PROJECT FILE

Principles of Financial Accounting

Introduction to Financial Accounting, Accounting

Concepts and Conventions, Nature, Purposes and
Limitations.

Submitted To :
Prof. N.K. Sehgal

Submitted By:
Jashandeep Singh Warrich
Roll No. 190/14
B.Com LLB (Hons.)
Section C

University Institute of Legal Studies,Panjab University, Chandigarh

ACKNOWLEDGEMENT

It is with profound gratitude and deep reverence that we complete this project
report, as it would have note been possible for us to do so without the
indispensable guidance of our professor Prof. N.K. Sehgal, who not only
encouraged us to go forward with this project report but also propagated all our
ideologies and interpretations about the same.

I would also like to extend my gratitude to our families and fellows, as without
their help we would not have been able to complete such extensive research for
this project report.

Thank You!

Contents
S.N
o

Content

Page No.

1.

Introduction to financial
Accounting

4.

2.

Objectives of Financial Accounting

5.

3.

Qualities of financial accounting

6.

4.

Accounting Concepts and

5.

6.

Conventions

7.

-Accounting Concepts

7.

-Accounting conventions

9.

Nature, Purposes and Limitations

of Financial Accounting

13.

Bibliography

18.

Introduction to Financial Accounting

A field of accounting that treats money as a means of measuring economic

performance instead of as a factor of production. It encompasses the entire
system of monitoring and control of money as it flows in and out of an
organization as assets and liabilities, and revenues and expenses.
Financial accounting gathers and summarizes financial data to prepare financial
reports such as balance sheet and income statement for the organization's
management, investors, lenders, suppliers, tax authorities, and other
stakeholders.1
Financial accounting (or financial accountancy) is the field of accounting
concerned with the summary, analysis and reporting of financial transactions
pertaining to a business. This involves the preparation of financial statements
available for public consumption. Stockholders, suppliers, banks, employees,
government agencies, business owners, and other stakeholders are examples of
people interested in receiving such information for decision making purposes.

Financial accountancy is governed by both local and international accounting

standards. GAAP (which stands for Generally Accepted Accounting Principles)
is the standard framework for guidelines for financial accounting used in any
given jurisdiction. It includes the standards, conventions and rules that
accountants follow in recording and summarising and in the preparation of
financial statements. On the other hand, IFRS (International Financial Reporting
Standards) is a set of international accounting standards stating how particular
types of transactions and other events should be reported in financial statements.
IFRS are issued by the International Accounting Standards (IASs). With IFRS
becoming more widespread on the international scene, consistency in financial
reporting has become more prevalent between global organisations.

Financial accounting is used to prepare accounting information for people

outside the organisation or not involved in the day-to-day running of the
company, management accounting provides accounting information to help
managers make decisions to manage the business.

Objectives of Financial Accounting

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One of the main functions of financial accounting is the preparation of final

accounts, also commonly referred to as financial statements. These consist of a
profit and loss account and a balance sheet. In the case of companies, the final
accounts are often referred to as published accounts. These are sent to
shareholders in the form of a pamphlet known as the annual or corporate report.
It is therefore usual to discuss the objectives of company final accounts in terms
of the functions of annual reports.
The basic objective of accounting is to provide information to the interested
users to enable them to make business decisions. The necessary information,
particularly in the case of external users, is provided in the basic financial
statements: Profit and loss statement and Balance sheet.
Besides the above sources of information, the internal users, officers and staff of
the enterprise, can obtain additional information from the records of business.

The users of financial statements may be broadly classified in the following

groups
The investor This group includes both existing and potential owners of shares
in companies. They are broadly interested in the performance of the entity and
the dividend declared by such entity. They also measure the social and
economic policies of the company to decide whether they will remain
associated with such entity.
The lender This group includes both secured and unsecured lenders. Such
creditors may be financing long term or short term loans. The financial
statements are analysed to determine an organisations ability as to pay the
interest on due date, the growth and stability of the organisation, capability of
repaying the loan as agreed upon, and. the book value of assets offered as
security by the organisation.
The customers and suppliers While customers are interested in the ability of
the organisation to provide goods/services, the suppliers are interested in the
capability of the organisation to pay their dues as and when due.
The government This group includes various taxation authorities viz. Income
tax, Excise department, Sales tax department etc. and also various other
government authorities for statistical purposes and for framing various
economic and planning policies.

