UNIT I : FINANCIAL ACCOUNTING

_______________________________________________________________________

1.1 INTRODUCTION:

Accounting has been termed as the language of business. The basic function of
accounting thus is to communicate the operating results of the business to the
stake holders and share holders of a business.

1.2 LEARNING OBJECTIVES

After going through this chapter, the reader is expected to –

1. Understand what accounting is, does and how its different branches serve the
purpose of providing information to the needy
2. Know the various users of accounting information
3. Identify the objectives of financial statements
4. Understand the various functions and limitations of financial accounting
5. Understand the generally accepted accounting principles (GAAP) which
governs the preparation of financial statements of a concern
6. Understand the various financial statements such as – balance sheet and its
related concepts, profit and loss account and its related concepts etc
7. Develop an idea about the concepts of inflation accounting and human
resources accounting

1.3. DEFINITION OF ACCOUNTING:

The American Institute of certified public accountants (AICPA) defined

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 the results thereof”.

1.4. OBJECTIVES OF FINANCIAL STATEMENTS

The basic objective of financial statements according to AICPA is ‘to provide

qualitative financial information about the business enterprise that is useful to
statement users, particularly owners and creditors in making economic decisions.
Apart from this the other important objectives are :
1) To provide information about the economic activities of the enterprise to several
external groups who, otherwise have no access to such information.
2) To provide useful information to investors and creditors in taking decisions
relating to investment and lending.
3) To provide information to potential investors in evaluating the earning power of
the enterprise.

1
 4) To provide economic information to the owners to judge the management on its
stewardship of the resources of the enterprise and the achievements of the
corporate objectives.
5) To provide information which enables the investors to compare the performance
with similar other undertakings and take appropriate decisions regarding retention
or disinvestments of their holdings.
6) To provide information regarding accounting policies and contingent liabilities of
the enterprise as these have a barring in predicting, comparing and evaluating the
earning power of the enterprise.

1.5. FUNCTIONS OF FINANCIAL ACCOUNTING :

1. Keeping systematic records

2 Protecting the properties of the business
3 Communicating the results to the stake holders of the business
4 Meeting the legal requirements

1.6. LIMITATIONS OF FINANCIAL ACCOUNTING :

1. Only transactions which can be measured in terms of money can be recorded

in the books of accounts. Events however important they may be to the
business do not find a place in the accounts if they can not be measured in
terms of money.
2. According to the cost concept assets are recorded at the cost at which they are
acquired and therefore ignore the changes in values of assets brought about by
changing value of money and market factors.
3. There is conflict between one accounting principle and another. For example,
current assets are valued on the basis of cost or market price whichever is less
according to the principle of conservatism. Therefore in one year cost basis
may be taken, whereas in another year market price may be taken. This
principle contravenes the principle of consistency.
4. The balance sheet is largely the result of the personal judgement of the
accountant with regard to the adoption of accounting policies and as such
objectivity factor is lost.
5. Financial accounting can be understood only by persons who have accounting
knowledge.
6. Inter firm comparison and comparative study of two periods is not possible
under this system as required past information cannot be made available.
7. Financial accounting does not indicate the cost behaviour, therefore cost
control cannot be adopted.

1.7. COST ACCOUNTING

DEFINITION: According to the Institute of Cost and Works Accountants

(ICWA), London, Cost accounting is “ the process of accounting for costs from the

2
 point at which expenditure is incurred or committed to the establishment of its
ultimate relationship with cost centers and cost units. In its widest usage it
embraces the preparation of statistical data, the application of cost control methods
and the ascertainment of the profitability of activities carried out or planned.”

1.8. OBJECTIVES OF COST ACCOUNTING :

1) to aid in the development of long range plans by providing cost data that acts
as a basis for projecting data for planning.
2) To ensure efficient cost control by communicating essential data costs at
regular intervals and thus minimize the cost of manufacturing.
3) Determine cost of products or activities, which is useful in the determination
of selling price or quotation.
4) To identify profitability of each product, process, department etc of the
business
5) To provide management with information in connection with various
operational problems by comparing the actual cost with standard cost, which
reveals the discrepancies or variances.

1.9. LIMITATIONS OF COST ACCOUNTING

Cost Accounting like other branches of accountancy is not an exact science but is an art
which was developed through theories and accounting practices based on reasoning and
commonsense. These practices are dynamic and evolving. Hence, it lacks a uniform
procedure applicable to all the industries across. It has to be customized for each
industry, company etc.

1.10. MANAGEMENT ACCOUNTING

DEFINITION : According to M.A.Sahaf Management Accounting is “ a system for

gathering, summarizing, reporting and interpreting accounting data and other financial
information primarily for the internal needs of the management. It is designed to assist
internal management in the efficient formulation, execution and appraisal of business
plans.”

Management Accounting covers not only the use of financial data and a part of costing
theory but extends beyond. It scope covers

1. Financial accounting
2. Cost accounting
3. Financial statement analysis
4. Budgeting
5. Inflation accounting
6. Management reporting
7. Quantitative techniques

3
 8. Tax accounting
9. Internal audit
10. Office services

1.11. FUNCTIONS OF MANAGEMENT ACCOUNTING :

1. To help the management in planning, forecasting and policy formulation

2. To help in analysis and interpretation of financial information
3. To help in decision making- long term as well as short term
4. To help in controlling and coordinating the business operations
5. To communicate and report the operational results to the share and stock
holders of the business.
6. To motivate the employees by encouraging them to look forward
7. To help the management in tax administration

1.12. TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING :

1. Financial planning
2. Analysis of financial statements
3. Cost accounting
4. Standard costing
5. Marginal costing
6. Budgetary control
7. Funds flow analysis
8. Management reporting
9. Statistical analysis

1.13. ADVANTAGES OF MANAGEMENT ACCOUNTING :

1. It increases efficiency of business operations

2. It ensures efficient regulation of business activities
3. It ensures utilization of available resources and thereby increase the return on
capital employed.
4. It ensures effective control of performance
5. It helps in evaluating the efficiency of the companies business policies

1.14. LIMITATIONS OF MANAGEMENT ACCOUNTING :

1. It is based on historical data, as such it suffers from the drawbacks of the

financial statements.
2. The application of management accounting tools and techniques requires
people who are knowledgeable in subjects such as accounting, costing,
economics, taxation, statistics, mathematics, etc.
3. Though management accounting attempts to analyse both qualitative and
quantitative factors that influence a decision, the elements of intuition in
managerial decision making have not been completely eliminated.

