FINANCIAL ACCOUNTING 1 – Degree 1st semester material pdf

1.1 Financial Accounting: Introduction – Definition – Evolution

Financial Accounting Definition:

The American Institute of Certified Public Accountants (AICPA) defines accounting as:”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.”

Importance (in Brief)

The importance of financial accounting is to:

• Provide Information for Decision-Making: Its primary role is to furnish relevant, reliable, and comparable financial information to external stakeholders—such as investors, creditors, and government agencies—to help them make sound economic decisions about the entity.
• Determine Profitability and Financial Position: It helps assess an organization’s performance (profit or loss) over a period and its financial standing (assets, liabilities, and equity) at a specific point in time.
• Ensure Compliance and Transparency: It adheres to established standards (like GAAP or IFRS) and regulatory requirements, ensuring that financial reporting is transparent and consistent.

Financial Accounting 1 – Theory Important Questions (Click Here)

Evolution of Accounting:

The evolution of financial accounting is a long process tied to the development of trade and commerce:

• Early History (Ancient Civilizations): Basic record-keeping for taxes and trade began in ancient Mesopotamia, Egypt, and China. Simple inventory lists and debt records were common.
• The Birth of Double-Entry Bookkeeping (13th-15th Centuries): Modern accounting is largely rooted in the double-entry bookkeeping system, which emerged in Italian city-states like Florence and Venice during the late Middle Ages. This system requires every transaction to be recorded in at least two accounts (a debit and a credit) to maintain the fundamental accounting equation (Assets = Liabilities + Equity). The first detailed description of this method was published by Italian mathematician Luca Pacioli in 1494.
• Industrial Revolution (18th-19th Centuries): As businesses grew larger and ownership separated from management (e.g., joint-stock companies), the need for formal financial reporting to external shareholders increased. Accounting began to focus more on determining profitability (through the Profit & Loss Account) and financial position (Balance Sheet).
• 20th Century and Regulation: The 20th century saw a greater emphasis on public accountability, particularly following the Great Depression. This led to the formation of regulatory bodies and the development of formalized, globally-recognized accounting standards (like GAAP in the US and later IFRS globally) to ensure transparency and prevent fraudulent reporting.
• Modern Era: Financial accounting continues to evolve with technology and changing business complexity. It incorporates new standards for intangible assets, financial instruments, and sustainability reporting, leveraging digital tools for real-time reporting and analysis.

Difference Between Bookkeeping and Accounting

1.1.1  Functions – Advantages and Limitations 

Functions of Accounting:

1. Recording: This is the initial function, often called bookkeeping, that involves the systematic and chronological writing down of all financial transactions and events. It is done in the Journal and Subsidiary Books, adhering to the double-entry system. The purpose is to create a complete and accurate historical record of the firm’s economic activities.

2. Classifying: This process involves grouping transactions of a similar nature into separate accounts. It is performed by posting entries from the journal into the main book of accounts, the Ledger.  Classification organizes vast transactional data into a manageable and meaningful set of data per account.

3. Summarising: The classified data is condensed and presented in a concise and understandable form for external and internal users. This step includes preparing the Trial Balance from the Ledger balances. It culminates in the creation of the primary financial statements, which are the final summarized reports.

4. Analysing and Interpreting: Analysis breaks down the financial statements to study key relationships, while interpretation explains the meaning of these relationships. This is done using analytical tools such as Ratio Analysis and trend analysis. The goal is to evaluate the company’s profitability, solvency, and operational efficiency for decision-making.

5. Communicating: This is the function of transferring the analyzed and interpreted financial results to interested parties. The communication must be timely, reliable, and in a format that is easily understood by the users. Reports are sent to investors, creditors, management, and regulatory bodies.

6. Preparation of Financial Statements: This is the formal process of creating the final, external financial reports at the end of the accounting period. It includes the Trading Account, the Profit & Loss Account, and the Balance Sheet. These statements provide a comprehensive view of performance and financial position.

7. Determination of Profit or Loss: This core function measures the financial performance of the business over an accounting period. It is achieved through the Profit & Loss Account, which systematically matches revenues and expenses. The result is the calculation of the Net Profit or Net Loss, essential for assessing business success.

8. Providing Information to Stakeholders: This is the overarching purpose of financial accounting, serving as the ‘language of business.’ It supplies essential, reliable data to various parties (investors, creditors, government, management) for their specific needs. The information enables stakeholders to make informed economic judgments and strategic decisions.

