Introduction to Financial Accounting

Accounting:

  • Accounting is an interpretation, in terms of monetary units, of an activity like a business and the financial results of that activity during a period. As per American Institute of Certified Public Accountants (AICPA) “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 financial character, and interpreting results thereof” Tus accounting includes recording, summarizing, reporting and analyzing financial data.



Bookkeeping:

  • Bookkeeping involves the recording, storing and retrieving of financial transactions for a company, organization, individual, etc. using the technique of double entry system. If bookkeeping is done correctly, then the accounting records can be considered for preparation of financial statements.

Books of Accounts:

  • Books of accounts are the records those are structured for inputting every transaction in codified form for being processed further.
  • The number of books to be kept as accounts depends on the nature of the activity and business.

Accounting Process:

Step – 1: Identifying transactions and events:

  • Transaction: A transaction is any commercial activity like sales, purchase, expenditure, etc. which involves the transfer of financial value between the two entities.
  • Characteristics of Transactions:
    • All transactions are events.
    • The financial changes caused by transactions must be measurable in terms of money.
    • For a transaction to take place there must be two entities.
    • As a consequence of transactions, there must be a transfer of goods or services. Exceptions: burning of goods, fixed asset depreciation etc.
    • Every transaction must be recorded in the books of accounts.
    • Financial transactions may be settled in Cash or are made on credit.
    • Method of recording transaction is, a transaction should be first journalized, then posted in a ledger and the financial statement is prepared.
    • The scope of a transaction is limited.
    • Business transactions must be supported by appropriate evidence.

  • Event: An event in a commercial happening that involves a gain or loss of financial value for an entity.
  • Characteristics of Event:
    • All events are not transactions.
    • An event may or may not bring change in the financial position of a person, family, or organization.
    • Financial changes caused by events may or may not be measurable in terms of money. e.g. death of an efficient, intelligent, skilled, and qualified employee.
    • For an event to take place there is no need for two entities.
    • Events are used in a wider sense and its scope is wide.
    • Transfer of goods or services may or may not occur for an event.
    • It is. not necessary that every event will be recorded in the books of accounts if it has no monetary value.
    • Transaction relating event is settled for cash.
    • Method of recording an event is first to make cash statement, next making of separate statements for receipts and payments head wise and then the final statement of receipts and payments are made.
    • Transactions related to events are not always supported by evidence.
  • A transaction can be called as an event if it causes an immediate change in the financial resources or obligations of the business and can be measured objectively in monetary terms.

Step – 2: Measuring:

  • In this step value of transactions and events are expressed in monetary terms.
  • The monetary value of a transaction can be easily found as it is the value agreed upon by the involved two entities. But the monetary value of an event cannot be found easily, because a transaction may not take place. In such case a careful judgement is required.

Step – 3: Recording:

  • The primary function of accounting is to make records of all the transactions that the firm enters into. Recognised transactions are recorded in books of accounts. This is the first stage of accounting.
  • The entire recording is done through a number of accounts also called ledgers. Books of accounts are classified into five categories. viz. liabilities, assets, revenues, expenses and capital. All the transactions are recorded in relevant accounts. The procedures to record a transaction is very systematic.



  • Steps involved in recording are
    • Journal entries: The book in which transactions are first recorded is called a journal. The transaction is listed in the appropriate journal, maintaining the journal’s chronological order of transactions. The journal is also known as the “book of original entry”. The system used for recording is called double entry system of bookkeeping.
    • Posting: In a next step the transactions are posted to the account (ledger) that it impacts. These accounts are part of the General Ledger, where you can find a summary of all the business’s accounts.
    • Trial balance: At the end of the accounting period (depending upon the business practices it may be a month, quarter, or year), a trial balance is calculated. In this process, at the end of a period, we find the net balance of each ledger account and locate the positive and negative balances of all the accounts in a trial balance statement.
  • The advantages of using a journal in the recording process are
    • it discloses in one place the complete effects of a transaction
    • it provides a chronological record of transactions,
    • The debit and credit amounts for each entry can be easily compared, hence it helps to prevent or locate errors.

Step – 4: Reviewing and Reconciling:

  • To guarantee the correctness of transactions, all accounts listed in trial balance at the end of transaction accounting are reviewed and reconciled. This is the first stage of accounting and is called “reconciliation adjustments”.
  • These adjustments are required so that the accounts are in line with standard accounting principles. After reconciliation, the trial balances of all the accounts is calculated again and extracted. A fresh trial balance is prepared again and is called adjusted trial balance.
  • Reconciliation adjustments are required for
    • To account for invisible transactions (incomes and expenses that have happened but not through transaction). It is done by reviewing each account.
    • To account for changes which have happened in the values of liabilities and assets but are not visible. It is done by reconciling the assets and liabilities with correct values.
    • To check the arithmetical accuracy of both sets of accounts.
    • To know the reasons for the difference in results of both cost and financial accounts.
    • To explain the difference which further facilitates internal control.
    • To promote coordination between cost and financial departments.
    • To help in the formulation of policies regarding absorption of overheads and depreciation and stock valuation method.
    • To help in managerial decision-making.



Step – 5: Reporting and Closing:

  • This is the last stage of accounting. In this step, a financial statement is made with a use of trial balance. The financial statement is important because it is the report on the financial health of the entity to all stakeholders.
  • The basic financial statements are Profit & Loss Account and balance sheet. Supporting statements are Cash Flow Statement and Statement of Changes in Equity. These financial statements are regulated by government bodies to ensure that there is no misleading financial reporting.
  • After preparing the financial statement, the period closing is done. i.e. closing the books for the period and extracting closing trial balance. After this accounting for next period can be started.  Thus the new cycle starts.

Step – 6: Analyzing and Interpreting:

  • Accounting helps in analyzing the financial statement by comparison. It is common practice to compare profits, cash, sales, assets, etc with each other to analyze the performance of the business. The financial statement is analyzed for capturing trends, for identification of factors which lead to success or failures. Financial information is presented in form of important ratios like return on investment (ROI), Earning per share (eps), etc. Using these ratios the strategy is modified, decisions are made and corrective actions are taken.

Step – 7: Communicating:

  • The information obtained from the analyzation of accounts is communicated to concerned stakeholders or users with specific requirements.



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