4
 4. The installation of management accounting system is expensive and hence not
suitable for small firms.

USERS OF FINANCIAL ACCOUNTS

Many people use financial statements for varied purposes. The table below summarises
the main user groups and provides examples of their areas of interest in accounts:

User Interest in / Use of Accounting Information

Investors Investors are concerned about risk and return in relation to their
investments. They require information to decide whether they should
continue to invest in a business. They also need to be able to assess
whether a business will be able to pay dividends, and to measure the
performance of the business' management overall. The key accounting
information for an investor is therefore:
- Information about growth - sales, volumes
- Profitability (profit margins, overall level of profit)
- Investment (amounts invested, assets owned)
- Business value (share price)
- Comparative information of competitors
Lenders Banks and loan stockholders who lend money to a business require
information that helps them determined whether loans and interest will
be paid when due. The key accounting information for lenders is
therefore:
- Cash flow
- Security of assets against which the lending may be secured
- Investment requirements in the business
Creditors Suppliers and trade creditors requirement information that helps them
understand and assess the short-term liquidity of a business. Is the
business able to pay short-term debt when it falls due? Creditors will,
therefore, be looking for information on:
- Cash flow
- Management of working capital
- Payment policy
Debtors Customers and trade debtors require information about the ability of the
business to survive and prosper. As customers of the company's
products, they have a long-term interest in the company's range of
products and services. They may even be dependent on the business for
certain products or services. Customer will be particularly interested in:
- Sales growth
- New product development
- Investment in the business (e.g. production capacity)

5
Employees Employees (and organisations that represent them - e.g. trade unions)
require information about the stability and continuing profitability of
the business. They are crucially interested in information about
employment prospects and the maintenance of pension funding and
retirement benefits. They are also likely to interested in the pay and
benefits obtained by senior management!. Employees will, therefore
look for information on:
- Revenue and profit growth
- Levels of investment in the business
- Overall employment data (numbers employed, wage and salary costs)
- Status and valuation of company pension schemes / levels of company
pension contributions
Government There are many government agencies and departments that are
interested in accounting information. Local government needs
information to levy local taxes and rates. Various regulatory agencies
need information to support decisions about takeovers and grants, for
example.
Analysts Investment analysts are an important user group - specifically for
companies quoted on a stock exchange. They require very detailed
financial and other information in order to analyse the competitive
performance of a business and its sector. Much of this is provided by
the detailed accounting disclosures that are required by authorities.
However, additional accounting information is usually provided to
analysts via informal company briefings and interviews.
Public at large Interest groups, formed by various groups of individuals who have a
specific interest in the activities and performance of businesses, will
also require accounting information.

1.16. ACCOUNTANCY PRINCIPLES (GAAP – GENERALLY ACCEPTED

ACCOUNTING PRINCIPLES)

Accounting principles, rules of conduct and action are described by various terms such as
concepts, conventions, tenets, assumptions, axioms, postulates, etc.

1.16.1. Accounting concepts

The term ‘Concept’ is used to mean necessary assumptions and ideas which are
fundamental to accounting practice. The various accounting concepts are as
follows:

• Business Entity concept : For accounting purposes, the proprietor of an entreprise

is always considered to be separate and distinct from the business which he/she
controls

6
• Dual aspect concept : Every business transaction involves two aspects – a receipt
and a payment. i.e, every debit has an equal and corresponding credit. The dual
aspect concept is expressed as : Capital + Liabilities = Assets. This is known as
‘the accouting equation’.
• Going concern concept :Under this assumption, the entreprise is normally viewed
as a going concern. It is assumed that the entreprise has neither the intention nor
the necessity of liquidation of of curtailing materially the scale of its operations.
That is why assets are valued on the basis of going concern concept and are
depreciated on the basis of expected life rather than on the basis of market value.
• Accounting period concept : ‘Accounting year’ is the period of 12 months for
which accounts are to be prepared under the Companies Act and Banking
Regulation Act.
• Money measurement concept : In accounting, every event or transaction which
can be expressed in terms of money is recorded in the books of accounts. This
concept doesnot record any fact or happening, however important it is to the
business, in the books of accounts if it cannot be expressed in terms of money.
And as per this concept, a transaction is recorded at its money value on the date of
occurance and the subsequent changes in the money value are conveniently
ignored.
• Historical Cost concept : The underlying idea of cost concept is – I) asset is
recorded at the price paid to acquire it, that is, at cost and ii) this cost is the basis
for all subsequent accounting for the asset. Fixed assets are shown in the books of
accounts at cost less depreciation. Current assets are periodically valued at cost
price or market price whichever is less.
• Revenue recognition concept : In accounting, ‘revenue’ is the gross inflow of
cash, receivables or other considerations arising in the course of an enterprise
from the sale of goods, from the rendering of services and from the holding of
assets. In the case of revenue, the important question is at what stage, the
transaction should be recognised and recorded.
• Periodic matching of cost and revenue concept : After the revenue recognition,
all costs, incurred in earning that revenue should be charged against that revenue
in order to determine the net income of the business.
• Verifiable objective evidence concept : As per this concept, all accounting must
be based on objective evidence. I.e, the transactions should be supported by
verifiable documents.
• Accrual concept : Under this concept, revenue recognition and costs for the
relevant period, depends on their realisation and not on actual receipt or payment.
In relation to revenue, the accounts should exclude amounts relating to subsequent
period and provide for revenue recognised, but not received in cash. Like wise, in
relation to costs, provide for costs incurred but not paid and exclude costs paid for
subsequent period.

