THE NATURE AND SCOPE OF FINANCIAL ACCOUNTING

THE DEVELOPMENT OF ACCOUNTING

Meaning of Financial Accounting: 

Accounting is the process of recording, classifying, summarizing, analyzing, and

interpreting the financial transactions of the business for the benefit of
management and those parties who are interested in business such as shareholders,
creditors, bankers, customers, employees, and government. Thus, it concerns with
financial reporting and decision-making aspects of the business.

The American Institute of Certified Public Accountants Committee on Terminology

proposed in 1941 that accounting may be defined as,
“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 a financial character
and interpreting the results thereof.”

Financial Accounting:

The term ‘Accounting’ unless otherwise specifically stated always refers to

‘Financial Accounting’. It is commonly carrying on in the general offices of a
business. It concerns with revenues, expenses, assets, and liabilities of a business
house. Also, they have the two-fold objective, viz,

 To ascertain the profitability of the business, and

 To know the financial position of the concern.

Nature and Scope of Financial Accounting:

Financial accounting is a useful tool to manage and to external users such as

shareholders, potential owners, creditors, customers, employees, and government.
It provides information regarding the results of its operations and the financial
status of the business.

The following are the functional areas of financial accounting:-

1] Dealing with financial transactions:

Accounting as a process deals only with those transactions which are measurable
in terms of money. Anything which cannot be expressed in monetary terms does
not form part of financial accounting however significant it is.

2] Recording of information:

Accounting is the art of recording financial transactions of a business concern.

There is a limitation on human memory. It is not possible to remember all
transactions of the business. Therefore, the information is recorded in a set of
books called Journal and other subsidiary books and it is useful for management in
its decision-making process.

3] Classification of Data:

The recorded data arrange in a manner to group the transactions of similar nature at
one place so that full information of these items may collect under different heads.
This is done in the book called ‘Ledger’. For example, we may have accounts
called ‘Salaries’, ‘Rent’, ‘Interest’, Advertisement’, etc. To verify the arithmetical
accuracy of such accounts, the trial balance prepare.

4] Making Summaries:

The classified information of the trial balance uses to prepare a profit and loss
account and balance sheet in a manner useful to the users of accounting
information. As well as, the final accounts prepare to find out the operational
efficiency and financial strength of the business.

5] Analyzing:

It is the process of establishing the relationship between the items of the profit and
loss account and the balance sheet. Also, the purpose is to identify the financial
strength and weaknesses of the business. It also provides a basis for interpretation.

6] Interpreting financial information:

It is concerned with explaining the meaning and significance of the relationships

established by the analysis. It should be useful to the users, to enable them to take
correct decisions.

7] Communicating the results:

The profitability and financial position of the business as interpreted above

communicate to the interest parties at regular intervals to assist them to make their
conclusions.
The Role of Accounting in Business and Why It’s Important
Accounting refers to the systematic and detailed recording of financial
transactions of a business. There are many types, from accounting for small
businesses, government, forensic, and management accounting, to accounting
for corporations.

Why Is Accounting Important?

Accounting plays a vital role in running a business because it helps you track
income and expenditures, ensure statutory compliance, and provide investors,
management, and government with quantitative financial information which
can be used in making business decisions.

There are three key financial statements generated by your records.

 The income statement provides you with information about the profit and
loss
 The balance sheet gives you a clear picture on the financial position of your
business on a particular date.
 The cash flow statement is a bridge between the income statement and
balance sheet and reports the cash generated and spent during a specific
period of time.
It is critical you keep your financial records clean and up to date if you want
to keep your business afloat. Here are just a few of the reasons why it is
important for your business, big or small!

 It Helps in Evaluating the Performance of Business

Your financial records reflect the results of operations as well as the financial
position of your small business or corporation. In other words, they help you
understand what’s going on with your business financially. Not only will clean
and up to date records help you keep track of expenses, gross margin, and
possible debt, but it will help you compare your current data with the
previous accounting records and allocate your budget appropriately.

 It Ensures Statutory Compliance

Laws and regulations vary from state to state, but proper accounting systems
and processes will help you ensure statutory compliance when it comes to
your business.
The accounting function will ensure that liabilities such as sales tax, VAT,
income tax, and pension funds, to name a few, are appropriately addressed.

