Financial Accounting I

Financial Accounting I 

Meaning of Accounting:

Accounting is the process of identifying,measuring,and communicating economic information to various users,including management of the company,stockholders,creditors,financial analysts and government agencies.
OR
Accounting is an information system which measures, processes and communicates financial information of an organization. The business activities are indentified and measured in term of money, which are then processed and finally communicated to the various group of users.
 

Function of Accounting;

1)Recognizing and recording of financial transaction:
Human memory is subject to limitations.It cannot remember all the details of happenings so written records are required for future use.
For example, receipt of cash, payment of cash, purchase and sale of goods, items that are purchased for not for resale etc. are items that need recording. This part of accounting is called the recording function.
 
2)Classifying and summarizing:
The recorded data are then sorted so that the data can be meaningful to the users. This sorting of accounting data is known as classifyingand summarising. Perhaps, the recorded information would have the least meaning to the various groups of people if such classifications and summaries do not establish whether the business is making profit or loss during a particular period.
 
3)Analysis, Interpretation and communication of information:
Simply recording, classifying and summarising is not enough. The accounting experts need to provide their opinion whether or not the business is doing well financially. They should be able to establish the strength and weaknesses of the business with regards to profitability, liquidity, and financial position.
 

Users of Accounting information and their needs:

It is helpful to categorize users of accounting information on the basis of their relationship to the organization .Internal users,primarily the managers of a company,are involved in the daily affairs of the business.All other groups are external users.
1)Internal users:
  • Management: The managers are responsible for planning, control and decision making.
2)External users:
  • Suppliers: They need accounting information to provide credit, its continuation or withdraw the existing credit facility
  • Shareholders: They need accounting information to know the efficiency of business i.e. profitability and dividend payout ratio.
  • Government Agencies: They need accounting information for tax purpose, VAT, municipal taxes, custom duty, subsidy of business making business policy, standard of product, resources mobilization
  • Employee and their Union: They need accounting information for salary, wages, gratuity, bonus and retirement benefit.
  • Analysts, Brokers, advisers and researchers: Many users seek the help of these specialists who analyze the financial information and provide their expert opinions to their clients. The clients uses the information provided by them to make decisions or to form judgments about a business.
 

Forms of organization:

Business entities are organized as sole proprietorships, partnership and corporations. Nonbusiness entities include government entities, such as local, state and federal governments and private organizations such as hospitals and universities.There are many different types of organizations in our society. One convenient way to categorize the myriad types is to distinguish between those that are organized to earn money and those that exist for other purpose.
 
A)Business entities:Business entities are organized to earn profit. Legally, a profit –oriented company one of these types: a sole proprietorship, a partnership or a corporations.
 
1)Sole proprietorships:
This form of organization is characterized by a single owner. Many small businesses are organized as sole proprietorships. The business is often owned and operated by same person. Because of the close relationship between the owner and business, the affairs of the two must be kept separate. This is one example in accounting of the economic entity concept, which requires that a single, identifiable unit of organization be accounted for all situations.
 
2)Partnerships:
A partnership is a business owned by two or more individuals. Many small businesses begin as partnerships. When two or more partners start out, they need some sort of agreement as to how much each will contribute to the business and how they will divide any profits. In many small partnerships, the agreement is often just an oral understanding between the partners. In large businesses, the partnership agreement is formalized in a written document.
 
3)Corporations:
Although sole proprietorships and partnerships dominate in sheer(quite) number, corporations control an overwhelming majority of the private resources in this country. A corporation is an entity organized under the laws of particular state. Each of the 50 states is empowered to regulate the creation and operation of businesses organized as corporation in it.
       To start a corporation, one must file articles of incorporation with the states. If the articles are approved by the state, a corporate charter is issued and the corporation can begin to issue stock. A share of stock is a certificate that acts as evidence of ownership in a corporation.
 
Advantage of incorporation:
  • One of the primary advantages of the corporate form of organization is the ability to raise large amounts of money in a relatively brief period of time.
  • The case of transfer of ownership in a corporation is another advantage of this form of organization.
 

