Introduction to Financial Accounting

1.1          INTRODUCTION

Accounting is a system meant for measuring business activities, processing of information into reports and making the findings available to decision-makers. The documents, which communicate these findings about the performance of an organization in monetary terms, are called financial statements.

Usually, accounting is understood as the Language of Business. However, a business may have a lot of aspects which may not be of financial nature. As such, a better way to understand accounting could be to call it The Language of Financial Decisions. The better the understanding of the language, the better is the management of financial aspects of living. Many aspects of our lives are based on accounting, personal financial planning, investments, income-tax, loans, etc. We have different roles to perform in life-the role of a student, of a family head, of a manager, of an investor, etc. The knowledge of accounting is an added advantage in performing different roles. However, we shall limit our scope of discussion to a business organization and the various financial aspects of such an organization.

When we focus our thoughts on a business organization, many questions (is our business profitable, should a new product line be introduced, are the sales sufficient, etc.) strike our mind. To answer questions of such nature, we need to have information generated through the accounting process. The people who take policy decisions and frame business plans use such information.

All business organizations work in an ever-changing dynamic environment. Any new programme of the organization or of its competitor will affect the business.  Accounting serves as an effective tool for measuring the financial pulse rate of the company. It is a continuous cycle of measurement  of results  and reporting  of results  to decision- makers.

Just like arithmetic is a procedural element of mathematics, book keeping is the procedural element of accounting. Figure 1 shows how an accounting system operates in business and how the flow of information occurs.


  People make decision  
  Business transactions occur
  Accountants prepare reports to show the results of business operations



Source:    Liorngren,    Harrison    and    Robinson,     Financial    and    Management Accounting, Prentice Hall, New Jersey, 1994.



The history of accounting can be traced back to ancient times. According to some beliefs, the very art of writing originated in order to record   accounting   information.   Though   this   may   seem   to   be   an exaggeration, but there is no denying the fact that accounting has a long history.   Accounting   records   can   be   traced   back   to   the   ancient civilizations of China, Babylonia, Greece and Egypt. Accounting was used to  keep  records  regarding  the  cost  of  labour  and  materials  used  in building great structures like the Pyramids.

During 1400s, accounting grew further because the needs for information of merchants in the Venis City of Italy increased. The first known description of double entry book keeping was first published in 1994 by Lucas Pacioli. He was a mathematician and a friend of Leonardo Ileda Vinci.

The onset of the industrial revolution necessitated the development of more sophisticated accounting system, rather than pricing the goods based on guesses about the costs. The increase in competition and mass production of goods led to the rise of accounting as a formal branch of study.

With  the  passage   of  time,  the  corporate  world  grew.  In  the nineteenth century, companies came up in many areas of infrastructure like the railways, steel, communication, etc. It led to a rapid growth in accounting. As the complexities of business grew, ownership and management of business was divorced. As such, managers had to come up with well-defined, structured systems of accounting to report the performance of the business to its owners.

Government also has had a lot to do with more accounting developments. The Income Tax brought about the concept of ‘income’. Government takes a host of other decisions, relating to education, health, economic planning, for which it needs accurate and reliable information. As  such,  the  government   demands  stringent  accountability   in  the corporate sector, which forces the accounting process to be as objective and formal as possible.


A  man  who  is  involved  in  the  process  of  book  keeping  and accounting is called an accountant. With the coming up of accounting as a specialized field of knowledge, an accountant has a special place in the structure of an organization, because he performs certain vital functions.

The following paragraphs examine the functions of accounting and what role does an accountant play in discharging these functions.

An accountant is a person who does the basic job of maintaining accounts as he is the man who is engaged in book keeping. Since the managers would always want to know the financial performance of the business. An accountant prepares profit and loss account which reports the profits/losses of the business during the accounting period, Balance Sheet, which is a statement of assets and liabilities of the business at a point of time, is also proposed by all accountants. Since both statements are called financial statements, the person who prepares them is called a financial accountant.

Accounting   information   serves   many   purposes.   A   part   from revealing  the  level  of  performance,  it  throws  light  on  the  causes  of weakness and deviation from plans (in any). In this way an accountant becomes an important functionary who plays a vital role in the process of management control, which is a process of diagnosing and solving a problem. Seen from this point of view, an accountant can be referred to as a management accountant.

Tax planning is an important area as far as the fiscal management of a company  is concerned.  An accountant  has a suggestive  but very specific job to do in this regard by indicating ways to minimize the tax liability through his knowledge of concessions and incentives available under the existing taxation framework of the country.

An accountant can influence a company even by not being an employee. He can act as a man who verifies and certifies the authenticity of accounts of a company by auditing the accounts. It is a strictly professional job and is done by persons who are formally trained and qualified  for  the  purpose.  They  have  an  educational  status  and  a prescribed code of conduct like the Chartered Accountants in various countries and Certified Public Accountants in USA.

Information  management     is   another    area   which   keeps   an accountant busy. He is the one who classifies the financial information into information for internal use (management accounting function); and information or external use (financial accounting function). Irrespective of the    size   and   degree    of  automation    of  a  business,    information management is a key area and many organizations are known to have perished because they failed to recognize this as an important function of an accountant because information system is imperative for effective cost control, to forecast cash needs and to plan for future growth of the organization.


The preceding section has just brought out the importance of information. Effective decisions require accurate, reliable and timely information. The need for quantity and quality of information varies with the importance of the decision that has to be taken on the basis of that information. The following paragraphs throw light on the various users of accounting information and what do they do with that information.

Individuals   may  use  accounting   information   to  manage   their routine  affairs  like  operating  and  managing  their  bank  accounts,  to evaluate the worthwhileness of a job in an organization, to invest money, to rent a house, etc.

Business Managers have to set goals, evaluate progress and initiate corrective  action  in  case  of  unfavourable  deviation  from  the  planned course of action. Accounting information is required for many such decisions—purchasing  equipment,  maintenance  of inventory,  borrowing and lending, etc.

Investors and creditors are keen to evaluate the profitability and solvency of a company before they decide to provide money to the organization.  Therefore,  they  are  interested  to  obtain  financial information about the company in which they are contemplating an investment. Financial statements are the principal source of information to them which are published in annual reports of a company and various financial dailies and periodicals.

Government and Regulatory agencies are charged with the responsibility of guiding the socio-economic system of a country in such a way that it promotes common good. For example, the Securities and Exchange Board of India (SEBI) makes it mandatory for a company to disclose certain financial information to the investing public. The government’s task of managing the industrial economy becomes simplify if  the  accounting  information  such  as  profits,  costs,  taxes,  etc.  is presented in a uniform manner without any manipulation or ‘window- dressing’.

Central and State governments levy various taxes. The taxation authorities, therefore, need to know the income of a company to calculate the amount of tax that the company would have to pay. The information generated by accounting helps them in such computations and also to detect any attempts of tax evasion.

Employees  and  trade  unions  use  the  accounting  information  to settle   various  issues  related  to  wages,  bonus,  profit  sharing,  etc. Consumers and general public are also interested in knowing the amount of income  earned by various  business  houses. Accounting  information helps in finding whether or not a company is over charging or exploiting the customers, whether or not companies are showing improved business performance, whether or not the country is emerging from the economic recession, etc. All such aspects draw heavily on accounting information and are closely related to our standard of living.

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