 It Helps to Create Budget and Future Projections

Budgeting and future projections can make or break a business, and your
financial records will play a crucial role when it comes to it.

Business trends and projections are based on historical financial data to keep
your operations profitable. This financial data is most appropriate when
provided by well-structured accounting processes.

 It Helps in Filing Financial Statements

Businesses are required to file their financial statements with the Registrar of
Companies. Listed entities are required to file them with stock exchanges, as
well as for direct and indirect tax filing purposes. Needless to say, accounting
plays a critical role in all these scenarios.

Disadvantages or Limitations of Financial Accounting:

The concerns with the preparation of final accounts. Also, the business has
become so complex that mere final accounts are not sufficient for meeting
financial needs. It is like a post-mortem report. At the most, it can reveal what
has happened so far, but it cannot exercise any control over the past
happenings.

The disadvantages of financial accounting are as follows:-

1. It records only quantitative information.

2. Records only the historical cost. The impact of future uncertainties has
no place in financial accounting.
3. It does not take into account price level changes.
 4. It provides information about the whole concern. Product-wise, process-
wise, department-wise, or information of any other line of activity
cannot obtain separately from financial accounting.
5. Cost figures do not know in advance. Therefore, it is not possible to fix
the price in advance. It does not provide information to increase or
reduce the selling price.
6. As there is no technique for comparing the actual performance with
that of the budgeted targets, it is not possible to evaluate the
performance of the business.
7. It does not tell about the optimum or otherwise of the quantum of profit
made and does not provide the ways and means to increase the profits.

In other words;

1. In case of loss, whether loss can reduce or convert into profit using cost
control and cost reduction? It does not answer this question.
2. Does it not reveal which departments are performing well? Which ones
are incurring losses and how much is the loss in each case?
3. It does not provide the cost of products manufactured
4. There are no means provided by financial accounting to reduce the
wastage.
5. Can the expenses reduce which results in the reduction of product cost
and if so, to what extent and how? No answer to these questions.
6. It is not helpful to the management in taking strategic decisions like a
replacement of assets, an introduction of new products, discontinuation
of an existing line, expansion of capacity, etc.
7. It provides ample scope for manipulation like overvaluation or
undervaluation. This possibility of manipulation reduces reliability.
8. It’s technical. A person not conversant with accounting has little utility
of the financial accounts.
“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 the results thereof.”

Accounting entails recording, classifying and summarizing of business

transactions. It is a process of identification, measurement and
communication of economic information involving four interconnected
phases. They are outlined herein:

At the outset, the first phase is meant to record the economic events or
transactions -depending upon their occurrences, chronologically in the books
of accounts - called journal. This process is known as journalizing. Next comes
the phase of ledger-posting: It is the process by which all the transactions are
synthesized account-wise so that the accumulated balance of each of those
accounts can be determined. The process of ledger posting is vitally
important, as it helps in ascertaining the net effect of various transactions
during a given period. The subsequent stage is preparing the trial
balance which involves the arrangement of all ledger accounts having been
aggregated into debit and credit balances. This activity enables to check and
confirm whether the total of debits is equal to that of credits. Finally, comes
the phase of preparing financial statements. This phase is meant for
finalization of accounts by measuring profit & loss account and preparing
Balance Sheet- at the end of accounting period.
There are many different users of accounting information and the users may
be inside or outside the organization. Accounting information is economic
information, as it relates to financial or economic activities of a business
organization. There are so many people using the accounting information for
so many diverse purposes, thus, the purpose of financial statements is to cater
for the needs of the users that could lead them to make better financial
decisions. The users may be classified into Internal and external users.

Internal users or Primary users of accounting information include:

 Management- Accounting information is of great assistance to

management for planning, controlling and decision making process.
Also, management needs the accounting information to evaluate the
performance of the organization and position, so that the necessary
measures may be taken to bring improvements in terms of business
results. Besides, accounting information is useful to help mangers to do
their jobs better.
 Employees - Employees use the accounting information to find out the
financial health, amount of sales and profitability of business to
determine their job security, the possibility of future remuneration,
retirement benefits and employment opportunities.
 Owners – Owners use the accounting information for analyzing the
viability and profitability of their investments. Accounting information
enables the owners to assess the ability of the business organization to
pay dividends. It also leads them to determine any future course of
action.