Advantages of Financial Accounting

• Systematic Record Keeping
  It provides a complete and systematic record of all business transactions, which helps in avoiding reliance on memory and minimizes the chances of errors and fraud.
• Ascertainment of Profit or Loss
  It helps in preparing the Trading and Profit & Loss Account to determine the net profit earned or loss sustained during a specific accounting period.
• Ascertainment of Financial Position
  The preparation of the Balance Sheet at the end of the accounting period helps to determine the financial position of the business by showing its assets and liabilities.
• Assistance to Management
  Financial accounting data is crucial for the management to make informed decisions, plan for the future, and exercise control over business operations.
• Comparison and Benchmarking
  The financial statements allow for comparison of performance over different periods (time-series analysis) or with other similar businesses (cross-sectional analysis).

Limitations of Financial Accounting

• Historical in Nature
  Financial accounting records transactions that have already occurred. As such, it provides historical data, which may not be entirely relevant or sufficient for future decision-making in a rapidly changing environment.
• Ignores Qualitative Elements
  It only records transactions that can be expressed in monetary terms, completely ignoring qualitative factors such as the quality of management, employee morale, customer satisfaction, or the firm’s reputation, which are vital for a business.
• Lack of Real-Time Information
  Financial statements are typically prepared at the end of an accounting period (e.g., quarterly or annually), meaning the information provided is not real-time and may be outdated by the time it is used for decision-making.
• Subjectivity and Estimates
  Many accounting concepts require the use of personal judgments, estimates, and conventions (e.g., useful life of an asset for depreciation, method of valuing inventory, provision for bad debts). This introduces an element of subjectivity and can limit the comparability and reliability of the final figures.
• Susceptible to Manipulation (Window Dressing)
  While regulations exist, there is a possibility for management to present a more favorable financial picture than the reality, often referred to as ‘window dressing,’ by making changes to accounting policies or using certain estimates.

 1.1.2. Users of Accounting Information – Branches of Accounting

Users of Accounting Information

Internal Users

Owners: To assess the overall performance and profitability of the business and determine the return on their investment. They use the information to decide on the future direction of the enterprise.

Managers: To plan, control, and make daily operational decisions. They need detailed reports to evaluate the efficiency of various departments, set budgets, and formulate strategies.

Employees: To assess the company’s stability and profitability, which is linked to their job security, remuneration, and the possibility of bonuses or retirement benefits.

External Users

Creditors: To determine the creditworthiness of the business before lending money or extending credit (selling goods on credit). They assess the company’s ability to pay off its short-term and long-term debts.

Investors: To make investment decisions, i.e., to decide whether to buy, hold, or sell the company’s shares. They analyze financial data to gauge the company’s profitability and long-term growth prospects.

Government: To formulate economic policies, determine national income, and calculate and collect various taxes (like income tax and GST) from the business. They also use the data for regulatory compliance.

Citizens: The general public and consumers are interested in the company’s contribution to the economy and society, such as employment opportunities, corporate social responsibility activities, and compliance with environmental regulations.

Branches of Accounting

• financial accounting: It focuses on recording, classifying, and summarizing business transactions to prepare financial statements (like the Balance Sheet and Income Statement) for external users such as investors and creditors.
• Cost Accounting: It involves the recording, classifying, summarizing, and analyzing of costs associated with a process, project, or product. Its main goal is to help management control costs and set selling prices.
• Management Accounting: It focuses on providing financial and non-financial information to internal managers for planning, controlling, and making decisions within the business, including budgeting and performance evaluation.
• Inflation Accounting: It is a process that adjusts traditional financial statements to reflect changes in the general price level or in the current cost of specific assets, thereby accounting for the effect of inflation.
• Human Resource Accounting (HRA): It involves measuring and reporting the cost and value of human resources (employees) as assets to an organization.
• Responsibility Accounting: It is a system where costs and revenues are traced to responsibility centers (e.g., departments, divisions) and the individual managers who are primarily responsible for controlling them.