The employee group The employees are concerned with the capability of an
organisation to pay their present emoluments and future retirement benefits.
Moreover, financial statements help them to asses job security.
The analyst Advisors to the management, investors, employees or public at
large collect various data from financial statements to advise their clients.
The Management Financial statements provide required information to
different levels of management to assist them in making decisions at each
appropriate level.

Qualities of financial accounting

Financial accounting is the preparation of financial statements that can be
consumed by the public and the relevant stakeholders using either HCA or
CPPA. When producing financial statements, they must comply to the
following:
Relevance: accounting which is decision-specific. It must be possible for
accounting information to influence decisions. Unless this characteristic is
present, there is no point in cluttering statements.
Materiality: information is material if its omission or misstatement could
influence the economic decisions of users taken on the basis of the financial
statements.
Reliability: accounting must be free from significant error or bias. It should be
capable to be relied upon by managers. Often information that is highly relevant
isnt very reliable, and vice-versa.
Understandability: accounting reports should be expressed as clearly as possible
and should be understood by those at whom the information is aimed.
Comparability: financial reports from different periods should be comparable
with one another in order to derive meaningful conclusions about the trends in
an entitys financial performance and position over time. Comparability can be
ensured by applying the same accounting policies over time.

Accounting Concepts and Conventions

7

Accounting concepts and conventions evolved as a result of information needed

by the users of accounting information which became conflicting over time
because of different methodology or procedure used in its preparation .it was
thereby adopted to ensure that accounting information is presented accurately
and consistently
Accounting concepts and conventions could be defined as ground or laid down
rules of accounting that should be followed in preparation of all accounts and
financial statements.2

Accounting Concepts
Accounting concepts are also basic assumptions or truths which are accepted by
people with out further proof. They are conceptual guidelines for application in
the financial accounting process. According to Glenn A. Wisch and Daniel G.
Short the concepts are important because they
i) help to explain the 'why' of the accounting
ii) provide guidance to deal with new accounting problems
iii) there is no need to memorise accounting procedures.
There are different kinds of accounting concepts and conventions
The concepts include
i.GOING CONCERN CONCEPT
Giving the fact that a business entity is solvent and viable this concept assumes
the notion that the business unit will have a perpetual existence and will not be
sold or liquidated
ITS IMPORTANCE
It supports the use of historical cost concept in measuring assets such as;
supplies equipments etc. that will be used in operation of a business. Without
the Going concern concept accounts will be drawn up on a winding up basis.
ii. ENTITY CONCEPT

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This concept states that every business unit not withstanding its legal existence
is treated a separate entity from the body or bodies that owe it, this implies that
its existence is distinct from its owner(s).
ITS IMPORTANCE
It records and reflects the financial activity of the specific business organization
and not of its owner(s) or employees. It is also important because it ensures that
a company and its owner(s) can contract and sue each other incase of any
misunderstanding arising in the future.
iii. MATCHING OR ACCURAL CONCEPT
This concept states that in an accounting period the earned income and the
incurred cost which earned the income should be properly matched and reported
for the period. This concept is also universally accepted in Manufacturing,
Trading organization.
Points to considered when matching
1. Outstanding expenses though not paid for in cash are shown in the profit and
loss accounts.
2. Prepaid expenses are not shown in profit and loss accounts
3. Income receivable should be added in the revenue
4. Income receivable in advance should be deducted from revenue
ITS IMPORTANCANCE
Accrual concept attempt to correctly match all the accounting expenses (cost) to
income (revenue) to the time it occurs at that accounting period. It also enables
all revenue and expenditure of an accounting period to be recognized. It helps
specify the profit of the organization in the accounting period.
iv. REALISATION CONCEPT
Realization concept encourages the periodic recognition of revenue as soon as it
can be measured and the value of the assets is reasonably certain
In realization the revenue are realized in three basis
1. Basis of cash
2. Basis of sale
3. Basis of production.