External users or Secondary users of accounting information include:

 Creditors – Creditors are interested in accounting information, because

it enables them to determine the credit worthiness of the business. The credit
terms and standards are set on the basis of the financial health of a business,
so, it helps them to analyze by using the accurate information accordingly.
Creditors include suppliers and lenders of finance, such as banks. Trade
creditor are generally interested in the accounting information for a short
period of time than lenders.
 Investors – They need the information, because they are concerned with
the risk inherent in investing and the returns. Since it is important to assess
the feasibility of making investments in the company, they need to analyze
before they provide any financial resources to the company.
 Customers – Customers have interest in the accounting information for
assessing the financial position of a business, especially, when they have a long
term involvement with, as it enables to maintain a steady source of business.
 Regulatory Authorities – The accounting information is needed for
them to ensure that it is in accordance with the rules and regulations and that
it protects the interests of the stake holders who rely on such information.

Users of Accounting Information

The accounting process provides financial data for a broad range of

individuals whose objectives in studying the data vary widely.   Three primary
users of accounting information were previously identified, Internal users,
External users, and Government/ IRS.  Each group uses accounting
information differently, and requires the information to be presented
differently.

Internal Users

Accounting supplies managers and owners with significant financial data that
is useful for decision making. This type of accounting in generally referred to
as managerial accounting.

 Some of the ways internal users employ accounting information include the

following:

 Assessing how management has discharged its responsibility for

protecting and managing the company’s resources
 Shaping decisions about when to borrow or invest company resources
 Shaping decisions about expansion or downsizing
External Users

Typically called financial accounting, the record of a business’ financial

history for use by  external entities is used for many purposes.  The external
users of accounting information fall into six groups; each has different
interests in the company and wants answers to unique questions. The groups
and some of their possible questions are:

 Owners and prospective owners. Has the company earned satisfactory

income on its total investment? Should an investment be made in this
 company? Should the present investment be increased, decreased,
or retained at the same level? Can the company install costly pollution
control equipment and still be profitable?
 Creditors and lenders. Should a loan be granted to the company? Will
the company be able to pay its debts as they become due?
 Employees and their unions. Does the company have the ability to pay
increased wages? Is the company financially able to provide long-term
employment for its workforce?
 Customers. Does the company offer useful products at fair prices? Will
the company survive long enough to honor its product warranties?
 Governmental units. Is the company, such as a local public utility,
charging a fair rate for its services?
 General public. Is the company providing useful products and gainful
employment for citizens without causing serious environmental
problems?

Some of the ways external users employ accounting information include the
following:

 Stockholders have the right to know how a company is managing its

investments
 Federal and State Governments require tax returns and other documents
often prepared by accountants
 Banks or lending institutions may use accounting information to guide
decisions such as whether to lend or how much to lend a business
 Investors will also use accounting information to guide investment
decisions

General-purpose financial statements provide much of the information

needed by external users of financial accounting. These financial statements
are formal reports providing information on a company’s financial position,
cash inflows and outflows, and the results of operations. Many companies
publish these statements in annual reports, also known as a 10-K or a 10-Q
(quarterly report). The annual report contains the independent auditor’s
opinion as to the fairness of the financial statements, as well as
information about the company’s activities, products, and plans.  Typically,
the best place to find these reports for a public company can be on their
website under the Investor relations section. Financial statements used by
 external entities are prepared using generally accepted accounting principles,
or GAAP. We will discuss the language of GAAP further in later sections.

Government / IRS

Government agencies that track and use taxes are interested in the financial
story of a business.  They want to know whether the business is paying taxes
according to current tax laws. The language in which tax-related financial
statements are prepared is called IRC or Internal Revenue Code.  Tax
preparation will be outside the scope of this course.

IMPORTANT POINTS TO REMEMBER

 Internal users are people within a business organization who use

financial information. Examples of internal users are owners, managers,
and employees.
 External users are people outside the business entity (organization) who
use accounting information. Examples of external users are suppliers,
banks, customers, investors, potential investors, and tax authorities.

SIGNIFICANCE OF ACCOUNTING INFORMATION

Company Management

With accounting information, management is able to evaluate a company's

financial position, make appropriate use of resources, and plan how to take
the company forward in the future.

Investors

Accounting data enables both individual and corporate investors to value

how much a firm is worth and whether or not they should invest in the
company.