1.2 Accounting Principles: Concepts and Conventions

Accounting Concepts

1. Business Entity Concept
   1. Principle: The business is treated as completely separate from its owner(s).
   2. Example: If the owner, Raju, pays for his personal grocery bill using the business’s bank account, this must be recorded in the books as a ‘Drawing’ (a reduction in the owner’s capital), and not as a business expense.
2. Money Measurement Concept
   1. Principle: Only transactions that can be expressed in monetary terms are recorded in the books.
   2. Example: A company’s decision to hire a new, highly-skilled CEO is an important event, but the CEO’s skill and reputation cannot be recorded in the accounting books. Only the CEO’s salary can be recorded.
3. Going Concern Concept
   1. Principle: It is assumed that the business will continue its operations for a long and indefinite period.
4. Accounting Period Concept
   1. Principle: The indefinite life of the business is broken down into shorter periods (e.g., one year) for performance assessment.
5. Cost Concept (or Historical Cost Concept)
   1. Principle: An asset is recorded at its original acquisition cost.
   2. Example: Land purchased 50 years ago for 50,000 is still shown on the Balance Sheet at 50,000, even if its current market value is 5,000,000.
6. Dual Aspect Concept
   1. Principle: Every transaction has two effects (a debit and a corresponding equal credit).
   2. Example: When a business buys furniture for cash (5,000), the accounting record shows two effects: increase in the Asset ‘Furniture’ (debit) and decrease in the Asset ‘Cash’ (credit), keeping the fundamental equation (Assets = Liabilities + Capital) balanced.
7. Accrual Concept
   1. Principle: Revenue is recognized when earned, and expenses are recognized when incurred, regardless of when cash is received or paid.
   2. Example: A company completes a service for a client on December 31st and issues an invoice. The revenue is recorded on December 31st (Revenue Earned), even if the client does not pay the cash until January 15th of the next year.

Accounting Conventions:

1. Convention of Conservatism (or Prudence)
   • Principle: Do not anticipate profits, but be prepared for all possible losses. When in doubt, choose the option that leads to lower assets or higher liabilities/expenses.
   • Simple Example: If you have inventory (unsold goods), and its cost was 10,000/- but the market value has dropped to 8,000/-, you must record it at the lower value, 8,000/-, to prepare for the potential loss.
2. Convention of Consistency
   • Principle: Once an accounting method is chosen, it should be applied uniformly from one year to the next to ensure that the financial statements are comparable.
   • Simple Example: If a company decides to use the Straight-Line  Method for calculating depreciation on its machinery in 2025, it should continue using the Straight-Line Method in 2026, 2027, and so on.
3. Convention of Full Disclosure
   • Principle: All material and relevant facts concerning the financial affairs of the business must be completely and clearly reported in the financial statements.
   • Simple Example: If the company is facing a large, uncertain lawsuit (a contingent liability) that could result in a significant loss, this potential problem must be disclosed and explained in the notes accompanying the financial statements.
4. Convention of Materiality
   • Principle: Financial reporting should focus on items that are significant enough to make a difference to the decisions of the users. Trivial (immaterial) items can be handled conveniently.
   • Simple Example: A small item like a paper punch that costs 5/- might last for many years. Technically, it’s an asset, but because its value is tiny, it is often simply recorded as an expense in the year of purchase rather than depreciated over its long life.

1.3 Accounting Standards – Meaning – Importance

Accounting Standards: Meaning

Accounting standards are formal, authoritative rules, principles, and procedures for the preparation and presentation of financial statements. They prescribe how specific types of transactions and events must be recorded, measured, presented, and disclosed in the financial reports. The goal is to standardize accounting policies.1

Accounting Standards: Importance

Importance of Accounting Standards

• Foundation for Financial Reporting
  Provides the core structure for reliable financial statements, helping external parties make informed decisions.
• Standardization of Accounting Policies
  Ensures uniformity and consistency in recording transactions, making financial statements comparable.
• Promotion of Knowledge and Awareness
  Builds user confidence in financial data and helps stakeholders better interpret financial health.
• Regulatory Framework and Guidance
  Establishes an authoritative framework for legal compliance and transparency, reducing the risk of fraud.
• Support for Government and Economic Planning
  Provides standardized, reliable data vital for the government’s economic policy formulation and tax calculation.

1.4 Accounting System

Accounting System

An accounting system is a structured set of policies, procedures, and internal controls used by an organization to collect, process, summarize, and report financial transactions. It is designed to track a company’s financial activities and ultimately generate financial statements like the Trading, Profit & Loss Account, and Balance Sheet.

Differences B/w Single Entry & Double Entry System:

1.5 Types of Accounts

Types of Accounts (with Golden Rules)

There are  three main types of accounts. Each with its own rule for recording transactions.

1. Personal Accounts

• Brief Definition: Accounts related to persons (individuals, firms, companies, and representative groups).
• Examples: Raju, Ravi, Shwetha, Debtors, Creditors, Capital, Drawings, Outstanding Salary.
• Rule: Debit the Receiver, Credit the Giver.