7
1.16.2. Accounting conventions

The term ‘convention’ is used to signify customs or traditions as a guide to the

preparation of accounting statements. The various accounting conventions are as
follows.

• Convention of disclosure : This convention implies that accounts must be

honestly prepared and all material information must be disclosed therein. The
term ‘disclosure’ implies that there is to be a sufficient disclosure of information
which is of material interest to proprietors, present and potential creditors and
investors. This concept also applies to events occuring after the balance sheet
date and the date on which the financial statements are authorised for issue, which
are likely to have a substantial influence on the earnings and financial position of
the enterprise. Their non-disclosure would affect the ability of the users of such
statements to make proper evaluations and decisions.
• Convention of materiality : As per this convention, financial statements should
disclose all items which are material enough to effect evaluations or decisions.
The American Accounting Association (AAA) defines ‘ materiality’ as “an item
should be regarded as material if there is reason to believe that knowledge of it
would influence the decision of informed investor”. Unimportant items can be
either left out or merged with other items. Sometimes, items are shown as
footnotes or in parentheses according to their relative importance.
• Convention of consistency : Consistency, as used in accounting means that
persistant application of the same accounting procedures or method by a given
firm from one time period to the next so that the financial statements of different
periods can be compared meaningfully. This convention thus implies that in
order to enable the management to draw important and meaningful conclusions of
performance over a period or between different firms, accounting practices should
remain unchanged for a fairly long time.
• Convention of conservatism : According to this convention, the accountant
should be conservative in his/her approach in his estimated, opinions and
selection of procedure. In accounting, conservatism refers to the early recognition
of unfavourable events. For instance, all possible and expected losses must be
provided for. But on the other hand, gains and other financial benefits should not
be provided for unless they are realised. In other words, ‘anticipate no profit and
provide for all possible losses’.

1.17. PROFIT AND LOSS ACCOUNT AND RELATED CONCEPTS:

The starting point in understanding the profit and loss account is to be clear about the
meaning of "profit". Profit is the reward for taking risk. Profit has an important role in
allocating resources (land, labour, capital and enterprise). Put simply, falling profits
signal that resources should be taken out of that business and put into another one; rising
profits signal that resources should be moved into this business. The main task of
accounts, therefore, is to monitor and measure profits. Profit = Revenues less Costs. So

8
monitoring profit also means monitoring and measuring revenues and costs. There are
two parts to this:-
1) Recording financial data. This is the ‘book-keeping’ part of accounting.
2) Measuring the result. This is the ‘financial’ part of accounting.

Profits are ‘spent’ in three ways.

1) Retained for future investment and growth.
2) Returned to owners eg a ‘dividend’.
3) Paid as tax.

1.17.1. Components of Profit and Loss Account

The Profit & Loss Account aims to monitor profit. It has three parts.

1) The Trading Account: This records the money in (revenue) and out (costs) of the
business as a result of the business’ ‘trading’ ie buying and selling. This might be buying
raw materials and selling finished goods; it might be buying goods wholesale and selling
them retail. The figure at the end of this section is the Gross Profit.

2) The Profit and Loss Account : This starts with the Gross Profit and adds to it any
further costs and revenues, including overheads. These further costs and revenues which
may be in the nature of other operating, administrative, selling and distribution expenses.
This account also includes expenses which are from any other activities not directly
related to trading (non-operating). An example is interest on investments. Thus, profit
and loss account contains all other expenses and losses, incomes and gains of the
business for the accounting year for which financial statements are being prepared. In
this process, it follows the mercantile basis of accounting (i.e, it takes into account all
paid and payable expenses, and received and receivable receipts). The net result of profit
and loss account is called as net profit. The main feature of profit and loss account is that
it takes into account all expenses and incomes that belong to the current accounting year
and excludes those expenses and incomes that belong either to the previous period or the
future period.

3) The Appropriation Account. This shows how the profit is ‘appropriated’ or divided
between the three uses mentioned above.

1.17.2. INTRODUCTION TO THE TRADING ACCOUNT:

A Trading account is a statement prepared by a firm to ascertain its trading results for the
accounting year. Just like Profit & Loss account, it is also prepared for the year ending.
It takes into account the various trading expenses (usually all direct expenses) and
incomes. The net result will be either trading / gross profit or gross loss. In case of a
manufacturing concern, it will prepare an additional statement called a manufacturing
account. A manufacturing account is prepared by a manufacturer to ascertain the cost of
goods manufactured during the current accounting year.

9
1.17.3. FORMAT OF MANUFACTURING ACCOUNT:

Manufacturing account of ABC. Ltd for the year ending…..

PARTICULARS AMOUN PARTICULARS AMOUNT

To work-in-process (opening) By Closing stock

To Raw material consumed: Raw materials
Opening stock Work-in-process
Add: Purchase of raw material By Cost of production
Less: Closing stock of Raw transferred to Profit & Loss
material account
To Direct or productive wages
To Factory overhead:
Power and Fuel
Factory rent
Carriage inwards
Octroi. etc
TOTAL TOTAL

1.17.4. FORMAT OF TRADING ACCOUNT

Trading account of ABC. Ltd for the year ending…..

PARTICULARS AMOUN PARTICULARS AMOUNT

To Opening stock By Closing stock

To Purchases By Sales
To Direct or productive wages By Gross Loss transferred to
To wages and salaries Profit & Loss account
To Power and Fuel
To Factory rent
To Carriage inwards
To Octroi. etc
To Gross profit transferred to
Profit & Loss account
TOTAL TOTAL

1.17.5. Uses of the Profit and Loss Account.

1) The main use is to monitor and measure profit. This assumes that the information
recording is accurate. Significant problems can arise if the information is inaccurate,
either through incompetence or deliberate fraud.