Generally Accepted Accounting Principles(GAAP):

The various methods, rules, practices, and other procedures that have evolved over time in response to the need to regulate the preparation of financial statements.
  • Going concern: The assumption that an entity is not in the process of liquidation and that it will continue indefinitely.
  • Time period: An artificial segment on the calendar used as the basis for preparing financial statements.
  • Monetary unit: The yardstick used to measure amounts in financial statements, e.g., Rs. Nepal
  • Economic entity concept: The assumption that a single identifiable unit must be accounted for the all the situation.
  • Cost principle: Assets are recorded at the cost to acquire them.

Qualitative Characteristics of accounting information:

  • Understandability:
    The quality of accounting information that makes it  comprehensible to those willing to spend the necessary time.For anything to be useful, it must be understandable. Usefulness and understandability go hand to hand. However, understandability of financial information varies considerably depending on the user’s background.
         Understandability alone is certainly not enough to render information useful.According to the FASB,two fundamental characteristics make accounting information useful.The information must b e relevant,and it must be faithful representation.
  • Relevance:
    The capacity of information to make difference in a decision. Sometimes information may have predictive value. for e.g. Assume that you are a banker evaluating the financial statements of a company seeking a loan.The financial statements point to a strong,profitable company .However,today’s news revealed that the company has been named in a multimillion-dollar lawsuit.This information would be relevant to your talks with the company.Disclosure of the lawsuit in the financial statements would help you predict whether it would be wise to make a loan to the company.
               In other case information may have confirming value. for e.g. Assume that you invest in a company because you think it may enter new Asian markets in the near future.Disclosure in the statements that the company acquired a Chinese subsidiary would confirm you made the right decision to invest in the company.
  •  Reliability:
    The quality that makes accounting information dependable in representing the events that it purposes to represent.
                  – Verifiability (free from error)
                  –Representational faithfulness
                  –Neutrality
  • Comparability:
    Comparability allows comparisions to be made between or among companies.For accounting information, the quality that allows a user to analyze tow or more companies and look for similarities and differences.
  • Consistency:
    Consistency means that financial statements can be compared within a single company from one accounting period to the next.For accounting information, the quality that allows a user to compare two or more accounting periods for single company.
  • Materiality:
    The magnitude of an accounting information omission or misstatement that will affect the judgement of someone relying on the information. It is closely related to relevance and deals with the size of an error in accounting information. The issue is whether the error is large enough to affect the judgment of someone relying on the information.(Pencil and computer).
  • Conservatism:
    The practice of using the least optimistic estimate when two estimates of amounts are about equally likely. It is a holdover from earlier days when theprimary financial statement was the balence sheet and the primary user of this statement was the banker.It was customary to deliberately understate assets on the balence sheet because this resulted in an even larger margin of safety that the assets being provided as collateralfor a loan were sufficient.Today,the balence sheet is not the only financial statement ,and deliberate understatement of assets is no longer considered desirable.The practice of conservatism is reserved for those situation in which there is uncertainity about how to accout foer aparticular item or transaction.

Nature of business activities:

Overview:
Business engage in three types of activities: financing, investing and operating. Financing is necessary to start a business and funds are obtained from both stockholder and creditors. These funds are invested in the various assets needed to run a business. Once funds are obtained and investments made in productive assets, a business begins operations, which may consists of providing goods and services or both.
 
1)Financing activities:
All business must start with financing. Simply put, money is needed to start a business. The company sells stock to the public to raise money. Most companies not only sell stock to raise money but also borrow from various sources to finance their operations.Accounting has unique terminology. In fact accounting is often referred to as the language of business. The discussion of financing activities brings up two important accounting term: liabilities and capital stock.
 
2)Investing activities:
There is a natural progression in a business from financing activities to investing activities. Once That is, once are generated from creditors and stockholders, money is available to invest.An asset is a future economic benefit to a business. For example, cash, equipment.An asset represents the right to receive some sort of benefit in the future. The point is that not all assets are tangible in nature like, inventories, building and equipment.
 
