Introduction to Financial Accounting

Introduction to Accounting
By. Prof Navneet Saxena
IBS Gurgaon

Objective:
At the end of this session you should be able to understand
Distinction among Financial Accounting, Cost Accounting and Management Accounting
Evolution of Accounting
Basic Concepts of Financial Accounting
Conventions of Accounting
Stages of Preparing Accounting Statements
From Input to Output
Users of Financial Statements
Advantages of Accounting
Generally Accepted Accounting Principles

1. Introduction to Financial Accounting Accounting for managers Session 1-2

2. Objective At the end of this session you should be able to understand Distinction among Financial Accounting, Cost Accounting and Management Accounting Evolution of Accounting Basic Concepts of Financial Accounting Conventions of Accounting Stages of Preparing Accounting Statements From Input to Output Users of Financial Statements Advantages of Accounting Generally Accepted Accounting Principles

3. What is Accounting Accounting is the process of identifying, measuring and communicating economic information, to permit informed judgments and decisions by a user of the information. Accounting information is used both by external users as well as internal users. Financial Accounting involves identifying and recording business transactions and summarizing them in rupee terms.

4. What is Accounting Cost Accounting may be defined as “Accounting for costs classification and analysis of expenditure as will enable the total cost of any particular unit of production to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted”. Management Accounting collects and provides accounting, cost accounting, economic and statistical information to the men at various managerial levels to assist them in the performance of managerial functions and their evaluations.

5. Evolution of Accounting

6. Evolution of Accounting 15th Century - In the 15th century, Italian mathematician Luca Pacioli first established the “language of business”, now considered to be the spearhead of modern bookkeeping. 19th Century - The first accounting organization was established in New York in 1887, which later became the American Institute of Certified Public Accountants. 20th Century - The evolution of accounting was revolutionized with computer technology, which meant bookkeeping no longer had to be done with paper and pencil. The Future of Accounting - Businesses now have the option of using cloud-based accounting.

7. Basic Concepts of Financial Accounting Separate Entity – The accounts are kept for the business entity which is distinct from the owner Q. Ram Manohar & Sons is a proprietorship firm owned by Mr Ram Manohar. During the year 2010, the firm bought goods worth Rs.1,000,000 were consumed by Mr Ram Manohar for personal purposes. The remaining goods were sold for Rs. 9,60,000. What is the profit or loss for the year?

8. Basic Concepts of Financial Accounting Accounting Period – is usually a period of 12 months. Additionally, interim reports are prepared to meet the requirement of users for more concurrent information. Q. Hindustan Boiler Limited, an Indian subsidiary of a US company, prepares its accounts using financial year as the accounting period. The US parent company prepares its accounts on calendar year basis. What kind of problem the US company would face to present consolidated results?

9. Basic Concepts of Financial Accounting Money Measurement – makes it possible to aggregate different types of assets, liabilities, revenues and expenses by expressing them in a common unit of reporting Q. After the death of the promoter of E-Sport Limited, there is fierce battle between his two sons for succession. How will this be reflected in the books of accounts of the company?

10. Basic Concepts of Financial Accounting Going Concern – requires a longer term view to be taken for recording business transactions as if the business will continue to operate for an indefinite period of time Q. Healthcare Pharmaceutical Ltd has three plants located at Delhi, Mumbai and Pune. The company has decided to shut down the Pune plant and sell its assets either as a running unit or in a piecemeal manner. What is the implication of such decision in the books of accounts of the company?

11. Basic Concepts of Financial Accounting Cost Concept – lends objectivity to the financial statements as a long-term asset will continue to be shown at its historical cost irrespective of fluctuation in the market price. However a permanent fall in value is recognized. Q. Industrial Lab Limited bought a piece of land for Rs. 5 million in the year 1970. The company had used the land to set up an industrial unit. The current market price of the land is Rs. 20 million. At what value of this asset should be shown in the financial statements of the company?

12. Basic Concepts of Financial Accounting Conservatism – prefers accounting policies that understate rather than overstate profits; ignore probable gains but account for probable losses. Q . Reliable Ltd sells goods on credit basis. On 31 st March 2011, it has a total outstanding of Rs. 120 million from its customers. The past experience shows that about 5% of the customers invariably default. How do we account for this anticipated loss?

13. Basic Concepts of Financial Accounting Materiality – provides for all information that is relevant to the users but avoid unnecessary details Q . In the P&L statement of Tee Ltd. about 60% of the expenses have been clubbed under the heading ‘miscellaneous expenses’, whereas Cee Ltd has reported all heads of expenses separately including about 100 different types of expenses which together constitute only 10% of the total expenses in rupee terms. What are your views?

14. Basic Concepts of Financial Accounting Consistency – facilitates inter-period comparison by requiring that same accounting policies are followed period after period. Change in accounting policies, if any, must be adequately disclosed Q . Red Swan Auto Ltd. is proposing to change its accounting policy for the valuation of inventories, as the management feels that it would lead to better estimation of cost of inventories. Can they do so?

15. Basic Concepts of Financial Accounting Matching – concept for correct ascertainment of profits, expenses incurred to earn revenue are matched against the revenue earned. Both revenue and related expenses must be accounted for in the same accounting period Q. During the year 2010-11, Smart Trading Ltd bought goods worth Rs. 1,350,000. It also had goods worth Rs. 200,000 bought during the year 2009-10. At the end of 2010-11, goods costing Rs. 450,000 are still unsold. Remaining goods have been sold during the year for Rs.1,400,0000. Ascertain the cost of goods sold during the year 2010-11 and profit or loss for the year.