ITS importance
It encourages the recognition of transaction and profit arising from them at the
point of sale or transfer of ownership
v. HISTORICAL COST CONCEPT
This concept implies that all assets acquired, service rendered or received,
expenses incurred etc. should be recorded in the books at the price at which it
was acquired
(Its cost price). The cost is distinct from its value and the record does not
signify the value. It also holds that cost is the most reliable and verifiable value
at which a good is or services should be initially recognized.
ITS importance
It allows the record of all transaction no matter how minute it may be before it
might or might not be subjected to depreciation.
vi. DUAL ASPECT CONCEPT
This concept ensures that transaction are recorded in books at least in two
accounts, if one account is debited its also credited with the same amount in a
different account. The recording system is also known as double entry system.
Assets = Liabilities + Capital.
vii. MONEY MEASUREMENT CONCEPT
This concept states that an item should not be recorded unless it can be
quantified in monetary terms in other words it specifies that accountants should
not record facts that are not expressed in money terms.
ITS importance
This concept could be said to be efficient because money enables various things
of diverse nature to be added together and dealt with.3

Accounting Conventions
The term 'convention' includes those customs and traditions which guide the
accountant while preparing the accounting statements. Conventions have their
origin in the various accounting practices followed by the accountant. It is very
difficult to trace the origin of the conventions and establish their authenticity as
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accounting principles. But by usage they have attained the status of accounting
principles.

In this study the basic principles on which accounting is based are proposed to
be classified into 'Accounting Concepts ' and 'Accounting Conventions'. All
those basic assumptions or conditions upon which the science of accounting is
based are grouped under accounting concepts .Those customs or traditions
which guide the accountant while preparing the accounting statements are
included under the head accounting conventions.
The accounting conventions followed in the preparation of accounting
statements are

1.Conservatism
The rule of the accountant is 'anticipate no profit but provide for all possible
losses' at the time of recording the business transactions and preparation of
annual financial statements. The accountant wants to be on the safer side by not
taking some profits which may be received but which is not yet received and
providing for losses which he thinks may happen but which has not yet
happened. This is because he thinks the chances of non-receipt of anticipated
profit and the incurring of losses anticipated are higher. If he is very optimistic
regarding receipt of profits and non incurring of losses , the financial
statements may present a very rosy picture of the state of affairs of the entity
which may not subsequently materialise. So he acts conservatively by not taking
anticipated profits and but taking anticipated losses in the preparation of the
financial statements.

Because of the convention of conservatism inventory is valued at 'lower of cost

or market price and provision is made for bad and doubtful debts out of current
year's profits. But reckless application of this convention may lead to creation of
'secret reserves' and the financial statements may fail to disclose a true and fair
view of the state of affairs of the business.

2.Materiality
11

The convention of materiality advocates that the accountant should give

importance to transactions and events which are material in the preparation of
accounts and presentation of financial statements. He should ignore those items
in the recording of transactions and preparation of financial statements, items
which are immaterial or not having much bearing in giving a true and fair view
of the state of affairs of the entity. It is very difficult to fix a threshold limit in
deciding materiality or non-materiality of events. It is left to the discretion and
best judgement of the accountant to decide upon the materiality and nonmateriality of events. Materiality is dependent on the purpose for which
reporting is being done. For example at the time of preparing the annual
financial statements the accountant may ignore paise altogether and may even
round of the figures to the nearest 10 rupees with out affecting the true and fair
view of the statement.

According to Kohler " Materiality is the characteristic attaching to a statement

,fact or item whereby its disclosure or method of giving it expression would be
likely to influence the judgement of a reasonable person."

Accounting is designed by man with a set of objectives. AICPA has observed "
The accounting principles cannot therefore be derived from or proven by the
laws of nature." They are rather in the category of conventions or rules
developed by man from experience to fulfill the essential and useful needs and
purposes ,in establishing reliable financial and operating information system to
control business activities. In this respect they are similar to principles of
commercial and other social disciplines.

3.Consistency
According to the convention of consistency the accounting practices employed
should be consistent, that is, applied without change in the coming periods also.
In other words the practices should not be changed with out sufficient reason.
For example if stock is valued on the basis of 'cost or market price which ever is
lower' the same method should be employed year after year. If depreciation is
charged on straight line method ,the same method of computing depreciation
should be used thereafter. Consistency of the methods employed should be
maintained due to various reasons. First of all it will help the users to make

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comparative study of financial statements by employing methods of intra-firm

and inter-firm comparison.
Again consistency increases the acceptability of the financial statements since
the users are averse to frequent changes. Consistency should not be maintained
at the cost of accounting development. There should be flexibility in the
methods and practices employed. Other wise it will stifle the growth of
accounting thought. But full disclosure of the changes effected and its effect on
the working results and financial statements of the business should be disclosed.
This will help the users to ascertain the impact of the changes on the
performance of the business.