3)Operating activities:
Revenue is the inflow of assets resulting from the sale of product and services. When company makes a cash sale, the asset it receives in cash. When a sale is made in credit, the asset received is an account receivable. Revenue represents the amount of sales of products and services for specific period of time.We have thus far identified one important operating activity: the sale of products and services. However, costs must be incurred to operate business.
–Suppliers must be paid for purchase of inventory
–Utility expense has to be paid
–Wages and salaries expenses
 

Objectives of financial reporting:

  • Financial reporting has one primary objective: to provide useful information to those who must make financial decisions.
  • A variety of external users need information to make sound business decisions, including stockholders, bondholders, bankers and other types of creditors such as suppliers. These users must make an initial decision about investing in a company, regardless of whether it is in the form of a stock, a bond or a note. The balance sheet, the income statement, and the cash flow statement, along with the supporting notes and other information found in an annual report, are the key sources of information needed to make sound decision.
  • The balance sheet tells what obligations will be due in the near future and what assets will be available to satisfy them.
  • The income statement tells the revenue and expenses for a period of time.
  • The statement of cash flow tells where cash came from and how it was used during the period.
  • The note provides essential details about the company’s accounting policies and other key factors that affect its financial condition and performance.

Primary objectives of financial reporting:

  • The primary objectives of financial reporting are to provide economic information to permit users of the information to make informed decisions. Users include both the management of a company (internal users) and others not involved in the daily operations of the business (external users). External users usually do not have access to the detailed records of the business or the benefit of daily involvement in the company’ affairs. They make decisions based on financial statements prepared by management.

Secondary objectives of financial reporting:

1)Reflect prospective cash receipts to investors and creditors:
a)Investor: If I buy stock in this company, how much cash will I receive?
                    •In dividends
                    •From the sale of the stock
b)Banker: If I lend money to this company, how much cash I will receive?
                    •In interest on the loan
                    •When and if the loan is repaid
2)Reflect prospective cash flows to company:Investors, bankers and other users ultimately care about their cash receipts, but this depends on to some extent on the company’s skills in managing its own cash flows.
3)Reflect the company’s resources and claims to its resources: A company’s cash flow is inherently ties to the information on the:
        –Balance sheet (assets, liabilities and owners’ equity)
        –Income statement ( Revenue and expenses)
 
 

Source Documents:

A piece of paper that is used as evidence to record a transactions. Examples are:

  • Cash Memo:

    This is used for cash transactions. A Cash Memo is received or given when goods are purchased or sold for cash. Hence, all cash transactions are recorded in the books of accounts on the basis of these cash memos. The cash memo is different from Cash Receipt in the sense that it is normally issued for cash received subsequent to the sale of goods but Cash Memo is used for money received instantly.

  • Invoice or Credit Bill:

    An Invoice or Credit Bill is used for business transactions carried out on credit. A sales invoice is prepared to record the credit sale of goods or provision of services. The original copy of the sales invoice is sent to the purchaser and the seller keeps a duplicate copy as the proof of sale.

  • Receipts:

    A firm issues a receipt when it receives cash or cheques. It is an acknowledgement of receipt of cash or chequeand acts as a documentary proof for receiving the cash.

  • Deposit Slip:

    It is a form available from the bank for depositing money or chequein a bank account. It has a counterfoil or a carbon copy, which is returned to the depositor with signature of the cashier, as receipt. The counterfoil or a carbon copy of the deposit slip gives the details regarding the date, the amount (in cash or chequedeposited) etc.

  • Cheque:

    A cheque is a form made available by a Banker to its account holder. Each chequehas a counterfoil to record the same information written on the chequethat remains with the account holder for his future reference. The counterfoil is taken as a source document to make entries about payments in the books of accounts.

  • Debit Note:

    Debit note is a note sent to a supplier informing him that his account has been debited to the extent of goods returned to him. It is also used to send to a customer informing him that an additional amount is recoverable from him for difference in price etc.

  • Credit Note:

    Credit note is a note sent to a customer informing him that his account has been credited to the extent of goods returned by him or sent to a supplier informing him about the difference in price etc.

  • Bank Statement:

    It is a statement sent by the Bank on a regular basis, say monthly. It shows the running balance of the bank account for the period with details of deposits and payments out of the Bank Account.

Role of Source Documents in Accounting:

  • Recording basis:The source documents are the basis for recording and accounting, without which recording would be virtually meaningless.

  • Authenticates the amount paid or received:The source document establishes the amount paid or received.

  • Evidence in the court of law:The source documents can be produced in the court of law as documentary proof in the event of any dispute involving the accounting entity.

  • Basis for taxation:The tax authorities use the source documents to establish the amount of tax to be paid by the accounting entity extensively.

