Principles of Financial Accounting

Principles of Financial Accounting ACCT-103 Dr. Fayaz Ahmad Lone Chapter 1

Accounting is called the Language of Business

What is accounting? • The language of business • Measures financial aspects of a business • Communicates this information to decision makers

Accounting Activities • Identifying Business Activities • Recording Business Activities • Communicating Business Activities 1-4

The Need for Accounting Managers, investors, and other internal groups want the answers to two important questions: How well did the organization perform? Where does the organization stand?

The Need for Accounting Accountants answer these questions with three major financial statements: Income statement Balance sheet Statement of cash flows

Introduction • Accounting - a process of identifying, recording, summarizing, and reporting economic information to decision makers in the form of financial statements • Financial accounting - focuses on the specific needs of decision makers external to the organization, such as stockholders, suppliers, banks, and government agencies

is a system that information that is What is Accounting? Accounting Identifies Records Relevant Communicates Reliable about an organization’s business activities. Comparable 1-8

Definition of Accounting American Institute of Certified Public Accounts (AICPA) has defined accountings as: “Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in parts at least of a financial character and interpreting the result thereof”.

The Nature of Accounting • The accounting system is a series of steps performed to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their effects on an organization and to prepare the financial statements.

The Nature of Accounting • Accounting systems are designed to meet the needs of the decisions makers who use the financial information. • Every business has some sort of accounting system. • These accounting systems may be very complex or very simple, but the real value of any accounting system lies in the information that the system provides.

Financial and Management Accounting • The major distinction between financial and management accounting is the users of the information. • Financial accounting serves external users. • Management accountingserves internal users, such as top executives, management, and administrators within organizations.

Financial and Management Accounting The primary questions about an organization’s success that decision makers want to know are: What is the financial picture of the organization on a given day? How well did the organization do during a given period?

Financial and Management Accounting Accountants answer these primary questions with three major financial statements. • Balance Sheet - financial picture on a given day • Income Statement - performance over a given period • Statement of Cash Flows - performance over a given period

Financial and Management Accounting • Annual report - a document prepared by management and distributed to current and potential investors to inform them about the company’s past performance and future prospects. • The annual report is one of the most common sources of financial information used by investors and managers.

Financial and Management Accounting • The annual report usually includes: • a letter from corporate management • a discussion and analysis of recent economic events by management • footnotes that explain many elements of the financial statements in more detail • the report of the independent auditors • a statement of management’s responsibility for preparation of the financial statements • other corporate information

Users of Accounting Information • Different categories of users need different kinds of information for making decisions. These users can be divided into : • Internal Users; and • External Users.

Internal Users These are the persons who manage the business, i.e. management at the top, middle, and lower levels. Their requirements of information are different because they make different types of decisions.

Internal Users continue… The top level is more concerned with planning; the middle level is concerned equally with planning and control; and the lower level is concerned more with controlling operations. Information is supplied on different aspects, e.g. cash resources, sales estimates, results of operations, financial position, etc.

External Users All persons other than internal users come in the group of external users. External users can be divided into two groups: · those having direct interest; and · those having indirect interest in a business organization.

External Users continue… The main sources of information for external users are annual reports of business organizations, which state the financial position and performance and give the auditor’s report, director’s report and other information.

External Users continue… Investors and creditors are the external users having direct interest. Tax authorities, regulatory agencies, customers, labour unions, trade associations, stock exchanges, investors, etc are indirectly interested in the company’s financial strength, its ability to meet short-term and long-term obligations, its future earning power, etc for making various decisions.

