by its owner(s). 5 Any money that has been borrowed by the business. In the case of a sole trader, these final accounts show the owner his or her earnings for the period and may be used to evaluate the profitability of the business. However, they are often primarily used to determine the owners tax liability. Final accounts perform similar functions in the case of companies. However, company final accounts are also designed to give information to third parties to enable them to evaluate the profitability and financial stability of the company. These include prospective shareholders, trade unions and employees, creditors and those who have lent the company money, government departments and social pressure groups. This function of financial accounting is often referred to as stewardship, which may be defined as the accountability of an enterprises management for the resources entrusted to them. Accountability refers to the managements responsibility to provide an account report on the way in which the resources entrusted to them have been used.

To present other financial reports and analyses

This includes the use of ratios to evaluate the following matters: 1 The profitability of the business. 2 The level of activity and productivity. 3 The solvency and liquidity position (i.e. whether the business will be able to pay its debts). 4 The efficiency of credit control procedures. 5 The efficiency of stock control procedures. 6 The effect of any loans on the businesss profitability and financial stability. To

To facilitate the efficient allocation of resources

Viewing the function of financial accounting at a more general, abstract level, its ultimate raison dtre is usually described as being to facilitate the efficient and effective allocation of resources. This is generally given a macroeconomic interpretation as providing information to investors so that capital is directed towards more efficient firms. A less common but similar interpretation would be to extend this to providing information to prospective employees so that labour is directed towards more efficient firms. The same interpretation could also THE NATURE AND OBJECTIVES OF FINANCIAL ACCOUNTING 5 be extended to other potential users of final accounts and providers of resources in a broad sense that embraces quality of life and environmental considerations, etc. This would include others such as bank lenders, creditorssuppliers, the government and the public in general. This function of financial accounting can also be viewed at a microeconomic or individual firm level. One of the main purposes of financial accounting may be said to be to enable an organizations management to operate the enterprise efficiently and effectively. This embraces at least three of the functions referred to above, namely, the recording and control of business transactions, accuracy in recording and the preparation of final accounts (for management use). However, this function of accounting is more commonly attributed to management accounting, particularly in larger organizations.

Accounting Concepts and Principles

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GAAP Principles:
The GAAP principles are divided into two categories: 1. Accounting Concepts: Accounting Concepts are basic assumptions or conditions upon which science of accounting is based. 2. Accounting Conventions: Accounting Conventions include those customs and traditions which are followed up by an accountant while preparing a financial statement.

GAAP (Generally Accepted Accounting Principles): The rules that govern accounting are called GAAP (Generally Accepted Accounting Principles).

GAAP (Generally Accepted Accounting Principles): The common set of accounting principles, standards and procedures. Combination of authoritative standards (set by policy boards) and simply, the commonly accepted ways.

GAAP (Generally Accepted Accounting Principles):

Explanation: Provides a fair financial image of the company. Provides with different Information:
Revenue recognition. Balance sheet item classification. Outstanding share measurements.

3 Main Categories of GAAP: Assets: An asset is an item of value owned by a company. Liabilities: In accounting, liabilities are obligations of the company, to transfer something of value to another party. Equity: Equity is the owner's value in an asset or group of assets.

Introduction
Actually there are a number of accounting concepts and principles based on which we prepare our accounts These generally accepted accounting principles lay down accepted assumptions and guidelines and are commonly referred to as accounting concepts

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Users of Financial Statements

Investors
Need information about the profitability, dividend yield and price earnings ratio in order to assess the quality and the price of shares of a company

Lenders
Need information about the profitability and solvency of the business in order to determine the risk and interest rate of loans

Management
Need information for planning, policy making and evaluation

Suppliers and trade creditors

Need information about the liquidity of business in order to access the ability to repay the amounts owed to them
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 Government
Need information about various businesses for statistics and formulation of economic plan

Customers
Interested in long-tem stability of the business and continuance of the supply of particular products

Employees
Interested in the stability of the business to provide employment, fringe benefits and promotion opportunities

Public
Need information about the trends and recent development

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Limitations of conventional financial statements

