Introduction to financial accounting

Definition of Accounting According to The American Institute of Certified Public Accountants, 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”

Classification of Accounting Accounting is classified into three broad categories: Financial Accounting, Cost Accounting and Management Accounting



Financial Accounting: Financial Accounting is that part of accounting which is mainly concerned with the historical, custodial and stewardship aspects of external reporting to shareholders, government and other users of accounting information outside the business entity. Financial accounting emphasizes the stewardship aspect of accounting rather than the control or decision making aspects of accounting. It is the recording and processing of financial data affecting the business unit, which relates to the past and is generally for one year. The end product of financial accounting is the Profit and loss for the period ended (which shows the profit earned or loss incurred) and the Balance Sheet as on the last day of the accounting period (which shows the financial position). The preparation of the financial accounting is based on generally accepted accounting principles, enunciated by the accounting profession and is heavily constrained by legal regulations and accounting standards.
Cost Accounting: Is that part of accounting which is concerned with the accumulation and assignment of historical costs to units of product and departments, primarily for the purpose of valuation of stocks and measurement of profits. Cost accounting seeks to ascertain the cost of a unit produced and sold or the services rendered by the business unit with a view to exercising control over these costs to assess the profitability and efficiency of the enterprise. It generally relates to the future and involves an estimation of future costs to be incurred. The process of cost accounting is based on the data provided by the financial accounting.

Management Accounting: is that part of accounting which is concerned mainly with internal reporting to the managers of a business unit. It relates to planning, control and decision –making which are useful to the management in the discharge of its functions. Thus, it emphasizes the control of decision-making aspects of accounting which is tailor-made to suit the management needs of a specific enterprise, rather than stewardship aspects of accounting. Management accounting is ‘forward looking’ and generally includes cost accounting and budgeting. The preparation of management accounting is not based on generally accepted accounting principles and is relatively free of constraints imposed by legal regulations and accounting standards.

Financial Statements
The broad classifications of financial statements are
Income Statement
Balance sheet
Income statement is further classified into

Trading account: The main objective of preparing Trading Account is to ascertain gross profit or loss of a business during an accounting period- usually a year. In accounting parlance, gross profit means over all profit. Gross Profit is the difference between sale proceeds of a particular period and the cost of the goods actually sold. Since gross profit means the overall profit, no deduction of any sort is made, i.e general, administrative or selling and distribution expenses. Gross Profit is said to be made when the sale proceeds exceed the cost of goods sold. Conversely, when sale proceeds are less than the cost of goods sold, gross loss is incurred.
Profit and Loss Account: Profit and Loss Account can be defined as a report that summarizes the revenues and expenditure of an accounting period to reflect the changes in various critical areas of a firm’s operations. The balance from trading account’s gross profit or gross loss is transferred to the profit and loss account, which is the starting point of the Profit and Loss Account preparation. This is the reason the Trading account is treated as the sub-section of the profit and loss account. Profit and Loss account shows the profit or loss on ordinary activities, profit and loss on sale of capital assets, other abnormal losses and gains but excludes the payment of taxation, the transfer and withdrawal from reserves and distribution of profit.

Profit and Loss appropriation account: This is the extension of the Profit and Loss account and is mainly prepared by the Public Limited Companies. And this account records the data pertaining to taxes, paid amount transferred to reserves, Dividends to the share holders etc
Balance sheet: A Balance Sheet is a list of assets and claims of business at some specific point of time and is prepared from an adjusted Trial Balance. It shows the financial position of a business with the details of the sources of funds and the utilization of these funds. A Balance Sheet shows the assets and liabilities grouped, classified and arranged in a proper and specific manner.

Contents of Income Statement
The Companies Act, 1956, does not prescribe a particular form for preparing the Income statement but states that the income statement should cover the revenues earned and the expenses incurred over a period during the accounting period. The following are the contents of an income statement

Net sales: Net sales appear in the Income Statement. It is the sum of the invoice price of goods sold and services rendered during the period. Sales inwards represent the invoice value of goods returned by the customers.

Cost of Goods Sold: It is the sum of costs incurred for manufacturing the goods sold during the accounting period. It consists of direct material costs, direct labour costs, and factory overheads.

Gross Profit: This is the difference between net sales and cost of goods sold.

Operating Expenses: Comprises general administrative expenses, selling and distribution expenses and depreciation.

Operating Profit: is the difference between the gross profit and operating expenses. As a measure of profit, it reflects operating performance and is not affected by the non-operating gains/ losses, financial leverage, and tax factor.

Non-Operating Surplus: They represent gains arising from sources other than normal operations of the business. Its major components are income from investments and gains from disposal of assets. Likewise, non-operating deficit represents losses from activities unrelated to the normal operations of the firm.

Profit Before Interest and Taxes (EBIT): Is the sum of operating profit and non-operating surplus/deficit. Referred to also as Earnings before Interest and Taxes, this represents a measure of profit which is not influenced by financial leverage and the tax factor. Hence, it is pre-eminently suitable for inter-firm comparison.

Interest: It is the expense incurred for borrowed funds, such as term loans, debentures, public deposits, and working capital advances.

Tax: Represents the income tax payable on the taxable profit for the year.

Profit after Tax (PAT): is the difference between the profit before tax and tax for the year.

Dividends: represent the amount earmarked for distribution to shareholders

Retained Earnings: Is the difference between profit after tax and dividends.

Horizontal form of Income Statement
In the horizontal form the account is maintained in the T form with left side as debit side and the right side as credit side.
The debit side records all the expenses and the credit side records the revenues earned. The income statement is divided into : Trading account, Profit and Loss account and Profit and Loss appropriation account. The contents of trading account are

The Debit Side: The items that appear on the debit side can be broadly classified as
Opening Stock
Purchases
Direct Expenses

The Credit Side: The items that appear on the credit side can be broadly classified as
Sales
Closing Stock

Balancing of Trading Account: After recording the above items, the balance is calculated to ascertain gross profit or gross loss If the total of credit side is more than debit side, then it will amount to gross profit and if it is other way round then it will be gross loss. The gross profit or loss is recorded as the balancing figure and will be transferred to the profit and loss account

Profit and Loss Account: After the preparation of trading account, the profit and loss account is prepared. The following items appear on the debit side of the Profit and Loss account
Management expenses
Maintenance expenses
Selling and distribution expenses
Financial expenses
Abnormal losses

Credit Side:
The credit side of the profit and loss account records with gross profit carried from trading account. Besides, some non trading income and abnormal gains are recorded
Balancing of Profit and Loss Account: After recording the above items the balance is calculated to ascertain net profit or net loss. If the total of credit side is more than debit side then it will amount to net profit and if it is other way round then it will be net loss. The net profit or loss is recorded as the balancing figure and will be transferred to the Profit and loss appropriation account.

The profit and loss appropriation: After preparing the profit and loss account, the credit balance is transferred to appropriation account.
Debit side of appropriation account includes items like transfer to the reserves and the dividends to be paid is also recorded.
Balancing Profit and Loss appropriation Account: After recording the above items, the balance is calculated to ascertain the amount to be transferred to reserves and surplus in the balance sheet,

Contents of Balance Sheet
The balance sheet is divided into two parts – the Assets and Liabilities
I. Assets are again divided into
Fixed Assets
Investments
Current Assets, Loans and Advances
Miscellaneous Expenditure and Losses
II. Liabilities are divided into:
Share Capital
Reserves and Surplus
Secured Loans
Unsecured Loans
Current Liabilities and Provisions