4.Full disclosure
The very purpose of accounting is to facilitate the preparation of the income
statement and the statement of financial position so that the operating results of
the entity and the financial position could be ascertained. This is done at
periodic intervals usually on an annual basis. The business enterprise should
provide through the financial statements all the relevant information required
,so as to enable the external parties to make sound economic and investment
decisions. Any information which is relevant and likely to influence the decision
making process of the user should not be left out. This is more important in the
case of joint stock companies since the members and outsiders have no access
to the accounting records of the company and have to depend on the published
annual financial statements to dig out information relating to the company. If
full disclosure is not made the financial statements may present a distorted
picture of the entity. In India the Companies Act 1956 prescribes the form in
which the balance sheet should be presented , the items to be disclosed in the
profit and loss account and the accounting policies followed by the entity etc
with a view that the principle of full disclosure is followed.4

Nature, Purposes and Limitations of Financial

Accounting
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Nature
We know Accounting is the systematic recording of financial transactions and
presentation of the related information of the appropriate persons. The basic
features of accounting are as follows:
1. Accounting is a process: A process refers to the method of performing any
specific job step by step according to the objectives, or target. Accounting is
identified as a process as it performs the specific task of collecting, processing
and communicating financial information. In doing so, it follows some definite
steps like collection of data recording, classification summarization, finalization
and reporting.
2. Accounting is an art: Accounting is an art of recording, classifying,
summarizing and finalizing the financial data. The word art refers to the way
of performing something. It is a behavioral knowledge involving certain
creativity and skill that may help us to attain some specific objectives.
Accounting is a systematic method consisting of definite techniques and its
proper application requires applied skill and expertise. So, by nature accounting
is an art.
3. Accounting is means and not an end: Accounting finds out the financial
results and position of an entity and the same time, it communicates this
information to its users. The users then take their own decisions on the basis of
such information. So, it can be said that mere keeping of accounts can be the
primary objective of any person or entity. On the other hand, the main objective
may be identified as taking decisions on the basis of financial information
supplied by accounting. Thus, accounting itself is not an objective, it helps
attaining a specific objective. So it is said the accounting is a means to an end
and it is not an end in itself.
4. Accounting deals with financial information and transactions; Accounting
records the financial transactions and date after classifying the same and
finalizes their result for a definite period for conveying them to their users. So,
from starting to the end, at every stage, accounting deals with financial
information. Only financial information is its subject matter. It does not deal
with non-monetary information of non-financial aspect.
5. Accounting is an information system: Accounting is recognized and
characterized as a storehouse of information. As a service function, it collects
processes and communicates financial information of any entity. This discipline
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of knowledge has been evolved out to meet the need of financial information
required by different interested groups.
The basic aim of accounting in a business entity is to provide financial
information for making decisions on its activities. Managers of an economic
entity at various levels require analysed financial information for planning and
programming, for controlling expenditure, for ascertaining the extent of
profitability or otherwise of a department even of each production item for
undertaking new jobs, etc. Financial information in tabular forms and with
graphs and charts are also required by the outsiders, namely, bankers, financial
institutions, creditors, investors, government agencies and even by the labour
unions and the general public who have some interest in the particular business
concern.5

Purposes of Financial Accounting

The objective of financial statements is to provide information about the
financial position, performance and changes in financial position of an
enterprise that is useful to a wide range of users in making economic decisions
(IASB Framework).
Financial accounting for a business is generally done by an outside company,
and several people receive the reports. The company's managing officers and
the various stockholders and owners usually receive a copy. This allows
everyone involved to see how a company is progressing in terms of profits and
other economic goals. It helps companies to create new goals, to know where
and when they should spend their money and to know whether or not their
efforts are turning into profits.
Financial Statements provide useful information to a wide range of users:
Managers require Financial Statements to manage the affairs of the company by
assessing its financial performance and position and taking important business
decisions.
Shareholders use Financial Statements to assess the risk and return of their
investment in the company and take investment decisions based on their
analysis.
Prospective Investors need Financial Statements to assess the viability of
investing in a company. Investors may predict future dividends based on the
5http://classof1.com/homework_answers/financial_accounting/meaning_and_natu
re_of_financial_accounting
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profits disclosed in the Financial Statements. Furthermore, risks associated with

the investment may be gauged from the Financial Statements. For instance,
fluctuating profits indicate higher risk. Therefore, Financial Statements provide
a basis for the investment decisions of potential investors.
Financial Institutions (e.g. banks) use Financial Statements to decide whether to
grant a loan or credit to a business. Financial institutions assess the financial
health of a business to determine the probability of a bad loan. Any decision to
lend must be supported by a sufficient asset base and liquidity.
Suppliers need Financial Statements to assess the credit worthiness of a
business and ascertain whether to supply goods on credit. Suppliers need to
know if they will be repaid. Terms of credit are set according to the assessment
of their customers' financial health.
Customers use Financial Statements to assess whether a supplier has the
resources to ensure the steady supply of goods in the future. This is especially
vital where a customer is dependant on a supplier for a specialized component.
Employees use Financial Statements for assessing the company's profitability
and its consequence on their future remuneration and job security.
Competitors compare their performance with rival companies to learn and
develop strategies to improve their competitiveness.
General Public may be interested in the effects of a company on the economy,
environment and the local community.
Governments require Financial Statements to determine the correctness of tax
declared in the tax returns. Government also keeps track of economic progress
through analysis of Financial Statements of businesses from different sectors of
the economy.6

Limitations of Financial Accounting

Financial accounting is the only branch of accounting and it is not prefect.
There are large numbers of limitations which open new way to use other tools
of accounting. To know what are the main limitations of financial accounting. It
is very necessary for accountants. Accountants are often blind to these
limitations.
Some limitations are :
1. Financial accounting is of historical nature
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Net effect of transactions are recorded in financial accounting which has

happened in past. These accounts is just postmortem of all events of business in
past .These record does not help for future planning and other managerial
decisions. Financial accounting shows the profitability of business but it is
failure to tell that is it good or bad. Financial accounting is also failure to know
the reasons of low profitability position.
2. Financial accounting deals with overall profitability
Accounts of business are made by a way which shows only overall
profitability .It does not shows net profit per product , or per department or
according to job . Thus to find difficult to all activities which do not give profit.
So, it creates inefficiency in business activities.
3. Absence of full disclosure of facts
In financial accounting we record only those activities and transactions which
we can show or describe in money. There are many other facts of business
which are non financial and non monetary like efficient management, demand
of products of firm , good relations in industry , good working environments
which can not be known by financial accounting .
4. Financial reports are interim report of business
Financial statements made by financial accounting is the interim report of firms
all business work but financial position and profitability which are shown in it is
not fully true . Due to adopting cost concept, all transactions are recorded on it
real cost but by changing in the time; it is the need of time to adjust cost of
assets and liabilities according to inflation of market. Because, financial
accounting does not records according to inflation so its result does not show
true position of business.
5. Incomplete knowledge of costs
From cost point of view, financial accounting is incomplete. In financial
accounting, accountant does not calculate each and every products total cost.
So, financial accounting does not help to determine the price of product of
business.

6. No provision of cost control

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Financial accounting does not help business organization for controlling the
cost. Because, there is no provision of controlling cost in it. In financial
accounting, we write cost, if we paid any expenses. Thus there is no provision
of improvement in financial accounting. Except this, there is no any other way
to inspect all expenses.
7. Financial statements are affected from personal judgment
Many events of financial statements are affected from personal judgement of
accountant. Method of calculating depreciation, rate of provision of doubtful
debts and stock valuation method are decided by accountant. Thus, financial
statements do not show true and fair view of business.
Cost Accounting is developed from within the accounting process to overcoat
the limitations of Financial Accounting and it helps in calculating, controlling
and reducing cost.

BIBILIOGRAPHY
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INTERNET REFERENCES

1. http://www.businessdictionary.com/definition/financial-accounting.html
2. http://hyattractions.wordpress.com/2012/05/19/what-are-accountingconcepts-and-conventions/
3. http://www.indianmba.com/Faculty_Column/FC1364/FC1364
BOOKS REFERENCES

1. S.P Jain, Financial Accounting, Kalyani Publications.

2. R Narayanaswamy: Financial Accounting: A Managerial Perspective, PHI

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