Companies may use different methods of valuation, cost calculation and recognizing profit The balance sheet does not reflect the true worth of the company Financial statements can only show partial information about the financial position of an enterprise, instead of the whole picture
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Accounting Concepts

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Accounting Concepts
Business entity Money Measurement/stable monetary unit Going Concern Historical Cost Prudence/conservatism Materiality

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Objectivity Consistency Accruals/matching Realization Uniformity Disclosure Relevance

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Business Entity
Meaning
The business and its owner(s) are two separate existence entity Any private and personal incomes and expenses of the owner(s) should not be treated as the incomes and expenses of the business

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Business Entity

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 Examples
Insurance premiums for the owners house should be excluded from the expense of the business The owners property should not be included in the premises account of the business Any payments for the owners personal expenses by the business will be treated as drawings and reduced the owners capital contribution in the business

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Money Measurement

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Money Measurement
Meaning
All transactions of the business are recorded in terms of money It provides a common unit of measurement

Examples
Market conditions, technological changes and the efficiency of management would not be disclosed in the accounts

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Going Concern

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Going Concern
Meaning
The business will continue in operational existence for the foreseeable future Financial statements should be prepared on a going concern basis unless management either intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so

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 Example
Possible losses form the closure of business will not be anticipated in the accounts Prepayments, depreciation provisions may be carried forward in the expectation of proper matching against the revenues of future periods Fixed assets are recorded at historical cost

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Historical Cost

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Historical Cost
Meaning
Assets should be shown on the balance sheet at the cost of purchase instead of current value

Example
The cost of fixed assets is recorded at the date of acquisition cost. The acquisition cost includes all expenditure made to prepare the asset for its intended use. It included the invoice price of the assets, freight charges, insurance or installation costs
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Prudence/Conservatism

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Prudence/Conservatism
Meaning
Revenues and profits are not anticipated. Only realized profits with reasonable certainty are recognized in the profit and loss account However, provision is made for all known expenses and losses whether the amount is known for certain or just an estimation This treatment minimizes the reported profits and the valuation of assets
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 Example
Stock valuation sticks to rule of the lower of cost and net realizable value The provision for doubtful debts should be made Fixed assets must be depreciated over their useful economic lives

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Materiality

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Materiality
Meaning
Immaterial amounts may be aggregated with the amounts of a similar nature or function and need not be presented separately Materiality depends on the size and nature of the item

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 Example
Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to the profit and loss account as revenue expenditures, although they can last for more than one accounting period

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Objectivity

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Objectivity
Meaning
The accounting information should be free from bias and capable of independent verification The information should be based upon verifiable evidence such as invoices or contracts

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 Example
The recognition of revenue should be based on verifiable evidence such as the delivery of goods or the issue of invoices

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Consistency

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Consistency
Meaning
Companies should choose the most suitable accounting methods and treatments, and consistently apply them in every period Changes are permitted only when the new method is considered better and can reflect the true and fair view of the financial position of the company The change and its effect on profits should be disclosed in the financial statements
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 Examples
If a company adopts straight line method and should not be changed to adopt reducing balance method in other period If a company adopts weight-average method as stock valuation and should not be changed to other method e.g. first-in-first-out method

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Accruals/Matching

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Accruals/Matching
Meaning
Revenues are recognized when they are earned, but not when cash is received Expenses are recognized as they are incurred, but not when cash is paid The net income for the period is determined by subtracting expenses incurred from revenues earned
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 Example
Expenses incurred but not yet paid in current period should be treated as accrual/accrued expenses under current liabilities Expenses incurred in the following period but paid for in advance should be treated as prepayment expenses under current asset Depreciation should be charged as part of the cost of a fixed asset consumed during the period of use

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Problems in the recognition of expenses

Normally, expenses represents resources consumed during the current period. Some costs may benefit several accounting periods, for example, development expenditures, depreciation on fixed assets.