10
2) Once the profit (loss) has been accurately calculated, this can then be used for
comparison or judging how well the business is doing compared to itself in the past,
compared to the managers’ plans and compared to other businesses.

1.17.6. The format of a typical profit and loss account is as follows:

PARTICULARS AMOUNT PARTICULARS AMOUNT

To Gross loss b/d By Gross profit b/d
To Salaries By interest received
To Salaries and wages By rent received
To Rent By commission received
To Commission By bad debts recovered
To Advertisement By Reserve for discount on
To Bad debts creditors
To Discount allowed By discount received
To Reserve for bad debts By gain on sale of fixed
To Reserve for doubtful debts assets
To Reserve for discount on debtors By net loss transferred to
To Freight/ carriage outwards capital account
To loss on sale of fixed assets
To uninsured loss due to fire
To interest on capital
To manger’s commission
To transfers to reserve
accounts
To net profit transferred to
capital account
TOTAL TOTAL

1.18. THE BALANCE SHEET AND RELATED CONCEPTS:

According to Howard, a Balance sheet may be defined as – ‘a statement which reports the
values owned by the enterprise and the claims of the creditors and owners against these
properties’.

The Balance sheet is a statement that is prepared usually on the last day of the accounting
year, showing the financial position of the concern as on that date. It comprises of a list
of assets, liabilities and capital. An asset is any right or thing that is owned by a
business. Assets include land, buildings, equipment and anything else a business owns
that can be given a value in money terms for the purpose of financial reporting. To
acquire its assets, a business may have to obtain money from various sources in addition
to its owners (shareholders) or from retained profits. The various amounts of money
owed by a business are called its liabilities. To provide additional information to the
user, assets and liabilities are usually classified in the balance sheet as:

11
 - Current: those due to be repaid (Current liabilities) or converted into cash within 12
months of the balance sheet date(Current Assets).

- Long-term: those due to be repaid (Long term liabilities) or converted into cash more
than 12 months after the balance sheet date (Fixed Assets).
Fixed Assets

A further classification other than long-term or current is also used for assets. A "fixed
asset" is an asset which is intended to be of a permanent nature and which is used by the
business to provide the capability to conduct its trade. Examples of "tangible fixed
assets" include plant & machinery, land & buildings and motor vehicles. "Intangible
fixed assets" may include goodwill, patents, trademarks and brands - although they may
only be included if they have been "acquired". Investments in other companies which are
intended to be held for the long-term can also be shown under the fixed asset heading.

Capital

As well as borrowing from banks and other sources, all companies receive finance from
their owners. This money is generally available for the life of the business and is
normally only repaid when the company is "wound up". To distinguish between the
liabilities owed to third parties and to the business owners, the latter is referred to as the
"capital" or "equity capital" of the company. In addition, undistributed profits are re-
invested in company assets (such as stocks, equipment and the bank balance). Although
these "retained profits" may be available for distribution to shareholders - and may be
paid out as dividends as a future date - they are added to the equity capital of the business
in arriving at the total "equity shareholders' funds".

At any time, therefore, the capital of a business is equal to the assets (usually cash)
received from the shareholders plus any profits made by the company through trading
that remain undistributed

1.18.3. The basic functions of a balance sheet are:

1. It gives the financial position of a company on any given date

2. It gives the liquidity picture of the concern
3. It gives the solvency position of the concern

1.18.4. The basic components of a balance sheet are:

LIABILITIES ASSETS
1. Net Worth 1. Fixed assets
2. Non-current liabilities / long term 2. Intangible assets
liabilities 3. Current assets
3. Current liabilities 4. Deferred expenditure

12
 5. Other assets

1.18.5. Pro-forma of a Balance sheet is as follows:

Balance sheet of ABC Ltd as on 31st December 2005

LIABILITIES AMOUNT ASSETS AMOUNT

(Rs) (Rs)
Capital Fixed assets
Add: Net profit for the Land & Buildings
period Plant & Machinery
Further capital introduced Equipment
Interest on capital Furniture & Fixtures
Less: Drawings Investments:
Interest on drawings Current assets:
Net loss for the period Sundry debtors
Loans Closing stock
Other long term borrowings Bills / Notes receivable
Sundry creditors Prepaid expenses
Bills / Notes payable Outstanding incomes
Outstanding expenses Cash in hand
Incomes received in advance etc Cash at bank etc

TOTAL LIABILITIES TOTAL ASSETS

1.18.6. COMMON ADJUSTMENTS AFFECTING THE PREPARATION OF

BALANCE SHEET ARE:

1. Income received in advance: Income received in respect of which service has

not been rendered is known as income received in advance. In order to calculate
the exact profit or less made during the year, such income should not be taken in
to account while preparing profit and loss account. Hence this amount must be
deducted from the respective income account in the profit and loss account and
must be treated as a liability in the balance sheet. The adjustment entry is

Income account Dr.

To income received in advance.

2. Closing stock : Closing stock appears on the credit side of trading account and
assets side of balance sheet if it is given in the adjustments. If it is given in the
trial balance it will appear only on the assets side of the balance sheet. The entry
passed is

Closing Stock A/c Dr.

13
 To Trading Account.

3. Outstanding expenses : Outstanding expenses refer to those expenses which

have become due during the accounting period for which financial statements are
being prepared, but not yet have been paid. Such expenses if given in the
adjustments, should be added to the respective expenditure account on the debit
side of profit and loss account and must be shown as liabilities in the balance
sheet. If such expenses are given in the trial balance they should be recorded only
on the liability side of the balance sheet. The journal entry to be passed is

Respective Expenditure A/c Dr.

