To maintain full, systematic and permanent records of business transactions:

• Accounting is the language of business transactions. Accounting is done to keep a systematic record of financial transactions.  The main objective of accounting is to maintain ‘a full and systematic record of all business transactions for current and future references It saves human memory from overburden.
• These records are useful for the internal purpose, for taxation purpose or for any other purpose. These permanent records help the firm to understand the trend in the business and make decisions.

To ascertain profit or loss of the business:

• The main objective of any business firm is to earn a profit.  Business firms perform many transactions. Some of them are profitable while some may incur a loss. Profit & Loss Account gives an aggregate idea of these transactions and presents the financial performance of the firm for the period. The comparison of income and expenditure gives either profit or loss.

To present financial position of the firm:

• At the end of the period balance sheet gives the financial position of the firm on that date. The balance sheet shows assets and liabilities of the firm. Thus balance sheet shows the financial health of the firm.

To help top management to make decisions:

• Accounting through the collection, analysis and reporting provide information at the required points of time to the required levels of authority. A useful and sensitive information is available for internal users like top management and board of directors. It helps them to take a rational decision.

To project creditworthiness of the firm:

• Investors will invest or lenders will lend money to the firm only if they have reasonable assurance that the firm will be able to generate enough profit to service the debt. There are various parties who are interested in accounting information of the firm. These include bankers, creditors, tax authorities, prospective investors, researchers, stock exchanges, etc. Hence, Accounting provides the required information available in the form of an annual report to these interested parties to enable them to take sound and realistic decisions.

To use resources effectively:

• Accounting records tell the firm what resources were committed to what activity and at what time. Accounts give information about the return that was obtained from these activities. Using the data from accounts effective control can be obtained and effective use of resources is achieved.

To comply government requirements:

• In case of limited companies, the reporting financial information to shareholders, Registrar of companies and Security and exchange board of India is mandatory. Accounting helps the firm to comply these legal requirements.

To calculate taxable income:

• Using financial accounts the taxable income for the period can be calculated.

Users of Financial Statement:

• Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization.

Internal users (Primary Users):

• Internal users of accounting information are those persons or groups which are within the organization. Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.

• Management:  The accounts are the basis; the management to understand the progress of the firm. Accounts project financial health of the firm. Using which management can take strategic, operational decisions by studying the trend. If required some corrective measures are taken by the management. It also helps the management in cost control.
• Owners: The owners provide funds or capital for the organization. Accounts show viability, profitability and return on the investment made by the owners of the firm. It helps them in assessing the taxes, the goodwill of the firm and in determining the future course of action.
• Employees: It helps the employee to assess company’s profitability and credential. The demand for the wage rise, bonus, post-retirement benefits, stock options, better working conditions etc. depend upon the profitability of the firm which depends upon the financial position of the firm. From accounts, they can foresee their future remuneration and job security.

External users (Secondary Users):

• External users are those groups or persons who are outside the organization for whom accounting function is performed.

• Creditors: Using accounts determining the creditworthiness of the firm can be assessed. Accounts show repayment history and capacity of the firm. Creditors include suppliers supplying goods on credit, lenders, banks, etc. Terms of credit and its approval depend on the financial health of the firm. Profit and Loss Account and Balance Sheet gives an idea of the financial health of the firm to creditors.
• Government and Tax Authorities:  Tax authorities and government are interested in the financial statements to know the earnings of the firm for the purpose of taxation. To calculate GDP, various indices and to prepare budgets and policies this information is important for government. It helps tax authorities to check the credibility of the tax returns filed on behalf of the firm. The government can also check about monopolies, cartel formation and take effective action.
• Investors: Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company.  Hence they invest money in a firm with good financial performance. They can take the decision of investment by going through the financial statements of the firm. The stock prices of the firm on stock exchanges depend on their financial performance and policy of disbursement of profit.
• Customers: Consumers are interested in good products at low price with good after-sales service. A good accounting and cost control can reduce the cost of the product. Companies financial health assures consumer of stable, continuous supply of products, warranty obligations, services and spare parts.
• Regulatory Authorities: Regulatory authority like Registrar of the Companies are interested in the company’s disclosure of accounting information. They want to ensure that it is in accordance with the rules and regulations set in order to protect the interests of the stakeholders.
• Research Scholars: Financial information of the firm is useful for research scholar who wants to make a study into the financial operations of a particular firm.

Limitations of Financial Statements:

No qualitative approach:

• Only transactions that can be measured in terms of monetary unit are covered in financial accounting. Thus only quantitative information is included in the financial statements. it fails to explain qualitative information such as management labour relations, customer’s satisfaction, management’s skills, leadership, human relations, product quality, research & development, brand image, etc.which are also equally important for decision making.

Historical in Nature:

• Financial statements are calculated on the basis of historical cost. Thus it does not carry the real value of the asset but shows original cost less accumulated depreciation. Hence, historical information has little scope for decision making. The real position of a firm changes day by day.
• Various assets and liabilities are recorded in the balance sheet at their book value and not real value. Hence, ithe financial position of the company cannot be judged from the balance sheet.

Incomplete Information:

• The financial statements are prepared for an accounting period. Hence, they are estimated and not accurate. The exact financial position of the business can only be determined when it is closed down.

Can be Misleading:

• The accuracy of financial information largely depends on how accurately financial information is collected and how accurately the financial statements are prepared.The analysis of wrong financial statements will also be wrong which may mislead the user in making a decision.

Do not consider Social and Political Factor:

• The financial position of a business is affected by economic, social, cultural and financial. The financial statements include only financial factors.  Firms are greatly affected by economic, social, cultural factors. A change in these factors may affect the firm to large extent.

Non Comparable:

• Different companies adopt different accounting policies. and hence their financial statements differs from one company to another. Hence, the financial statements of two companies cannot be compared. The government now made it mandatory to have same accounting practices.

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• 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” Thus 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 the 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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