MGT101 Financial Accounting

inancial Accounting is concerned with the production of financial statements for external users. Investors need to be able to choose which companies to invest in and compare investments. In order to facilitate comparison, financial accounts are prepared using accepted accounting conventions and standards. International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) help to reduce the differences in the way that companies draw up their financial statements in different countries. The financial statements are public documents, and therefore they will not reveal details about, for instance, individual products' profitability.
Financial accounting provides information to decision makers who are external to the business. To understand the role of financial accounting, consider a large corporation such as IBM. The owners of corporations are called shareholders, and IBM has more than 600,000 shareholders. Obviously, each shareholder cannot participate directly in the running of IBM, and because IBM needs to maintain various trade secrets, its many thousands of shareholders are not permitted access to much of the firm’s information. Because of this, shareholders delegate most of their decision making power to the corporation’s board of directors and officers. Shareholders, however, need information to evaluate the performance of the business and the advisability of retaining their investment in the business. Financial accounting provides some of the information for this purpose; such information is also used by potential shareholders who are considering an investment in the business.
Creditors and potential creditors are also served by financial accounting. Firms often seek loans from banks, insurance companies, and other lenders. Although creditors are not internal parties of those firms, they need information about them so that funds are loaned only to credit-worthy organizations. Financial accounting will usually provide at least some of the information needed by these decision makers.
This Financial Accounting tutorial is useful for B.Com, B.B.A., M.Com., M.B.A., C.S., CA., LCW.A. students and professionals. Every lesson is logically set and graded. This tutorial is organized into main chapters and then into subtopics in order to make yourself comfortable learning Financial Accounting.
Financial Accounting is an Important subject of modern world. That is why we bring out this online resource of Financial Accounting Tutorial with advanced methods, Practices and in a inimitable style. The students, businessmen, traders, industrialists and professionals must know financial accounting to real life situations. This tutorial opens up the gateway of analysis to the world of accounting to those who go in for the study of accounting methods and techniques academically as well as practically. This tutorial has been organized in a way to teach Financial Accounting yourself strictly following a student friendly approach and essentially meant to serve the matter for their examination as a tutor at home.
Financial Accounting Method has first step in collecting business data and information is compiling a set of adequate definitions of the categories concerned so that there can be no confusion one the part of the reporters. In the private business organization there is some confusion in revenue between taxable and nontaxable sales, and there is always the possibility of confusion in classification of business expenses unless they are carefully designated by accountant. In the modern commercial world there are various manuals of accounts published by trade associations, each adapted to specific business needs.
There is no single authoritative and generally accepted definition of financial accounting, or of accounting in general. It began as a practical activity in response to perceived needs, and for most of its development it has progressed in the same way, adapting to meet changes in the demands made on it. Where the needs differed in different countries or environments, accounting tended to develop in different ways as a response to a particular environment, essentially on the Darwinian principle: useful accounting survived. Because accounting developed in different ways, it is likely that definitions suggested in different contextual surroundings will vary.
At a general level it is at least safe to say that accounting exists to provide a service. In the box below there are three definitions. These have all been taken from the same economic and cultural source (the United States) because that country has the longest history of attempting explicit definitions of this type. Note that each suggested definition seems broader than the previous one, and the third one, from 1970, does not restrict accounting to financially quantifiable information at all. Many would not accept this last point even in the US context and, as will be explored at length in this book, attitudes to accounting and its role differ substantially around the world and certainly between European countries.

The Objective of Financial Accounting

An important beginning point for understanding the social role and importance of financial accounting is identifying the objective that it should meet. Although there are many opinions as to what the objective should be, the most authoritative and influential is this definition provided by the Financial Accounting Standards Board (FASB) in its Conceptual Framework project, which was intended to develop a unified theory of accounting
Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. Thus, according to this definition, the goal is to provide information that allows users to reach better decisions than they would without it. (For simplicity, the FASB uses the term financial reporting to encompass the activities of “financial accounting and reporting,” which includes presenting both financial statements and the additional financial information that accompanies them. This chapter uses the term financial accounting in this broader sense.)
Usefulness may exist at the individual company level if management provides reports to investors and creditors when seeking financing or fulfilling various stewardship reporting responsibilities. Although this perspective undoubtedly explains why some aspects of accounting are regulated, it does not really provide an adequate basis for understanding the substantial governing structure. Instead, an economy-wide perspective is needed.