  • Information about make, quantity, and values:Source documents provide, in brief, the information about the model, make, quantity, amount of tax collected or payable, and the value of transactions.

  • Proof of payment or receipt:The source documents are the proof of payment made and amount received along with their purposes. For e.g., issue of account payee chequesand their record in the Bank Statement is a proof of payment.

 

Annual Report:

The joint stock companies publicly owned and listed on a stock exchange are required to prepare and publish an annual report for its shareholders. In Nepal, the privately owned companies are also required by the Companies Act, 2053 BS to prepare an annual report and submit it to the Office of the Registrar of Companies.

Components of annual report

  1. Financial Statements:

    The financial statements consist of four statements prepared by the companies as a form of communication with its shareholders and other user groups. They include income statement, the balance sheet, statement of cash flows, and statement of changes in stockholder’s equity. The information provided in the financial statements is the responsibility of the management and subject to verification as part of the external audit.

  2. Chairperson’s Report:

    This report is an address by the Chairperson of the company’s Board of Directors to its shareholders at the Annual General Meeting (AGM). It comprises the summary of the results of financial affairs, composition of the BOD and discussion about the external environment, especially the economic and financial situation of the country and place of operation of the business. The chairperson might take this opportunity to thank and acknowledge the support and co-operation of the company’s BOD, shareholders and staff and employees.

  3. Management Discussion and Analysis:

    The management team discusses the financial statements and provides vital explanations for the amounts reported in the financial statements. Some companies report this section as financial review. The section is directed at not only simplifying the information contained in the financial statement and any back-up information requiring clarification but also providing crucial information about the company’s business plan or strategy.

  4. Management’s responsibility for financial reporting:

    It is a written statement in the annual report indicating the responsibility of management for the financial statements.

  5. Management’s responsibility for financial reporting:

    It is a written statement in the annual report indicating the responsibility of management for the financial statements.

  6. Notes to Financial Statements:

    The notes to financial statements provide crucial information regarding the accounting policies and procedures adopted, the basis of taxation, the employee benefit schemes, the commitments and contingencies, the inventories, the account receivables, account payables and other details of items clubbed together to make the financial statements brief.

  7. Financial Summary:

    Another regular feature in any annual report is the summary of financial information, especially of the revenue, net income, and total assets. Many reports call it financial highlights. This section is primarily a pictorial representation using colourful pie charts, bar diagrams, or graphical curves.

  8. Report of the Independent Auditor:

    Before the annual report is presented to the company’s shareholders at the AGM and submitted to the concerned government office, the books of accounts and the financial statements of the company are subject to an external audit from an independent auditor. After such an audit, the auditor issues a report addressing to the company’s shareholders.(According to accounting standard)

 

Advantages of computer in accounting

  1. Speed:

    This is the first noticeable advantage computer has over humans and it can function at speeds unthinkable by them.

  2. Storage:

    The computer can store large volumes of information. But the retrieval system of humans is not able to diagnose the needed information at the right time and within a short time span. Whereas, a computer can bring back whatever is stored in memory, depending o its capacity as described in the magnetic disk section, repeatedly at an unbelievable speed and with certitude.Advantages of computer in accounting

  3. Accuracy:

    To err is human, however simple a problem may be one can make a mistake. But amount of research and hard work that has gone into developing the computer has made it 100% accurate. Any error in the results derived a computer is due to the error of human in giving the needed logical set of instructions to it.

  4. Automaticity:

    The computer is capable of functioning automatically; only the process must be initiated. This characteristic is best used in robots or special-purpose computers.Advantages of computer in accounting

  5. Diligence:

    Human beings are susceptible to boredom by physical and mental tiredness and by lack of concentration. This does not hold true for a computer which is capable of operating exactly the same level of speed and accuracy in carrying out the most complex and voluminous operation for a long period of time.

  6. Versatile:

    The wide use of computers in every field of human life is a proof of their versatility.  They can carry out widest range of calculations from those of a school student to the complex calculations and logical evaluation needed in launching a rocket. They are used widely different field.Cash and cash equivalents•An investment that is readily convertible to known amount of cash and has original maturity to the investor of three months or less. Examples:–Commercial paper issued by corporations–Treasury bills issued by the federal government–Money market funds offered by financial institutions

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