To Outstanding Expenditure

4. Pre-paid expenses : They are those expenses which have been paid in advance.
They are also known as un-expired expenses. If given in adjustments, they
should be deducted from the respective expenditure account on the debit side of
the profit and loss account and must be shown on the asset side of the balance
sheet. If given in the trial balance, they must be shown only on the asset side of
the balance sheet. The adjustment entry is

Pre-paid expenditure A/c Dr.

To Respective Expenditure

5. Outstanding or accrued income : This is the income which has been earned
during the current accounting year and has become due but not yet received by the
firm. If given in the adjustments, it must be added to the respective income
account on the credit side of the profit and loss account and must be shown on the
assets side of the balance sheet. But if given in the trial balance, it must be shown
only on the asset side of the balance sheet. The entry is

Outstanding/Accrued Income A/c Dr.

To Respective Income

6. Depreciation : It is a reduction in the value of the asset due to wear and tear,
lapse of time, obsolescence, exhaustion and accident. It is charged on fixed assets
of the business. If given in the adjustments, it must be shown on the debit side of
the profit and loss account and must be deducted from the respective asset
account in the balance sheet. If given in the trial balance, it must be shown only
on the debit side of the profit and loss account. The entry is

Depreciation A/c Dr.

To Respective Fixed Asset

7. Bad Debts : They represent that portion of credit sales (debtors) that had become
bad due to the inability of the debtor to repay the amount. It is a loss to the
business and gain to the debtor. This is a real loss to the business and as such

14
 must be deducted from the debtors before deducting any reserves created on
debtors. If given in the adjustments it must be shown on the debit side of the
profit and loss account and must be deducted from the debtors account on the
asset side of the balance sheet. If given in the trial balance this amount must be
shown only in the profit and loss account. The entry is

Bad debts A/c Dr.

To Debtor’s personal account

8. Provision for bad debts : This represents a provision made by the business for
any potential bad debts. It is charged to the profit and loss account debit side and
must be deducted from the debtors after deducting the bad debts if any on the
asset side of the balance sheet, if given in the adjustments. If given in the trial
balance, it must be considered only in preparing the profit and loss account. The
entry is

Profit and loss A/c Dr.

To Provision for bad debts

9. Provision for doubtful debts : This represents a provision made by the business
for any potential doubtful debts. If given in the adjustments, it must be charged to
the profit and loss account debit side and must be deducted from the debtors after
deducting the bad debts (if any) and reserve for bad debts on the asset side of the
balance sheet. If given in the trial balance, it must be considered only in
preparing the profit and loss account. The entry is

Profit and loss A/c Dr.

To Provision for doubtful debts

10. Provision for doubtful debts : This represents a provision made by the business
for any potential discount to be allowed to the debtors. If given in the adjustments,
it must be charged to the profit and loss account debit side and must be deducted
from the debtors after deducting the bad debts (if any), reserve for bad debts (if
any) and reserve for doubtful debts (if any) on the asset side of the balance sheet.
If given in the trial balance, it must be considered only in preparing the profit and
loss account. The entry is

Profit and loss A/c Dr.

To Provision for discount on debtors
11. Reserve for discount on creditors: This represents a provision made by the
business for any potential discount to be allowed by the creditors of the business.
If given in the adjustments, it must be charged to the profit and loss account
credit side and must be deducted from the creditors on the liabilities side of the
balance sheet. If given in the trial balance, it must be considered only in
preparing the profit and loss account. The entry is

15
 Reserve for discount on creditors A/c Dr
To Profit and Loss A/c

12. Interest on capital: This is the return the owners of the business will get for
investing in the business. Usually it is paid or added to the capital at a fixed
percentage. If given in the adjustments, it is shown on the debit side of the profit
and loss account and is usually added to the capital account on the liabilities side
of the balance sheet. If given in the trial balance, it must be shown on the debit
side of profit and loss account. The entries are :

Profit and Loss A/c

To Interest on capital

Interest on capital A/c Dr

To capital A/c

13. Interest on Drawings: Drawings represents the withdrawals made by the owners
during the accounting year either in the form of stock, cash or withdrawal from
bank for personal use. They must be deducted from the capital account on the
liabilities side of the balance sheet. Sometimes, firms charge interest on such
drawings made by the owners to discourage them from withdrawing their
investment. Usually it is levied as a fixed percentage. It is an income to the
business and a loss to the owner. Hence, if given in the adjustments, it must be
shown on the credit side of the profit and loss account and deducted from the
capital in the balance sheet. If given in the trial balance, it must be shown only in
the profit and loss account. The respective entries are:

Interest on Drawings A/c Dr

To Profit and loss A/c

Interest on Drawings A/c Dr

To capital A/c

1.19. POINTS TO BE REMEMBERED WHILE PREPARING THE

FINANCIAL STATEMENTS:

1. Items given in the trial balance must be shown only once as it is assumed that they
are already adjusted once
2. Items given in the adjustments must be accounted for twice.
3. Any difference in the trial balance must be transferred to suspense account. If the
balance is short on the debit side, the difference must be shown on the asset side
of the balance sheet and if the balance is short on the credit side, it must be shown
on the liabilities side of the balance sheet.
4. Wherever required, working notes must be maintained for accuracy and clarity.

16
 5. Some of the adjustments are unique, such as distribution of free samples. They
are to be treated case by case.

1.20 INTRODUCTION TO INFLATION ACCOUNTING

Assessing a company's performance after adjusting for the effects of inflation is the
general meaning of inflation accounting. And it involves the adoption of definitions of
costs, revenue, profit and loss that are fully inflation-adjusted.

1.20.1 DEFINITION OF INFLATION ACCOUNTING

According to M.A.Sahaf, Inflation accounting is an accounting technique which aims to

record business transactions at current values and to neutralize the impact of changes in
the price on the business transaction.

