Intro to Financial Accounting: Definitions, Users, Roles & Systems

TAKEAWAYS:

• Definition & Purpose: Accounting is the systematic recording, summarizing, analyzing, and communicating financial information to help users make informed decisions.
• Users of Accounting: Includes internal users (managers, owners) and external users (investors, creditors, government).
• Accounting vs. Accountancy: Accounting is the process; accountancy is the profession of practicing accounting.
• Types of Accounting: Financial accounting (external reporting), management accounting (internal decision-making), and tax accounting (compliance).
• Accounting Process: Follows a cycle—transactions → journal → ledger → trial balance → financial statements.
• Role in Decision-Making: Provides financial data to assess profitability, liquidity, and solvency for strategic planning.

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1. Definition and Scope of Financial Accounting

Financial accounting is the branch of accounting that records, classifies, summarizes, and communicates financial transactions of a business to external stakeholders. It ensures transparency, compliance, and accountability.

Key Features of Financial Accounting:

• Historical Data: Records past transactions.
• Standardized Rules: Follows NFRS (Nepal Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles).
• External Focus: Prepares financial statements (Income Statement, Statement of Financial Position) for investors, creditors, and regulators.
• Objective Evidence: Transactions must be verifiable with documents (invoices, receipts, bank statements).

Visual: The Accounting Process Cycle

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2. Users of Accounting Information

Accounting information is used by different stakeholders for decision-making:

Example: How eSewa Uses Accounting

• Internal Users: eSewa’s management uses financial statements to assess profitability and plan expansions.
• External Users: Investors analyze eSewa’s financial health before investing in its IPO.

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3. Objectives of Financial Accounting

1. Record Transactions: Systematic documentation of business activities.
2. Summarize Data: Consolidate transactions into meaningful reports.
3. Communicate Information: Provide financial statements to stakeholders.
4. Assist Decision-Making: Help users evaluate performance and future prospects.
5. Ensure Compliance: Adhere to legal and regulatory requirements (e.g., Company Act 2063 in Nepal).

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4. Accounting vs. Accountancy

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5. Types of Accounting

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6. Importance of Accounting in Decision-Making

Accounting provides critical financial data for:

• Profitability Analysis: Assess if a business is making a profit (e.g., Pathao’s ride-hailing revenue vs. expenses).
• Liquidity Assessment: Check if a business can pay short-term debts (e.g., NTC’s cash flow management).
• Investment Decisions: Investors use financial statements to evaluate stocks (e.g., NEPSE-listed companies).
• Creditworthiness: Banks like NMB or Global IME use accounting data to approve loans.

Real-World Example: Kathmandu Traffic Routes (Cost-Benefit Analysis)

• Problem: The government wants to build a new road in Kathmandu.
• Accounting Role:
  • Cost Accounting: Estimates construction costs (materials, labor).
  • Financial Statements: Projects future revenue from reduced traffic congestion.
  • Decision: If projected revenue > costs, the project is approved.

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7. The Accounting Equation

The foundation of double-entry accounting: $$\text{Assets}=\text{Liabilities}+\text{Owner’s Equity}$$

• Assets: Resources owned (cash, inventory, machinery).
• Liabilities: Debts owed (loans, unpaid bills).
• Owner’s Equity: Owner’s claim on assets after liabilities are paid.

Worked Example: Starting a Business in Nepal

Transactions for "Kathmandu Books Pvt. Ltd." (a bookstore in Kathmandu):

1. Started business with:
   • Cash: Rs 500,000
   • Inventory (books): Rs 300,000
   • Shop equipment: Rs 200,000
2. Borrowed from a bank: Rs 400,000 (loan)
3. Purchased additional inventory: Rs 150,000 (paid Rs 100,000 cash, Rs 50,000 on credit)

Accounting Equation After Each Transaction:

Final Equation: $$\text{Assets (Rs 1,550,000)}=\text{Liabilities (Rs 450,000)}+\text{Owner’s Equity (Rs 1,100,000)}$$

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8. Accounting Process: From Transactions to Financial Statements

Step-by-Step Flow:

1. Source Documents: Invoices, receipts, bank statements.
2. Journal Entry: Record transactions in the Journal (chronological order).
3. Ledger Posting: Transfer journal entries to the Ledger (T-accounts).
4. Trial Balance: Summarize ledger balances to check for errors.
5. Financial Statements: Prepare Income Statement and Statement of Financial Position.
6. Closing Entries: Reset temporary accounts (revenue, expenses) for the next period.

Visual: Journal Entry Example

Transaction: Purchased inventory worth Rs 60,000 on credit from Nepal Book Distributors. Journal Entry:

Ledger Posting (T-Account):

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9. Advantages and Disadvantages of Financial Accounting

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10. In the Real World

1. eSewa (Digital Payments):

   • Idea Used: Financial Statements (Income Statement, Statement of Financial Position) to attract investors before its IPO.
   • How: eSewa’s audited financial reports showed profitability, helping it raise Rs 10 billion in its 2023 IPO.

2. NMB Bank (Loan Approvals):

   • Idea Used: Accounting Equation and Financial Ratios to assess loan applications.
   • How: Before approving a loan, NMB checks the borrower’s liquidity ratio (Current Assets / Current Liabilities) to ensure they can repay.

3. Daraz (Inventory Management):

   • Idea Used: Cost Accounting to track inventory costs and set competitive prices.
   • How: Daraz uses FIFO (First-In-First-Out) to value inventory, ensuring accurate profit calculations.

4. NTC (Government Utility):

   • Idea Used: Financial Accounting for Budgeting to manage public funds.
   • How: NTC’s annual financial statements show revenue from telecom services and expenses on infrastructure, helping the government allocate funds.

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11. Worked Example: Full Accounting Cycle for a Nepali Business

Business: "Kathmandu Snacks" (a small retail shop in Thamel) Transactions for January 2023:

Step 1: Journal Entries

Step 2: Ledger Accounts (T-Accounts)

Step 3: Trial Balance (as of 2023-01-31)

Step 4: Financial Statements

Income Statement for January 2023:

Statement of Financial Position (as of 2023-01-31):

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Exam Tip

1. Definitions: Always define key terms like accounting, accountancy, and financial statements clearly.
2. Accounting Equation: Practice calculating assets, liabilities, and equity after transactions.
3. Journal Entries: Remember the rule: Debit what comes in, Credit what goes out (e.g., Cash increases with a debit).
4. Real-World Application: Relate examples to Nepali businesses (e.g., eSewa, NMB Bank, Daraz) in your answers.
5. Financial Statements: Know the difference between Income Statement (profit/loss) and Statement of Financial Position (assets/liabilities).
6. Common Mistakes to Avoid:
   • Mixing up debit and credit.
   • Forgetting to include owner’s equity in the accounting equation.
   • Ignoring source documents (e.g., invoices) in journal entries.

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