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Recognition criteria for expenses

Association between cause and effect
Expenses are recognized on the basis of a direct association between the expenses incurred on the basis of a direct association between the expenses incurred and revenues earned For example, the sales commissions should be accounted for in the period when the products are sold, not when they are paid

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 Systematic allocation of costs

When the cost benefit several accounting periods, they should be recognized on the basis of a systematic and rational allocation method For example, a provision for depreciation should be made over the estimated useful life of a fixed asset

Immediate recognition
If the expenses are expected to have no certain future benefit or are even without future benefit, they should be written off in the current accounting period, for example, stock losses, advertising expenses and research costs

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Realization

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Realization
Meaning Revenues should be recognized when the major economic activities have been completed Sales are recognized when the goods are sold and delivered to customers or services are rendered

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Recognition of revenue
The realization concept develops rules for the recognition of revenue The concept provides that revenues are recognized when it is earned, and not when money is received A receipt in advance for the supply of goods should be treated as prepaid income under current liabilities Since revenue is a principal component in the measurement of profit, the timing of its recognition has a direct effect on the profit
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Recognition criteria for revenues

The uncertain profits should not be estimated, whereas reported profits must be verifiable Revenue is recognized when
1. The major earning process has substantially been completed 2. Further cost for the completion of the earning process are very slight or can be accurately ascertained, and 3. The buyer has admitted his liability to pay for the goods or services provided and the ultimate collection is relatively certain

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 Example
Goods sent to our customers on sale or return basis This means the customer do not pay for the goods until they confirm to buy. If they do not buy, those goods will return to us Goods on the sale or return basis will not be treated as normal sales and should be included in the closing stock unless the sales have been confirmed by customers

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Problems in the recognition of revenue

Normally, revenue is recognized when there is a sale The point of sales in the earning process is selected as the most appropriated time to record revenues However, if revenue is earned in a long and continuous process, it is difficult to determine the portion of revenue which is earned at each stage Therefore, revenue is permitted to be recorded other than at the point of sales
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Exceptions to rule of sales recognition

1. Long-term contracts
Owning to the long duration of long-term contracts, part of the total profit estimated to have been arisen from the accounting period should be included in the profit and loss account Hire purchase sales have long collection period. Revenue should be recognized when cash received rather than when the sale (transfer of ownership) is made The interest charged on a hire purchase sale constitutes the profit of transaction
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2. Hire Purchase Sale

3. Receipts from subscriptions

A publisher receives subscriptions before it sends newspapers or magazines to its customers It is proper to defer revenue recognition until the service is rendered. However, part of subscription income can be recognized as it is received in order to match against the advertising expenses incurred

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Disclosure

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Disclosure
Meaning
Financial statements should be prepared to reflect a true and fair view of the financial position and performance of the enterprise All material and relevant information must be disclosed in the financial statements

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Uniformity

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Uniformity
Meaning
Different companies within the same industry should adopt the same accounting methods and treatments for like transactions The practice enables inter-company comparisons of their financial positions

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Relevance

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Relevance
Meaning
Financial statements should be prepared to meet the objectives of the users Relevant information which can satisfy the needs of most users is selected and recorded in the financial statement

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UNDERSTANDING OF ACCOUNTING STANDARDS

AGENDA OF DISCUSSION
Introduction of Accounting Standards Objectives of Accounting Standards Types of Accounting Standards

Introduction
Written Documents issued by Government or Regulatory Body In India, issued by ICAI( Institute of Cost Accountants of India ) on 21st April,1977 Initiated by Kumar Mangalam Birla, chairman committee of Corporate Governance for Financial Disclosures Also initiated by Chair person of NACAS( National Advisory Committee on Accounting Standard (NACAS))

Objectives
Standardise the diverse Accounting Policies Add the reliability to the Financial Statement Eradicate baffling variation in treatment of accounting aspects Facilitate inter-firm and intra-firm comparison

Accounting Standards in Different Nations

In India, 32 Accounting Standards as IAS under NACAS As per International, there are 41 Accounting Standards called as IFRS Adopted by 8 countries in the world 70 to 80 countries planning to adhere IFRS(International Financial Reporting Standards ) Clause 50 added to the listing agreement mandatory