16. Basic Concepts of Financial Accounting Accrual – Revenue are recorded when earned while expense are recorded when incurred irrespective of when received or paid Cash – Transactions are recorded on receipt and payment of cash Q . ABC Diagnostic Ltd. has the practice of paying the monthly salary on the 7 th of next month. Accordingly, salary for the month of March 2011 was paid on 7 th April 2011. If the company follows cash basis of accounting, when would the expenses be recognized? What if the company follows accrual basis of accounting?

17. Basic Concepts of Financial Accounting Dual – Every transaction affects at least two accounts in such a way that Assets = Capital + Liabilities Q . Mr Ramesh Jha started a new business on 1 st April 2011 contributing Rs. 1,000,000 in cash as capital. The firm bought some furniture for Rs. 200,000 in cash and bought machinery from XYZ Ltd for Rs. 700,000 on credit. How would these transactions affect the transaction equation?

18. Basic Concepts of Financial Accounting Substance over Form – Accountants often face situations where the real intent of a transaction is totally different from the form in which the transaction is entered into. Q . On 1 st May 2011, Moneywise Bank sold some securities to KM Bank for Rs. 100 million with an agreement to buy them back at Rs. 101 million after a month. The securities were delivered to KM Bank on 1 st May 2011. On 1 st June, Moneywise Bank paid Rs. 101 million and bought back the securities. How should the transactions be recorded in the books of Moneywise Bank.

19. Stages of Preparing Accounting Statements – Accounting Cycle

20. From Input to Output - Financial Statements The financial statement aim to answer three basic questions about a business entity: 1. How much profit was earned by the business during a particular time period? Statement of Profit and Loss 2. What are the assets and liabilities of the business at the end of the period? Balance Sheet 3. What were the sources and uses of cash during a particular period? Cash Flow Statement

21. Problem 1: Identify Relevant Accounting Principle Curewell Pharmaceutical Ltd is facing a law suit wherein it may be liable to pay a fine of Rs. 10 million. The lawyer of the company has advised that there is a high probability of the company losing the law suit. How should the company record this transaction in the books of accounts? What accounting principle is involved?

22. Solution 1: Curewell Pharmaceutical is advised to make appropriate provision for the loss as there is a reasonable probability of company losing the case. It is based upon the principle of conservatism.

23. Problem 2: Identify Relevant Accounting Principle Shivam Limited borrowed a sum of Rs. 50 million from the SBI on 1 st August 2010 for a period of one year. The loan matured on 30 th July 2011 and was duly repaid on due date with interest amounting to Rs. 5 million. The company maintains its books on financial year basis. In which accounting year the interest expenses should be recorded? Why?

24. Solution 2: The interest of Rs. 5 million is for a period of 12 months from 1 st August 2010 to 30 th July 2011. Interest accrues on a day-to-day basis. Interest from 1 st August 2010 to 31 st March 2011 should be accounted for in the year 2010-11, whereas interest for the period 1 st April 2011 to 30 th July will be treated as an expense for the year 2011-12. Accordingly, interest of Rs. 5 million will be split two-third: one-third between the two accounting years.

25. Problem 3: Identify Relevant Accounting Principle Which of the following transactions are subject matter of accounting: A. Purchase of 200 kg of goods by the firm on credit for Rs. 1,00,000 B. Resignation of one of the key salesman of the firm C. A pharmaceutical company has filed application for patent of a new drug D. A construction company has won a major contract from the government E. A telecom company has paid Rs. 200 million as a security deposit to the government

26. Solution 3: A. Yes: Rs. 1,00,000 will be recorded as purchase but not the quantity B. No: Cannot be expressed in money terms C. No: Filing an application cannot be expressed in terms of money D. No: Winning a contract cannot be expressed in monetary terms E. Yes: Amount of security deposit is an accounting transaction

27. Problem 4: Identify Relevant Accounting Principle Free Flow Oil Limited, an Indian company, set up an office in Sri Lanka for executing a specific contract. Due to some reasons, the Sri Lankan government put a ban on the company to operate in the country. How will it impact the valuation of assets of the Sri Lankan operations of the company?

28. Solution 4: As there is evidence to believe that the Sri Lankan Operation of the company are no longer viable, these operations can no longer be viewed as going concern. Accordingly, valuation of assets of Sri Lankan operations should reflect their realizable value.

29. Users of Financial Information Suppliers of Capital Shareholders Leading Banks and Financial Institutions Bond Holders Other Lenders Credit Rating Agencies Tax Authorities RBI, IRDA Employees and Trade Unions Academicians and Researchers

30. Generally Accepted Accounting Principles - GAAP Accounting is a management discipline and not an exact science Accounting principles and standards make financial statements prepared by various entities comparable by reducing management’s discretion in choice of accounting treatment. The need for comparability led to the evolution of GAAP Accounting Standards are mandatory requirements to be followed while preparing financial statements

31. Conclusion In this session we learnt about Distinction among Financial Accounting, Cost Accounting and Management Accounting Evolution of Accounting Basic Concepts of Financial Accounting Conventions of Accounting Stages of Preparing Accounting Statements From Input to Output Users of Financial Statements Advantages of Accounting Generally Accepted Accounting Principles