1.20.2 REASONS FOR DISCREPENCIES IN ACCOUNTS DUE TO ADOPTION

OF HISTORICAL COST ACCOUNTS

1. Recording of fixed assets at their historical costs

2. Recording of inventory at historical cost instead of current cost
3. Recording of other assets and liabilities without taking into account their current
values

1.20.3 ISSUES IN INFLATION ACCOUNTING

1. ADJUSTEMENT OF HISTORIC COST DATA: In the early days of inflation

accounting development, business houses often used to debate whether the
historic cost data should be adjusted for inflation induced price level changes or
not. But, later they started to follow it all the same while preparing their financial
statements.
2. ADJUSTMENT ITEMS: While adjusting items for inflation, there are 2 approaches
one can take – 1) covering the adjustment of all financial items, 2) covering the
adjustment of only those items that have direct impact on financial results
3. USE OF INDEX NO: The opinion of experts is varied on the use of index numbers
for adjusting the financial accounts. They can either use general purchasing
power index or specific index number. Mostly the use of general purchasing
power index is recommended as (a) it replaces the monetary unit of measurement
which ceases to be stable during the changing price level (b) it provides the
uniform standard of measurement for comparing diverse resources (c) it can be
used for restating assets as well as shareholders capital (d) it communicates
information regarding utilization of funds and profits gained to the proprietors

1.20.4 TECHNIQUES OF INFLATION ACCOUNTING

17
 The most important techniques developed by professional institutes and accountants
to deal with inflationary conditions are (1) Current purchasing power – [CPP], (2)
Replacement cost accounting method [RCA], (3) Current value accounting method
[CVA] and (4) Current cost accounting method [CCA].

1. Current Purchasing Power [CPP] : This is a very popular method among

professional institutes. Under this system the business keeps its accounts
maintained under financial accounting system {i.e. conventional historical cost
basis}. Then at the end of the account period supplementary statements must be
prepared showing all the items of financial statements in terms of the value of a
rupee to which they relate. These supplementary statements indicate the changes
in the financial conditions of the concern during the financial period as a result of
changes in the purchasing power of a rupee. For this purpose general price index
is used.

2. Replacement cost accounting method [RCA] : This method attempts to resolve

financial reporting problems that arise during the periods of rapidly changing
prices. It states that firms should create fixed asset replacement provision in the
Profit and loss account which is adequate to meet the requirements. Thus the
charges to profit and loss account are governed by the replacement cost of each
item rather than the depreciation cost. This concept requires that the reported
amount of expenses are to be measured at the time of asset expiration. Further all
the non-monetary items must be reported at the respective replacement cost as on
the balance sheet date.

3. Current value accounting method [CVA] : Under this method all items of
balance sheet are shown at current values. According to this method, the net
assets at the beginning and at the end of the accounting period are ascertained and
difference is implied to be profit or loss for the period. It attempts to reflect
economic reality to the preparation of financial statements by using current values
for reporting various items in the balance sheet.

4. Current cost accounting method [CCA] : This method had been suggested as a
base for financial reporting by Sandiland Committee appointed by the British
Committee in 1973 to solve the problem of price level changes. The Committee
reported that CPP may be used along with either historical cost or value
accounting.

1.20.5 ADVANTAGES OF INFLATION ACCOUNTING

18
 1. It reflects an accurate picture of the profitability of the concern as it matches its
current revenues with its current costs. It keeps that capital intact as it does not
allow payment of dividend and taxes out of capital.
2. It enables a comparative study of the profitability of various concerns set up at
different periods.
3. As depreciation is charged on current value of assets, it is easier for the concern to
replace the assets.
4. By providing accurate financial information to the various interested parties, it
discharges the social obligation of the business.
5. It enables the company to realize a realistic price for its shares in the investment
market.

1.20.6 DIS-ADVANTAGES OF INFLATION ACCOUNTING

1. It is a complicated, confusing and time consuming process as it requires lot of

work.
2. The adjusted financial statements are difficult to be understood, analyzed and
interpreted by a common man. If proper conversion method is not adopted the
information provided may be inaccurate.
3. Income Tax Act of 1961 does not recognize the depreciation charged on current
value of fixed assets. Hence it is not suitable for tax purposes.
4. During inflation profits are overstated as lower depreciation is charged to fixed
assets.

1.21 INTRODUCTION TO HUMAN RESOURCE ACCOUNTING

The concept of HR accounting was not known to the world till the early 60’s. During
this period, few experts like Hermanson, Hekimian, Jones and Rensis Likert had
recognised HR as assets just like any other tangible or intangible assets.

1.21.1 DEFINITION OF HUMAN RESOURCE ACCOUNTING (HRA)

The term ‘HR Accounting’ implies accounting for Human resources – namely, the
knowledgeable, trained and loyal employees who participate in the earning process and
total assets. Different authors have defined HR Accounting in different terms. According
to the American Accounting Association (1973), HR Accounting is ‘the process of
identifying and measuring data about human resources and communicating the
information to interested parties’. In the words of Stephen Knauf – HR Accounting is
‘the measurement and quantification of human organization inputs, such as recruiting,
training, experience and commitment’.

Thus, HR Accounting had been defined by many authors in different ways. In essence, it
represents a systematic attempt to assess the value of human resource of an organization.

1.21.2 THE PROCESS OF HRA

19
The process of HR Accounting includes – identification and measurement or
quantification of human resource in an organization and its reflection in its annual reports
or financial statements.

1.21.3 THE OBJECTIVES OF HRA

The objectives of HR accounting are:

1. To provide relevant information about the human resource to the management and
aid in its decision making
2. To help management in evaluating the performance of its personnel and calculate
its return on investment
3. To help the management in planning and controlling the various functions or
activities related with its human resource such as – man power planning,
recruiting, training and retirement etc.