Evolution and Types of AS

Accounting Standards 1. AS 1 to AS 15 2. AS 16 to AS 29 3. AS 30 to AS 32 Initiation 1979 to 1995 2000 to 2007 Later part of 2007

AS 1-Disclosure of Accounting Policies

Specific policies adapted to prepare FS Should be disclosed at one place Purpose :1. Better understanding of FS 2. Better comparison analysis 3. Mostly needed w.r.t Depreciation

AS 2- Accounting for Inventories

Used for computation of Cost of inventories and to show in BS till it is sold Consists of :1. Raw Materials 2. Work in progress 3. Finished goods 4. Spares, etc

Measurements of Inventories
Determination of Cost of Inventories Cost of purchase (Purchase price, duties & taxes, freight inwards) Cost of conversion Determination of Net realisable value Comparison of cost and net realisable

AS 3- Cash Flow Statements

1. 2. 3. Incoming and outgoing of cash Act as barometer to judge surplus and deficit Explain Cash flow under 3 heads :Cash flow from operating activities Cash flow from financing activities Cash flow from investing activities

AS 4- Contingencies and events occurring after BS date

For maintaining Provision of Bad debts Generally uses Conservative concepts of Accounting like Bankruptcy, frauds & errors.

AS 5- Net profit or loss for the period, prior period items and change in Accounting policies
Ascertain certain criteria for certain items Include income and expenditures of Financial year Consists of 2 component 1. Profit and loss of ordinary activities 2. Profit and loss of extra ordinary activities

AS 6- Accounting for Depreciation

1. 2. A non-cash expenditure Distribution of total cost to its useful life Occurs due to obsolescence Different methods of computation Straight line method ( SLM ) Written-down value or diminishing value (WDV)

AS 7- Construction Contract
Contract specifically negotiated for construction of Asset or combination of Assets closely inter-related

AS 8- Accounting for R&D

To deal with treatment of Cost of research and development in the financial statements, identify items of cost which comprise R&D costs lays down condition R&D cost may be deferred and requires specific disclosures to be made regarding R&D costs.

AS 9- Revenue Recognition
Means gross inflow of cash and other consideration like arising out of :1. Sale of goods 2. Rendering services 3. Use of enterprise resources by other yielding interest, dividend and royalities.

AS 10- Accounting for Fixed Assets

Called as Cash generating Assets Expected to used for more than a Accounting period like land, building, P/M, etc Shown at either Historical or Revalued value

AS 11- Effect of change in FOREX Rates

1. Classification for Accounting treatment:Category I: Foreign currency transactions: a) buying and selling of goods or services b) lending and borrowing in foreign currency c) Acquisition and disposition of assets 2. Category II: Foreign operations: a) Foreign branch b) Joint venture c) Foreign Subsidiary 3. Category III: Foreign Exchange contracts: a) For managing Risk/hedging b) For trading and Speculation

AS 12- Accounting for Govt. Grants

Assistance provided by Govt. in cash or in kind like 1. Grants of Assets like P/M, Land,etc 2. Grants related to depreciable FA 3. Tax exemptions in notified area

AS 13- Accounting for Investments

1. 2. 3. 4. 5. 6. Assets held for earning incomes like dividend, interest, rental for capital appreciation, etc It involves:Classification of Investment Cost of Investment Valuation of Investment Reclassification of Investment Disposal of Investment Disclosure of Investment in FS

AS 14- Accounting for Amalgamation

1. 2. 3. 4. Section 391 to 394 of Companies Act, 1956 governs the provision of amalgamation. Disclosures: Names and nature of amalgamating companies Effective date of amalgamation Method of Accounting used Particulars of scheme sanctioned under a statute

AS 15- Employees Benefits

All forms of consideration given by enterprise directly to the employees or their spouses, children or other dependants, to other such as trust, insurance companies in exchange of services rendered.

AS 16- Borrowing Costs

Interest and cost incurred by an enterprise in connection to the borrowed funds. Availed for acquiring building, installed FA to make it useable and saleable.

AS 17- Segment Reporting

1. 2. It consists of 2 segment:Business segment Geographical segment Information and different risk and return reporting.