Internal Users External Users • Managers • Officers • Internal Auditors • Sales Staff • Budget Officers • Controllers • Lenders • Shareholders • Governments • Consumer Groups • External Auditors • Customers Users of Accounting Information 1-23

ExternalUsers Financial accountingprovides external users with financial statements (shareholders, lenders, etc.). Users of Accounting Information Internal Users Managerial accounting provides information needs for internal decision makers (officers, managers, etc.). 1-24

Users and Uses of Financial Information Internal Users Illustration 1-1 Questions that internal users ask LO 2

Users and Uses of Financial Information External Users Illustration 1-2 Questions that external users ask LO 2

Balance Sheet Assets = Liabilities + Owners’ equity Assets are economic resources that are expected to benefit future activities of the organization. Liabilities are the entity’s economic obligations to others. Owners’ equityis the excess of the assets over the liabilities.

Paid-in capital Retained earnings Balance Sheet The owners’ equity of a corporation is called shareholders’ equity. Shareholders’ equity

The Balance Sheet Sections of the balance sheet: • Assets - resources of the firm that are expected to increase or cause future cash flows (everything the firm owns) • Liabilities - obligations of the firm to outsiders or claims against its assets by outsiders (debts of the firm) • Owners’ Equity - the residual interest in, or remaining claims against, the firm’s assets after deducting liabilities (rights of the owners)

The Balance Sheet The balance sheet equation: Assets = Liabilities + Owners’ Equity or Owners’ Equity = Assets - Liabilities

Four Basic Financial Statements • Balance Sheet • Assets = Liabilities + Equity • Income Statement (also called Statement of Operations, Earnings Statement, Profit/Loss (or P&L) Statement • Revenues - Expenses = Net income (or Net Earnings) • Statement of Changes in Stockholders’ Equity • Beginning of period total equity + Stock issued + Net income - Dividends = End of period total equity • Statement of Cash Flows • Cash inflow - Cash outflow = Net cash flow

ACCOUNTING PRINCIPLES Accounting principles can be subdivided into two categories: Accounting Concepts Accounting Conventions.

ACCOUNTING PRINCIPLES Accounting Concepts The term ‘concept’ is used to connote accounting postulates, that is necessary assumptions and conditions upon which accounting is based.

ACCOUNTING PRINCIPLES Accounting Conventions The term ‘convention’ is used to signify customs and traditions as a guide to the presentation of accounting statements.

Accounting Concepts and Conventions, • Concepts vs Conventions • Concepts are the basic ideas, the theories on how and why certain categories of transactions should be treated in a particular manner. • Once the theories have been established and tested and proved to be acceptable, the task of the Conventions is to set out the limit of their applications.

Concepts Conventions Kinds of Accounting Principles • Entity Concept • Cost Concept • Going Concern Concept • Accounting Period Concept • Money Measurement • Dual Aspect Concept • Accounting Equivalent • Matching Principle • Verifiable Objects • Realization Concept • Capital Concept • Accrual concept • True legal position • Disclosure Convention • Materiality Convention • Consistency Convention • Conservation Convention

Accounting Concepts • 1. Business Entity Concept – business is a separate entity. • 2. Money Measurement Concept – money common denominator of measurement. • 3. Going Concern Concept – perpetual succession. • 4. Accounting Period Concept – pre-determined periodicity generally an year. • 5. Cost Concept – an asset’s cost is the basis of all subsequent accounting.

Accounting Concepts • 6. Realisation Concept – revenue should be recognized “when it is earned”. • 7. Matching Concept – associating the cause and effect relationship of revenues and expenses. • 8. Accrual Concept – similar to matching, period should be decided on the basis of accrual. • 9. Dual Aspect Concept – 2 aspects must be examined – the giving and the receiving.

Accounting Conventions • 1. Consistency – method once adopted should be followed. • 2. Disclosure – all relevant facts concerning financial position must be communicated to users. • 3. Materiality – concerned with significant information. • 4. Objectivity – unbiased and subject to verification by external expert. • 5. Stable Monetary Unit – the Indian Rupee. • 6. Conservatism or Prudence – when in doubt, choose the solution that is least likely to overstate net assets and net income for the current period.

Home Assignment What do you mean by Accounting? Write two definitions of accounting. Write the name of any five concepts of accounting.

Principles of Financial Accounting