2. Real Accounts

• Brief Definition: Accounts related to assets, whether tangible (can be touched) or intangible (cannot be touched).
• Examples: Cash, Land, Building, Machinery, Goodwill, Patents.
• Rule: Debit what comes in, Credit what goes out.

3. Nominal Accounts

• Brief Definition: Accounts related to all expenses, losses, revenues, and gains of the business.
• Examples: Rent Paid, Salary, Commission Received, Interest Paid, Discount Allowed.
• Rule: Debit all expenses and losses, Credit all incomes and gains.

1.6 Accounting Cycle

Accounting Cycle

The Accounting cycle is the systematic, step-by-step process of recording, classifying, and summarizing all of a business’s financial transactions during an accounting period, leading up to the creation of financial statements.

The 6 steps involved in the accounting cycle are

1. Identity business transactions: Identifying and analyzing business transactions from source documents (like invoices, receipts, etc.).
2. Journalizing transactions: Recording the analyzed transactions chronologically in the Journal or Books of Original Entry.
3. Posting transactions to ledgers: Transferring the entries from the Journal to the appropriate accounts in the Ledger.
4. Preparing trial balance: Preparing a list of all ledger balances to check for the arithmetical accuracy of the double-entry system.
5. Preparing manufacturing, trading, and profit and loss account: Preparing the income statements (Trading and Profit & Loss Account) to determine the gross and net profit or loss of the business for the period.
6. Preparing balance sheet: Preparing the Balance Sheet to show the financial position (assets, liabilities, and capital) of the business at a specific point in time.

1.7 Journal

Meaning: A Journal is the first book of accounts where all business financial transactions are recorded for the very first time.

Here is the standard proforma:

Explanation of Columns:

• Date: The date on which the transaction took place is recorded.
• Particulars: This column contains the name of the account to be debited and the account to be credited. Below the entry, a brief explanation of the transaction, called the Narration, is written, starting with “Being…”
• Ledger Folio (L.F.): This number represents the page or account number in the Ledger where the entry has been posted. It is left blank during the initial journalizing phase and filled in later.
• Debit Amount (₹): The amount of the transaction to be debited is recorded here.
• Credit Amount (₹): The corresponding amount of the transaction to be credited is recorded here.

PROBLEMS ON JOURNAL

Transactions of Ramesh for September are given below. Journalise them

For the month of September

1.8 Ledger

Ledger

A Ledger is the main and final book of accounts in which all transactions recorded in the Journal (or subsidiary books) are systematically transferred and summarized. It is the book that contains all the classified accounts (e.g., Cash, Capital, Purchases, Sales, Rent, etc.) of a business.

 Proforma of a Ledger Account

A Ledger Account is typically maintained in a ‘T’ shape format, divided into two equal halves. The left-hand side is called the Debit (Dr.) side, and the right-hand side is called the Credit (Cr.) side.

Dr.                                                                                                                                                Cr.

Explanation of Columns:

• Date: The date on which the transaction occurred.
• Particulars: The name of the other account affected by the double-entry (e.g., if recording in the Cash Account, the particulars column will show the account that was credited/debited against the cash entry).
• J.F. (Journal Folio): The page number of the Journal book from where the entry has been transferred (posted). This is a cross-reference.
• Amount (₹): The monetary value of the transaction.

PROBLEM ON LEDGER:

Here are the Ledger Accounts in the books of Ramesh, based on the journal entries created previously.

1. Cash Account

2. Bank Account

3. Purchases Account

4. Amrit’s Account

5. Arvind’s Account

6. Sales Account

7. Capital Account

8. Furniture Account

9. Drawings Account

10. Purchase Return Account

1.9 Trial Balance 

Trail Balance

A Trial Balance is a statement prepared at the end of an accounting period with the debit and credit balances of all the Ledger accounts.

Trail Balance Proforma:

Explanation of Columns:

• S. No.: Serial number for the accounts.
• Name of Account: The name of the account from the Ledger (e.g., Cash, Rent, Creditors, etc.).
• Ledger Folio (L.F.): The page number of the Ledger account from which the balance is taken.
• Debit Balance (₹): The closing balance of an account if the total of its debit side is greater than its credit side.
• Credit Balance (₹): The closing balance of an account if the total of its credit side is greater than its debit side.

PROBLEM ON TRAIL BALANCE

Solution: Trail Balance: