Fundamentals of Accounting & Financial Analysis

Fundamentals of Accounting & Financial Analysis is the cornerstone of the subject Accounting & Auditing. This chapter lays the foundation for understanding how financial information is recorded, analyzed, and interpreted in any organization. It introduces key concepts, principles, and methods essential for accurate financial reporting and decision-making.

In this chapter, we will study the following topics:

• Accounting
• Meaning of Book-Keeping and Accounting
• Basic Terminology
• Generally Accepted Accounting Principles (GAAP)
• Double Entry System
• Rules for Double Entry System
• Financial Statements
• Types of Financial Analysis
• Techniques and Tools for Financial Analysis
• Comparative Financial Statements
• Common Size Financial Statements
• Ratio Analysis
• Trend Analysis
• Cash Flow Analysis
• Fund Flow Analysis

Accounting

Previous Year Questions

Year	Question	Marks
2023	Give journal entries for the following transactions without narration : Goods sold-to B for Rs 20,000 in cash and Rs 10,000 on credit. Goods returned by B for Rs 5,000. Withdrew goods of Rs 5,000 for personal use. Furniture purchased for office purposes worth Rs 30,000. Goods worth Rs 5,000 burnt by fire.	5 M
2021	What are compound journal entries?	2 M
2021	Explain Dual-aspect concept in context of Double Entry System of Accounting with suitable examples.	5 M

In all activities (whether business or non-business activities) and in all organisations (whether business organisations like a manufacturing entity or trading entity or non-business organisations like schools, colleges, hospitals, libraries, clubs, temples, political parties) which require money and other economic resources, accounting is required to be followed as the technique to account for these resources. 

In other words, in any organisation where there is involvement of money or economic resources, to ascertain the utility of such resources, accounting is essential. 

The technique of accounting involves a process which begins with the work of bookkeeping followed by the stage of accounting.

Meaning of Book-Keeping and Accounting

Book-keeping

• Recording of day to day business transactions in a systematic manner in the books of accounts is called book-keeping. It ensures that records of the individual financial transactions are correct, up-to-date and comprehensive.
• Bookkeeping includes recording of journals, posting in ledgers and balancing of accounts. 
• All the records before the preparation of trial balance is the whole subject matter of bookkeeping.
• The stage of bookkeeping is succeeded by accounting.

Accounting 

• Accounting, as an information system, is the process of identifying, measuring and communicating the economic information of an organisation to its management who need the information for decision making.
• American Institute of Certified Public Accountants (AICPA) defines accounting as : 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 a financial character, and interpreting results thereof. 

Feature	Book-keeping	Accounting
Nature	Identification, Measurement, Recording, and Classifying financial transactions.	Summarizing, Interpreting, and Communicating the results of recorded transactions.
Objective	Only to record systematically.	To ascertain business income and financial position by maintaining records of transactions.
Function	Limited (to recording business transactions)	Wide (includes interpretation and communication of results)
Basis	Vouchers and other supporting documents are necessary	Book-keeping serves as the basis
Level of Knowledge	Elementary knowledge of accounting required	Advanced and in-depth knowledge required
Relation	First step to accounting	Begins where bookkeeping ends
Type	Clerical	Analytical
Users	Used by internal users only	Used by internal and external users.

Qualitative Characteristics of Accounting Information

Accounting generates information that helps people make decisions. For the information to be useful, it should have these qualities:

1. Reliability : Information must be reliable, free from personal bias.
2. Relevance: It should be available on time, help in making predictions, provide feedback, and influence decisions.
3. Understandability: The information should be presented clearly so that users can easily understand it.
4. Comparability: Users should be able to compare the financial information of one business with another.
5. Verifiability: Different experts should reach the same conclusions when reviewing the same financial data.
6. Timeliness: The information should be available at the right time to help in decision-making.

Objectives of Accounting

The objectives of accounting may differ from business to business depending upon their specific requirements. However, the following are the general objectives of accounting:

1. To keep a systematic record.
2. To ascertain the results of the operation (Profit & Loss).
3. To ascertain the financial position of the business.
4. To portray the liquidity position.
5. To protect business properties.
6. To facilitate rational decision-making.
7. To satisfy the requirements of law.

Advantages of Accounting

The following are the advantages of accounting to a business:

1. It helps in having complete record of business transactions.
2. It supplies meaningful information (profit or loss made by the business) about the financial activities of the business to the owners and the managers.
3. It provides useful information for making economic decisions.
4. It facilitates comparative study of current year’s profit, sales, expenses etc. with those of the previous years.
5. It supplies information useful in judging the management’s ability to utilise enterprise resources effectively in achieving primary enterprise goals.
6. It provides users with factual and interpretive information about transactions and other events which are useful for predicting, comparing and evaluating the enterprise’s earning power.
7. It helps in complying with certain legal formalities like filing of income tax and sales tax returns. Properly maintained accounts facilitates the correct assessment of taxes.
8. Helpful in taking decisions regarding taking/giving loans.
9. Can be presented as evidence in court.

Limitations of Accounting

1. Accounting is historical in nature as it does not reflect the current financial position or worth of a business.
2. Transactions of non-monetary nature do not find place in accounting. Accounting is limited to monetary transactions only. It excludes qualitative elements like management, reputation, employee morale, labour strike and such matters.
3. Facts recorded in financial statements are greatly influenced by accounting conventions and personal judgements of the Accountant or Management.Valuation of inventory, provision for doubtful debts and assumption about useful life of an asset may, therefore, differ from one business house to another.
4. Accounting principles are not static or unchanging. Alternative accounting procedures are often equally acceptable. Therefore, accounting statements do not always present comparable data.
5. Historical cost concept is found in accounting. Price changes are not considered. Money value is bound to change often from time to time. This is a strong limitation of accounting.
6. Accounting statements do not show the impact of inflation.
7. Accounting statements do not reflect increase in those net asset values that are not considered realised.

Process

Stakeholders to whom Accounting is Important

Following are the parties or stakeholders to whom accounting is important:

Basic Terminology

Capital:

Refers to the amount invested by the proprietor in a business enterprise.

• Capital is also known as – Owner’s Equity.

Drawings:

Any cash or value of goods withdrawn by the owner for personal use or any private payments made out of business funds. The proprietor pays interest on drawings to the business.

Liabilities:

It refers to the amount which the firm owes to outsiders.

• Example: Unpaid wages, Loans etc.
• Classification of liabilities
  • Internal: which business entity has to pay to the proprietor or owners.
  • External: which a business entity has to pay to outsiders.
  • Based on time : Non- current liabilities (to be paid after more than 1 year), Current liabilities (to be paid within 1 year)

Assets:

Assets are valuable resources owned by businesses that are acquired at a measurable money cost.

• Example: Cash, Land, Furniture, etc.
• Classification of assets
  • Non – Current Assets: Held for continued use in business for producing goods and services; and not meant for resale. Eg: Furniture, Land & Building.
    • Tangible assets – which have a physical existence. Eg. Cash, Computer 
    • Intangible assets – do not have a physical existence. Eg. Patents, Goodwill).
  • Current assets (Floating assets/ Circulating assets): Meant for sale or converted into cash within 1 year. Eg: Debtors, Stock, Bills receivables
  • Fictitious/ Nominal Assets: Fictitious assets are those assets which are neither tangible assets nor intangible assets but represent loss or expenses yet to be written off. Eg: Debit balance of P&L, deferred revenue expenditure.

Deferred Revenue Expenditure :

Some expenses provide benefits for multiple years, so they are not entirely recorded in one year’s Profit & Loss Account. Instead, they are gradually written off over several years.

• Example: If ₹5 lakh is spent on advertisements in 2023-24, benefiting the next four years, then every year ₹1.25 lakh (1/4th) will be written off, and the remaining amount will be recorded as Deferred Revenue Expenditure in the Balance Sheet (Assets Side).

Purchase :

Refers to acquiring goods meant for resale.

• If a business buys raw materials to manufacture and sell products, it qualifies as a purchase.
• If a business buys assets for office use (e.g., office furniture), it is not considered a purchase.

Sales :

Refers to selling goods that were purchased for resale.

• The sale of assets is not considered sales in accounting.
• Services provided for income are also included in sales.
• Sales can be cash or credit sales.

Purchase Returns (Returned Outward) : Goods returned to the supplier due to defects, quality issues, or other reasons.

Sales Returns (Returned Inward) : Goods returned by customers due to defects or other reasons.

• These goods come back into the business.

Receivables :

Receivables refer to the amount of money a business expects to receive from its debtors (customers who purchased goods or services on credit).

• Example: If a business sells goods to a customer on credit, the customer becomes a debtor, meaning the business has a right to receive payment from him.
• If the debtor accepts a bill payable at a later date, it is recorded as Bills Receivable in the company’s accounts.

Journal:

A Journal is called a book of prime entry because all business transactions are entered first in this book. It records both aspects of the transaction i.e., credit and debit, in chronological order.

Journal Format

Date	Particular	Ledger Folio	Debit Amount	Credit Amount
	Debit A/c………Dr.    To Credit A/c(Being…………………)

• Ledger Folio (L.F.) : Ledger Folio is a column in accounting records that helps in tracking entries between the journal and the ledger. It contains the page number of the ledger where a particular journal entry is posted.
• Compound Journal Entries: In certain cases, a transaction might involve multiple accounts or there could be several transactions of similar nature occurring on the same date. Handling these individually through separate journal entries could consume additional time and space. Therefore, to streamline the process, these transactions can be recorded collectively in a single entry known as a ‘compound journal entry’.
  • The entry in which more than one account is debited or more than one account is credited, is known as compound entry. Three or more accounts are connected with a compound entry.
• Ledger: A ledger is a principal accounting book where all financial transactions of a business are systematically recorded and classified under specific accounts. For example, personal, real, and nominal accounts. Every transaction from the journal is transferred to the relevant ledger accounts.

Debit (Dr.)				Credit (Cr)
Date	Particular	J.F	Amount	Date	Particular	J.F	Amount

• Accounting standards: Accounting standards, issued by the ICAI, standardize accounting policies and valuation norms to enhance the reliability and comparability of financial statements across different enterprises.

Generally Accepted Accounting Principles (GAAP)

• Refers to the rules or guidelines adopted for recording and reporting of business transactions, in order to bring uniformity and objectivity in the preparation and presentation of financial statements. For example, a key rule is to record all transactions at their historical cost (original cost).
• Accounting principles are classified into two categories:

• The accountings concepts are the basic assumptions and ideas which are fundamental to accounting practice and on the basis of which transactions are recorded and accounts are maintained.  
• Conventions are principles that have emerged out of accounting practices that are adopted by various organizations over the period.

Accountings Conventions

Convention of Consistency 

• According to the convention of consistency, same accounting principles should be adopted over
• different accounting periods for preparing financial statements. 
• It helps in better understanding of accounting information and makes accounts more comparable. 
• For example, if a firm has chosen to adopt the straight-line method of depreciation, then it has to follow the same method consistently for the upcoming years.
• Three types of consistency-
  • Vertical Consistency (Within the same organization): Ensures that accounting methods remain the same within a company.
  • Horizontal Consistency (Over time): Ensures the same accounting principles are followed across different accounting periods.
  • Dimensional Consistency (Between organizations): Ensures that similar businesses in the same industry follow consistent accounting methods.

Convention of Materiality 

• The concept of materiality requires that accounting should focus on material facts. Efforts should not be wasted in recording and presenting facts, which are immaterial in the determination of income.  
• The materiality of a fact depends on its nature and the amount involved. 
• Any fact would be considered as material if it is reasonably believed that its knowledge would influence the decision of informed user of financial statements.  
• For example, Stock of erasers, pencils, scales, etc. is not shown as assets, and whatever amount of stationery is bought in an accounting period is treated as the expense of that period, whether consumed or not. 

Convention of Conservatism/Prudence 

• This convention clearly states that profit should not be recorded until it is realised. But if the business anticipates any loss in the near future, provision should be made in the books of accounts for the same.
• For example, creating provision for doubtful debts.
• Due to the principle of conservatism, the profit and loss of the company will disclose lower profits in comparison to the actual profits.

Convention of Full Disclosure

• According to this convention, all the economic activities of a business entity should be completely and understandably reported in the financial statements.
• It is relevant for taking rational decisions.

Accounting Concepts

Business Entity Concept : 

• This concept recognizes that business and owner are two separate and distinct entities. 
• It means when proprietor introduces money in the business, the accountant records it as a liability (capital). 
• Similarly when proprietor withdraws any amount from firm for his personal purposes, then it is treated as drawings.

Money Measurement Concept : 

• As per this concept, only those transactions and events are recorded which can be measured in terms of money. 
• For example, knowledge and skills of the manager of the organization are the assets for the organizations but their measurement in monetary terms is not possible therefore, not included in the books of account.

Going Concern Concept : 

• The concept of going concern assumes that a business firm would continue to carry out its operations indefinitely and would not be liquidated in the foreseeable future.

Accounting Period Concept (Periodicity Concept): 

• The accounting period concept requires that the entire life of the business is divided into smaller time intervals for the measurement of the profits of the business.
•  Usually the period of 12 months is taken for accounting purposes.

Historical Cost Concept : 

• According to this concept, an asset purchased is recorded in the books of accounts at the price paid to acquire it i.e. at its cost of acquisition and not at its market price.

Matching Concept

• The matching concept requires that the expenses for an accounting period are to be matched against related revenues rather than cash received or cash paid. 
• While ascertaining the profit or loss of an accounting year, we should not take the cost of all the goods produced or purchased during that period but consider only the cost of goods that have been sold during that year.

Realisation/Revenue Recognition Concept : 

• As per this concept, revenue is recognized when goods or services are transferred and a consideration or promise of consideration is received.

Accrual Concept : 

• Under accrual concept, the effects of transactions and other events are recognised on mercantile basis i.e., when they occur (and not when cash is received or paid)
•  They are recorded in the accounting records and reported in the financial statements of the periods to which they relate.

Dual Aspect Concept : 

• This concept recognizes that there are two aspects of each and every transaction. Every transaction has a dual effect and should therefore be recorded at two places. 
• In other words, every transaction affects at least two accounts. If one account is debited, any other account must be credited.
• It is because of this concept the two sides of the balance sheet will always be equal. (Accounting Equation)

 Assets = Capital + Liabilities

• For example if machinery is purchased by the business on cash basis, then on the one hand machinery is coming into the business but on the other hand cash is going out of business.
• This dual effect may be:
  • Increase in asset and decrease in asset
  • Increase or decrease in both (assets and liabilities)
  • Increase in liability and decrease in liability.
• This concept is the core principle of accounting and is called as double entry system of bookkeeping.

Objective Evidence Concept : 

• The concept of objectivity requires that accounting transactions should be recorded in an objective manner and should not be influenced by personal bias and opinions.
• This can be possible when each of the transactions is supported by verifiable documents or vouchers.