 
Lenders

If a company is not in a strong financial position, lenders will fear the

company will be unable to pay back the loan, and therefore reject the
company's bid for a loan.
 
Tax Authorities

The corporate tax department relies on accounting data to calculate taxes

owed; the tax authorities then review the financials to confirm the company
is following tax guidelines and calculating taxes correctly.

 
Regulators

Some of the most important users of accounting information are regulators

on the state and federal levels. Regulators have been much more aggressive
in reviewing the accuracy of accounting information, doing their best to
ensure the numbers represented in financials are prepared under strict
accounting guidelines.

THE ACCOUNTING CYCLE

What Is the Accounting Cycle?

The accounting cycle is performed during the accounting period, to analyze,

record, classify, summarize, and report financial information.

The Accounting Cycle

The accounting cycle is a series of steps performed during the accounting

period (some throughout the period and some at the end) to analyze, record,
classify, summarize, and report useful financial information for the purpose
of preparing financial statements. In bookkeeping, the accounting period is
the period for which the books are balanced and the financial statements are
prepared. Generally, the accounting period consists of 12 months. However,
the beginning of the accounting period differs according to the company. For
example, one company may use the regular calendar year, January to
December, as the accounting year, while another entity may follow April to
March as the accounting period.
Eight Steps in the Accounting Cycle

There are eight steps in the accounting cycle and they are as follows:

 Analyze transactions by examining source documents.

 Journalize transactions in the journal.
 Post journal entries to the accounts in the ledger.
 Prepare a trial balance of the accounts and complete the worksheet
(includes adjusting entries ).
 Prepare financial statements.
 Journalize and post adjusting entries.
 Journalize and post closing entries.
 Prepare a post-closing trial balance.

Source Documents

To begin the accounting cycle, it is necessary to understand what constitutes a

business transaction. Business transactions are measurable events that affect
the financial condition of a business. Business transactions can be the
exchange of goods for cash between the business and an external party, such
as the sale of a book, or they can involve paying salaries to employees. These
events have one fundamental thing in common: they have caused a
measurable change in the amounts in the accounting equation, assets =
liabilities + stockholders’ equity. The evidence that a business event has
occurred is a source document. Sales tickets, checks, and invoices are common
source documents. Source documents are important because they are the
ultimate proof that a business transaction has taken place.

After determining, via the source documents, that an event is a business

transaction, it is then entered into the company books via a journal entry.
After all the transactions for the period have been entered into the
appropriate journals, the journals are posted to the general ledger. The trial
balance proves that the books are in balance or that the debits equal the
credits. From the trial balance, a company can prepare their financial
statements. After the financials are prepared, the month end adjusting and
closing entries are recorded (journalized) and posted to the appropriate
accounts. After those entries are made, a post-closing trial balance is run. The
post-closing trial balance verifies the debits equal the credits and that all
beginning balances for permanent accounts are in place.

1. Transactions

Transactions: Financial transactions initiate the process. If there were no

financial transactions, you would be able to keep track of anything.
Transactions may include certain things such as the debt payoff, any
purchases or acquisition of assets, sales revenue, or any other expenses
incurred.
2. Journal Entries

Journal Entries: When the transactions are set in place, the next step is to
record the journal entries in the company’s journal in a chronological order.
When you debit one or more accounts and credit one or more accounts, the
debits and credits will always balance.

3. Posting to General Ledger (GL)

Posting to the GL: Next the journal entries are posted in the general ledger
where a summary of the transactions is made and individual accounts can be
seen.

4. Trial Balance

Trial Balance: When at the end of the accounting period which needs to
depend on the quarterly, monthly, or yearly, it all depends on the company), a
total balance may be calculated for the accounts.

5. Worksheet

Worksheet: When the debits and credits on the trial balance don’t match, the
bookkeeper must look for errors and make corrective adjustments that are
tracked on a worksheet.

6. Adjusting Entries
Adjusting Entries: At the end of a company’s accounting period, the adjusting
entries are posted to accounts for some accruals and deferrals.

7. Financial Statements

Financial Statements: Next the balance sheet, income statement, and cash flow
statement are prepared by using the correct balances.

8. Closing

Closing: The revenue and expense accounts are fixed for the next accounting
cycle. This is because revenue and expense accounts are known as the income
statement accounts, which show performance for a certain period of time.
Balance sheet accounts are not completed because they show the company’s
financial position at a fixed period of time.