Accounting & Financial Statements: Basics
Accounting is the systematic and comprehensive recording of financial transactions pertaining to a business. According to Bierman and Drebin:” Accounting may be defined as identifying, measuring, recording and communicating of financial information.”
Accounting can also be defined as the process of identifying, measuring, recording and communicating the required information relating to the economic events of an organisation to the interested users of such information.
Objectives of Accounting
Primary objectives of accounting include the following:
- Maintenance of Records of Business Transactions.
- Calculation of Profit and Loss
- Depiction of Financial Position
- Providing Accounting Information to its Users
Principles of Accounting
Generally Accepted Accounting Principles (GAAP) are basic accounting principles and guidelines which provide the framework for more detailed and comprehensive accounting rules, standards and other industry-specific accounting practices. In India, financial statements are prepared on the basis of accounting standards issued by the Institute of Chartered Accountants of India (ICAI) and the law laid down in the respective applicable acts.
Generally Accepted Accounting Principles (GAAP)
- Business Entity Assumption: It states that every business entity should be treated as an entity that is separate from its owners.
- Monetary Unit Assumption: All the financial transactions of a business should be capable of being expressed in a monetary unit (Example INR for India).
- Accounting Period: This principle entails that the accounting process of a business should be completed within a certain time period which is usually a financial year or a calendar year.
- Historical Cost Concept: According to this, when certain economic resources or assets are acquired by an enterprise, they are recorded as per the cash or cash equivalent actually spent to acquire that resource or asset on the transaction date, even if the transaction happened the previous day or twenty years ago.
- Going Concern Assumption: The business entity is assumed to be a going concern, i.e., it will continue to operate for an indefinite amount of time.
- Accrual Basis of Accounting: This principle requires all revenue and expenditure to be recorded in the period it is actually incurred and not when cash or cash equivalent has been received/spent.
- Matching Concept: This concept requires the revenue for a particular period to be matched with its corresponding expenditure so as to show the true profit for the period.
- Conservatism: While accounting for a particular transaction, all anticipated expenses or losses will need to be accounted for but all potential income or gains should not be recorded until actually earned/received.
Process of Accounting:
The process of accounting consists of number of steps or stages. However, we can identify 3 main steps as:
- Recording – Transaction is identified and recorded.
- Classification – Journal entries are classified into appropriate ledger accounts.
- Summarisation – Ledger balance is “summarised” and converted into trial balance.
- Preparation of financial statements.
The financial statements are the end products of accounting process. They are prepared following the consistent accounting concepts, principles, procedures and also the legal environment in which the business organisations operate.
Financial statements are the basic and formal annual reports through which the corporate management communicates financial information to its owners and various other external parties which include investors, tax authorities, government, employees, etc.
Types of Financial Statements:
They generally refer to:
- The balance sheet shows all the assets owned by the concern, all the obligations or liabilities payable to outsiders or creditors and claims of the owners on a particular date
Statement of profit and loss
- The Statement of profit and loss is prepared for a specific period to determine the operational results of an undertaking. It is a statement of revenue earned and the expenses incurred for earning the revenue.
Apart from these, there is also a need to know about movements of funds and changes in the financial position of the company. For this purpose, a statement of changes in financial position of the company or a cash flow statement is prepared.
Objectives of Financial Statements
- To provide information about economic resources and obligations of a business.
- To provide information about the earning capacity of the business.
- To provide information about cash flows.
- To judge effectiveness of management.
- To provide information about activities of business affecting the society.
- To disclose accounting policies
Importance or Uses of Financial Statements
- Report on performance: Financial statements report the performance of the management to the shareholders. The gaps between the management performance and ownership expectations can be understood with the help of financial statements.
- Basis for fiscal policies: The financial statements provide basic input for industrial, taxation and other economic policies of the government.
- Basis for granting of credit: The financial Statements provide information to credit granting institutions like Banks etc to take decisions on provide funds to company.
- Basis for prospective investors: Financial statements help the investors to assess longterm and short-term solvency as well as the profitability of the concern.
- Guide to Shareholders: Financial Statements serve as guide to shareholders of companies, who are interested in knowing the status, safety and return on their investment.
- Aids trade associations in helping their members: Trade associations may analyse the financial statements for the purpose of providing service and protection to their members. They may develop standard ratios and design uniform system of accounts.
- Helps stock exchanges: Financial statements help the stock exchanges to understand the extent of transparency in reporting on financial performance.
Limitations of Financial Statements
- Do not reflect current situation
- Accounting is done on the basis of certain conventions, hence some of the assets may not realise the stated values.
- Financial statements are the outcome of recorded facts, accounting concepts and conventions used and personal judgements made in different situations by the accountants.
- Financial statements show aggregate information but not detailed information.
- Financial statements contain only monetary information but not qualitative information like industrial relations, industrial climate, labour relations, quality of work, etc.
- Statement of Profit and Loss discloses the profit/loss for a specified period. It does not give an idea about the earning capacity over time.