1.21.4 ADVANTAGES OF HRA

The various advantages a firm can enjoy by establishing HR Accounting are as follows:

1. Its adoption acts as a motivating factor for the employees of the concern as it is
reflected in its financial statements
2. It helps the management in identifying and controlling several problems related
with human resources
3. It enables the management in efficiently using its man power by providing
quantified information about its HR
4. By considering HR as an asset in its financial statements, it provides a measure of
profitability
5. It helps the investors or potential investors in assessing the true value of a firm by
providing realistic information about its HR

1.21.5 DISADVANTAGES OF HRA

At the same time, a firm may also face certain limitations in implementing HRA such as :

1. HR as an asset cannot be owned by any firm.

2. Quantification of HR value is subjective in nature and there is no common
valuation model existing which can be used across the industries or by all the
companies in the same industry
3. As its establishment and implementation involves huge cost, it may not suit small
firms
4. The concept of HRA is not recognized by tax authorities and has only academic
value

20
 5. There is no objective procedure to be followed in the valuation of the HR, hence
comparative analysis may not be possible, and even if possible, may not be
reliable

1.21.6 TECHNIQUES OF VALUATION OF HR

There are around eight techniques for valuation of HR. They are as follows :

1. Historical cost Method: This method was developed by Rensis Likert and his
associates and was adopted by R.G.Barry corporation, Ohio, Colombia, USA, in
1968. This method involves capitalization of the costs incurred on HR related
activities such as – recruitment, selection, placement, training and learning etc,
and amortized over the expected length of services of the employees. The un
expired cost represents the firm’s investment in HR. In case an employee leaves
the organization before the expiry of the expected services’ life period, the firm
shall write off the entire amount of un expired cost against the revenue of the
period during which he or she leaves.

2. Replacement Cost Method: This method was initially developed by Hekimian

and Jones. According to this method, a firm’s HR value is its replacement cost.
According to Flamholtz, this replacement cost may be – i) individual
replacement cost – which refers to the cost of replacing an employee with an
equivalent substitute in terms of skill, ability and knowledge and ii) positional
replacement cost – which refers to the cost of replacing the set of services
expected to be rendered by an employee at the respective positions he holds and
will hold at present and in future. Thus, the HR value will appear in the financial
statements at its replacement cost.

3. Opportunity cost method: This method has been suggested by Hekimian and
Jones and refers to the valuation of HR on the basis of an employee’s value in
alternative uses, i.e, opportunity cost. This cost refers to the price other divisions
are willing to pay for the service of an employee working in another division of
an organization.

4. Capitalisation of Salary method: This method had been proposed by Baruch

Lev and Aba Schwartz in terms of economic value of HR. According to them, the
salaries payable to employees during their stay with the organization may be used
in valuing the HR of an organization. Thus the value of HR is the present value
of future earnings of homogeneous group of employees..
5. Economic valuation method: This values the HR of an organization by
considering the present worth of the employees’ future service expected to be
derived during their stay with the organization. Under this method, the valuation
of HR involves 3 steps – 1) estimation of employee’s future services, 2) multiply
step 1 by the employee’s rate of pay and 3) Multiply step 2 by the rate of return
on investment. This would give the present worth of employee’s service.

21
6. Return on efforts employed method: Under this method, HR valuation is done
on the basis of the quantifying the efforts made by the individuals for the
organizational benefits by taking into account factors such as –positions an
employee holds, degree of excellence employee achieves, and the experience of
the employee.

7. Adjusted discounted future wages method: This model has been developed by
Roger.H.Hermanson. Under this method, HR valuation is done on the basis of
relative efficiency of an organization in the industry. This model capitalizes the
extra profit a firm earns over and above that of the industry expectations. As
such, this model involves 4 steps – 1) estimation of 5 years (succeeding) wages
and salaries payable to different levels of employees 2) finding out the present
value of such estimated amount at the normal rate of return of the industry, 3)
determining the average efficiency ratio (the co’s average rate of return for the
past 5 yrs)/ Industry’s average rate of return for the past 5 yrs) for 5 years, 4)
finding out the present value of future services of the co’s Hr by multiplying the
discount value (as in 2nd step) by the firm’s efficiency ratio (as calculated in 3rd
step)

8. Reward valuation method: This model has been developed by Flamholtz and is
commonly known as – the stochastic rewards valuation model. It values the HR
of a concern on the basis of an employee’s value to an organization at various
service states (roles) that he is expected to occupy during the span of his working
life with the organization. This model involves – estimation of an employee’s
expected service life, identifying the set of service roles he may occupy during
his service life, estimating the value derived by an organization at a particular
service state of a person for the specified time period, estimating the probability
that a person will occupy at possible mutually exclusive service state at specified
future times, quantifying the total services derived by the organization from all its
employees, and discounting the total value thus arrived at to its present value at a
pre determined rate.

SUMMARY

• The American Institute of certified public accountants (AICPA) defined

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 the results thereof”.
• Basically, the financial statements provide quantitative data about the
performance of an organization to the users, thereby helping in their
decision making.
• The various functions of accounting include keeping systematic records of
the business, protecting the properties of a business, meeting the legal
requirements and communicating the operating results to the interested
parties