AS 18- Related party disclosure

1. 2. 3. 4. Related party are those party that controls or significantly influence the management or operating policies of the company during reporting period Disclosure: Related party relationship Transactions between a reporting enterprises and its related parties. Volume of transactions Amt written off in the period in respect of debts

AS 19- Accounting for Leases

1. 2. Agreement between Lessor And Lessee Two types of leases: Operating lease Finance lease Different from Sale Classification to be made at the inception

AS 20- Earning per share

Earning capacity of the firm Assessing market price for share AS gives computational methodology for determination and presentation of EPS 2 types of EPS

AS 21- Consolidated Balance Sheet

Accounting for Parent and Subsidiary company in single entity Disclosure:1. List of all subsidiaries 2. Proportion of ownership interest 3. Nature of relation whether direct or indirect

AS 22- Accounting for taxes and income Tax accounted for period in which are accounted It should be accrued and not liability to pay Deals in 2 measurements:1. Current tax 2. Deferred tax

AS 23- Accounting for investments in Associates in CFS

Objectives to set out principles and procedures for recognizing the investment associates in CFS of the investors, so that effect of investments in associates on financial position of group is indicated.

AS 24- Discontinuing operations

Establishes principles for reporting information about discontinuing operations Covers discontinuing operations rather than discontinued operation

AS 25-Interim Financial Reporting (IFR)

Reporting for less than a year i.e 3 months Clause 41 says publish financial results on quarterly basis Objective is to provide frequently and timely assessment

AS 26- Intangible Assets

1. 2. 3. No physical existence Can not be seen or even touched 3 featured as per AS Identifiable Non-monetary assets Without physical substance

AS 27- Financial Reporting of interest in Joint Venture

What is joint venture? Three types of JV in case of Financial reporting

AS 28- Impairment of Assets

Weakening of Assets value Occurs when carrying cost more than recoverable amt Carrying cost = Cost of assets Accumulated Depreciation

AS 29- Provision, contingent liabilities and assets

Provisions:It is a Liability Settlement should result in outflow Liability is result of obligating event Contingent liabilities:Obligation arises of past event Existence confirmed when actually occurred of uncertain future Contingent Asset Same as Contingent liability

Financial Instruments
AS 30 Recognition and Measurement AS 31 Presentation AS 32 Disclosures Has not been made mandatory (expected in 2009)

The Principles of GAAP

Generally accepted accounting principles, or GAAP for short, are the accounting rules used to prepare and standardize the reporting of financial statements, such as balance sheets, income statements and cashflow statements, for publicly traded companies and many private companies in the United States. GAAP-based income is measured so that the information provided on financial statements is useful to those making economic decisions about a company, such as potential investors and creditors. GAAP is implemented through measurement principles and disclosure principles. Measurement principles recognize and determine the timing and basis of items that enter the accounting cycle and impact the financial statements, such as the period in which transactions will be recorded.Disclosure principles determine what specific numbers and other information are essential to be presented in financial statements. Basically, GAAP is concerned with: the measurement of economic activity; the time when such measurements are to be made and recorded; the disclosures surrounding this activity; and the preparation and presentation of summarized economic information in financial statements.

GAAP (Generally Accepted Accounting Principles): The common set of accounting principles, standards and procedures. Combination of authoritative standards (set by policy boards) and simply, the commonly accepted ways.

GAAP (Generally Accepted Accounting Principles):

Explanation: Provides a fair financial image of the company. Provides with different Information:
Revenue recognition. Balance sheet item classification. Outstanding share measurements.

3 Main Categories of GAAP: Assets: An asset is an item of value owned by a company. Liabilities: In accounting, liabilities are obligations of the company, to transfer something of value to another party. Equity: Equity is the owner's value in an asset or group of assets.

GAAP Principles:
The GAAP principles are divided into two categories: 1. Accounting Concepts: Accounting Concepts are basic assumptions or conditions upon which science of accounting is based. 2. Accounting Conventions: Accounting Conventions include those customs and traditions which are followed up by an accountant while preparing a financial statement.