Balance Sheet       

The purpose of a balance sheet is to show the financial position of a business on a certain date, usually the end of the month or year. For this reason, it often is called the statement of financial position and is dated as of a specific date. The balance sheet presents a view of the business as the holder of resources, or assets, that are equal to the claims against those assets. The claims consist of the company’s liabilities and the owner’s equity in the company.
This chapter focuses solely on the balance sheet, which is often called the statement of financial position. Beginning with formal definitions of the basic elements of the balance sheet, the discussion describes the types of assets, liabilities, and owners’ equity that are found on the balance sheets of most business firms. A variety of balance sheet ratios are presented to show how managers and investors use balance sheet information in making decisions.
The basic elements of the balance sheet are assets, liabilities, and owners’ equity. Liabilities and owners’ equity are the sources from which a firm has obtained its funds, and assets show the way that the firm’s managers have invested those funds as the balance sheet shows a firm’s assets, liabilities, and owners’ equity. Assets are valuable resources that a firm owns or controls. The simplified balance sheet shown in the following figure includes four assets. Cash obviously has value. Accounts receivable are amounts owed to Harrisson Company by its customers; these have value because they represent future cash inflows. Inventory is merchandise acquired that is to be sold to customers. Newton expects its inventory to be converted into accounts receivable and ultimately into cash. Finally, equipment (perhaps delivery vehicles or showroom furniture) enables Newton to operate its business.
Liabilities are obligations of the business to convey something of value in the future. Harrisson’s balance sheet shows two liabilities. Accounts payable are unwritten promises that arise in the ordinary course of business. An example of this would be Newton purchasing inventory on credit, promising to make payment within a short period of time. Notes payable are more formal, written obligations. Notes payable often arise from borrowing money.

The final item on the balance sheet is owners’ equity, which refers to the owners’ interest in the business. It is a residual amount that equals assets minus liabilities. The owners have a positive financial interest in the business only if the firm’s assets exceed its obligations.
At the end of this chapter, You will know to:

• Identify the basic elements of the balance sheet.
• Recognize the types of assets, liabilities, and owners’ equity that are found on the balance sheets of most business firms.
• Comprehend the ordering and classification of items on the balance sheet.
• Appreciate why balance sheets differ for firms in different industries.
• Use balance sheet relationships to obtain information useful to investors and lenders.
• Be alert to the limitations as well as the usefulness of balance sheet information.

• Elements of the Balance Sheet       

  This chapter focuses solely on the balance sheet, which is often called the statement of financial position. At any given date, the balance sheet shows the sources from which the firm has obtained its resources and the ways in which those resources are currently employed. Recall the basic accounting equation:
  

  ASSETS + LIABILITIES = OWNERS’ EQUITY (capital)

  Another way to state this relationship is
  

  Uses of resources = Sources of resources
  assets + liability = capital () owners' equty

  In other words, liabilities and owners’ equity are the sources from which the firm has obtained its funds, and the listing of assets shows the way in which the firm’s managers have put those funds to work. This relationship is illustrated as follows, based on the balance sheet for Sample Company at the end of 2000, which is presented in Figure 2.1.
  

  
  Figure 2.1 - A Balance Sheet

  Viewed in this manner, there is no mystery to the fact that both sides of the balance sheet have the same total; they are merely two sides of a single coin, or two ways of describing the total wealth of the firm. The firm’s wealth can be viewed in terms of sources of financing (from creditors and owners) and in terms of uses of resources (owning or controlling assets).
  Another useful way to view the balance sheet is as the cumulative result of the firm’s past activities. Liabilities represent the total amount the firm has borrowed during its existence, minus the amounts that have been repaid to date. The owners’equity items show the total amount invested by owners, plus the total profits earned by the firm during previous periods, minus any amounts that have been distributed to owners. Similarly, the assets of the firm represent the total resources obtained by the firm from lenders and owners, minus those that have been consumed in the firm’s operations, repaid to lenders, or distributed to owners.
  
  

  Definitions of Assets, Liabilities, and Owners’ Equity       

  
  The Financial Accounting Standards Board (FASB) has identified the essential characteristics of assets, liabilities, and owners’ equity. The FASB definitions, which were introduced in the section, “The Basic Concepts of Financial Accounting,” and the summarization below, provide a frame of reference that helps accountants identify the items to be included in the balance sheet. They will be referred to frequently during the remaining discussions in this chapter. For now, note that according to the FASB’s definitions, assets represent future benefits, liabilities represent future sacrifices, and owners’ equity is the residual amount, or difference, between assets and liabilities.
  The following pages introduce you to the types of individual assets, liabilities, and owners’ equity to be found on the balance sheets of most business firms. In studying these individual balance sheet items, keep in mind the FASB’s definitions given below.
  

  FASB Definitions of Assets, Liabilities, and Owners’ Equity
  Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
  Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
  Equity is the residual interest in the assets of an entity that remains after deducting liabilities. In a business enterprise, the equity is the ownership interest.
  SOURCE: Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (Stamford, CT: FASB, 1980).