22
 • Inherently, financial accounting suffers from some limitations such as –
recording of monetary transactions alone, conflict between the various
accounting concepts and conventions such as for ex. – convention of
conservatism and convention of consistency regarding recording of assets,
personal bias of the accountant in the accounting treatment of certain
items, the need for expertise on the part of the users etc
• Cost accounting is designed as the process of accounting for costs from
the point at which expenditure is incurred or committed to the
establishment of its ultimate relationship with cost centers and cost units.
In its widest usage it embraces the preparation of statistical data, the
application of cost control methods and the ascertainment of the
profitability of activities carried out or planned.”
• Mainly, Cost accounting deals with providing cost data to the management
for internal decision making purpose.
• As Cost accounting is not a science but an art, and is still developing, it
lacks a uniform procedure which can be applied by all types of business.
It can only be customized by the firm which is adopting it
• Management Accounting is defined as a system for gathering, summarizing,
reporting and interpreting accounting data and other financial information
primarily for the internal needs of the management. It is designed to assist
internal management in the efficient formulation, execution and appraisal of
business plans.”
• The scope of Management accounting covers many areas of finance such as –
financial accounting, Cost accounting, Financial Statement Analysis, Budgeting,
Inflation accounting, Management reporting, Quantitative techniques, Tax
accounting, Internal audit etc
• The basic functions of Management accounting include helping the
management in decision making
• The various tools of Management accounting include – financial planning,
Analysis of financial statements, Cost accounting, Standard costing,
Marginal costing, Budgetary control, Funds flow analysis, Management
reporting, Statistical analysis etc
• The adoption of Management accounting ensures – efficiency in business
operations, regulation of business operations, utilization of resources etc
• But, as Management is based on financial statements, it suffers from all
the drawbacks of the financial statements.
• Many categories of people use financial statements for varied uses. Some
of them are – investors, lenders, creditors, debtors, employees,
government, analysts, public at large etc
• There are several principles and practices followed by businesses in
recording their information. These principles and practices are widely
known as – GAAP (Generally Accepted Accounting Principles). The
adoption of these enables adoption of common practices in accounting by
all the businesses.
• The FINAL accounts or Financial statements are prepared by all the
businesses at the end of their accounting year. They include – a Trading

23
 account, Profit & Loss account and a Balance sheet. If it is a
manufacturing concern, the list includes the preparation of a
manufacturing account also
• A Trading account is a statement prepared by a firm to ascertain its trading results
for the accounting year. A manufacturing account is prepared by a manufacturer
to ascertain the cost of goods manufactured during the current accounting year.
• A Profit & Loss account is a statement that is prepared for the accounting period
by taking into account the various trading expenses and incomes. The main
feature of profit and loss account is that it takes into account all expenses and
incomes that belong to the current accounting year and excludes those expenses
and incomes that belong either to the previous period or the future period.
• A Balance sheet is a statement that is prepared on the last day of the
accounting period by taking stock of the various assets and liabilities of a
business. It reflects the financial position of a concern. There are various
items that need to be adjusted while preparing the final accounts
• Inflation accounting has been defined as an accounting technique which
aims to record business transactions at current values and to neutralize the
impact of changes in the price on the business transaction
• Accounting transactions which are recorded on the basis of historical cost
basis do not reflect the true performance of the concern and also may not
help it in realistic decision making. Hence, inflation accounting need to be
adopted by businesses. There are around 4 techniques in which it can be
done. They include - (1) Current purchasing power – [CPP], (2)
Replacement cost accounting method [RCA], (3) Current value accounting
method [CVA] and (4) Current cost accounting method [CCA]. But
adoption of this is rather complicated, expensive, and the income tax Act
does not recognize it.
• HR Accounting has been defined as the process of identifying and
measuring data about human resources and communicating the
information to interested parties.
• The process of HR Accounting includes – identification and measurement
or quantification of human resource in an organization and its reflection in
its annual reports or financial statements
• HRA aims at recognizing the value of human factor in the organization
and thus, help the organization in achieving its objectives by motivating its
work force, increasing its efficiency, helping in measuring the profitability
of a concern etc.
• The basic limitation of HRA is that HR as an asset cannot be owned by
anyone. And quantification of HR is highly subjective in nature. It also is
expensive and is not recognized by Tax authorities
• There are around 8 methods of HR valuation in practice. They include –
Historical Cost Method, Replacement Cost Method, Opportunity Cost
Method, Capitalization of Salary Method, Economic Valuation Method,
Return on Efforts Employed Method, Adjusted Discounted Future Wages
Method and Reward Valuation Method.

24
 TEST YOUR KNOWLEDGE

Short Questions:

1. Define Accounting. What are its functions and limitations?

2. What are the objectives of financial statements?
3. Define cost accountancy. What are its objectives and limitations?
4. What is Management accounting? What are its functions, advantages and
disadvantages?
5. What are the various tools and techniques of Management accounting?
6. Why is Accounting regarded as an aid to management?
7. Explain any three of the accounting concepts
8. What are final accounts? What purpose do they serve?
9. Briefly explain the concept of inflation accounting. What are its merits and
demerits?
10. “Accounts ignore inflation and inflation makes a mockery of them.” Explain.
11. Explain the concept of HRA. What are its objectives?
12. Discuss the significance of HRA in the modern business

Long Questions:

1. Distinguish between financial, cost and management accounting

2. State the persons who will be interested in accounting information
3. Discuss briefly the accounting concepts and conventions
4. Differentiate between (i) outstanding expenses and prepaid expenses (ii)
Outstanding income and incomes received in advance (iii) interest on capital and
interest on drawings
5. Write short notes on – (i) manufacturing account (ii) trading account (iii) profit
and loss account and (iv) balance sheet.
6. Explain the various adjustments affecting the preparation of a balance sheet.
7. Discuss the various methods of accounting for price level changes.
8. Explain the various methods of HR valuation

TEXT BOOKS FOR THE CHAPTER:

1. S.N.Maheshwari, S.K.Maheshwari, “Accounting for Management”, Vikas
Publishing House Pvt. Ltd, 2006
2. M.A.Sahaf, “Management Accounting – Principles & Practice”, Vikas
Publishing House Pvt. Ltd, 2006
3. M.Y.Khan & P.K.Jain, “Management Accounting”, Tata Mcgraw Hill
Publishing company Ltd, 2004

REFERENCES FOR THE CHAPTER:

1. R.S.N.Pillai & Bagavathi, “Management Accounting”, S.Chand & Co. Ltd, New
Delhi, 2004

25
2. O.S.Gupta, Pankaj Kothari, “Accounting for Managers”, Frank Bros. Pvt. Ltd,
New Delhi, 2004.

26