Introduction CH 1-2

8/14/2019 Introduction CH 1-2

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Samaresh chhotray 9717219922CA/MBA

IntroductionChapter one

Every businessman wants to know the effectiveness of running a business organization to ascertainthe value created and associated with the business. The primary motive in doing a business ismaking profits and maximizing capital. So businessmen want to know the exact situation of

business they are running. Profit is vital but businessmen shall know why the business is makinglosses if any. To ascertain profit or loss making positions they must keep record of every businesstransactions. Then these informations are analyzed and various conclusions are found out.Accounting supplies the following kinds of information to every businessman:

The amount and type of revenues The amount and type of expenses Amounts of profits or loss. The nature and size of assets. The nature and value of assets. Information about suppliers and customers. The amount, size, decrease or increase of capital.

Other facts related to filing of income tax returns, sales tax etcAccounting is defined as the art of recording, classifying and summarizing in terms of monetarytransactions and events of a financial character and interpreting the results thereof.Accounting only takes into account the historical figures to analyze it and that too in monetaryterms only. Non-monetary terms are not and cant be considered in accounting.

Accounting is the art of recording, classifying and summarizing in a significant manner and in termsof money, transactions and events which are in part at least, of a financial character, andinterpreting the results thereof. - AICPA

With very rapid development in the field of accounting, the meaning also becomes very wider.According to AICPA The function of accounting is to provide quantitative information, primarily

financial in nature, about economic entities-which is intended to be useful in making decisions.

FRA LUCA PACIOLI wrote the first book on double entry book keeping in 1494. In India

accounting practices have started from the times of Kautilya when he wrote ARTHASHASTRA.

The important objectives of accounting can be summarized as follows:

To maintain records of a business:

To calculate profit or loss of the organization:

To depict the proper financial position of the organization:

To make information available to various groups and users:

1. To maintain records of a business: accounting makes it possible for business firms tomaintain systematic record of all business transactions .for example purchases, sales, cashreceived, cash paid on account of salaries, postages etc.purchase of fixed assets, paymentof liabilities etc are also recorded. Accounting helps us to know that any unauthorizedentries are not made and no valid entries are omitted. This happens because of propermaintenance of financial transactions.

2. To calculate profit or loss of the organization: every person who is doing business orintend to do business would be interested to know the profits or losses of his business at

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Classification of different items

ASSETS LIABILITY

CAPITAL

EXPENSES

RentSalariesPostagesPrinting/stationeryRepairsElectricityAudit fees

REVENUES

Basic terms explained

Business Transaction:

The term transaction in the business refers to business dealing. It indicates each individual activitydone in a business with a common aim of making profit. A business involves lot of variousactivities, like purchase of goods, payment for transport, payment of wages, salaries, sale ofgoods, collection of money etc. Each of these activities can be called a business transaction. Allbusiness transactions are coordinated like an orchestra. It is tuned to the single objective ofmaking profit. In business we must keep proof of every transaction. For example when we paysalary we need salary receipt signed by the employee. When we pay money to a supplier we need

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CURRENTASSETS FIXED

ASSETS

StocksDebtorsCashBank

LandBuildingPlantsMachineryVehicles

InvestmentFurniture

Fixtures

Long-term liabilityTerm loansDebenturesShort-term liabilityLoansCreditorsBank overdraftsOutstanding expenses

Equity share capital (owners capital)Preference share capital (creditors capital)Share premiumsReserves and surplus


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receipt from the supplier. These papers are useful as a evidence. Transactions are can be broadlyclassified into cash transactions and credit transaction depending on whether immediate cashpayment is made or not.Assets:

It means property of any kind of a business. In other words whatever the business possesses. Itincludes cash, bank balances, stocks, debtors, investments, land, building plant and machineries

etc. there are three kinds of assets which are explained in the table given above.

According to IASB Conceptual framework, an asset is defined as resources controlled by theenterprise as a result of past events and from which economic benefits are expected to flow to theenterprise. In simple terms an asset is defined as something valuable owned by the business

Liabilities: it means amount owed by the firm to others. For example if the firm purchases goodsfrom outside traders creditors or if the firm takes loans from a bank. Further liability may be longterm or short term liability (current liability).

According to IASB liabilities are defined as entitys obligation to transfer economicbenefits to another enterprise or individual as a result of past transactions or events.

Thus liabilities are amounts which the entity owes other businesses or individuals

Capital:It is that amount which is invested to start a business. It may be in the form of cash, goods orsome other property. In short cut ones own money invested in his own business is known ascapital. Capital Represents amount which the owners have invested in the business. Capital willalways equal to assets less the liabilities. Remember amount of the resources supplied by theowner are called capital while resources that are then in business are called assets. Capital is alsoreferred to as owners equity or net worth. It comprises the funds invested in the business by theowner plus any profits retained for use in business less any drawings distributed to the owners.

Equity share capital (owners capital):

Total capital of the company is divided into smaller denomination and each such unit is called a

share. Those shares which are not preference shares are called equity shares. Equity shares thoseshares which are entitled to receive dividend only after preference dividend is paid.

Preference share capital (creditors capital):

Preference shares are those shares on which dividend are payable before equity dividend are paid.Preference shares unlike equity shares carry a particular % of dividend paying rights. in case ofliquidation also they are repaid before equity shares are paid.

Security premiums:

When a company issues shares at a price which is higher than its par value it is said to be issuedat a premium. This is known as security premium. Preference shares can be issued at a premium.

There is a definite relation between the capital, liabilities and assets. That can be

expressed in terms of an accounting equation:Assets = capital + liability.

Stocks:

In case of a trader, all the goods that he has for sale in his place of business at a particular point oftime. But In case of a producer or manufacturer it means stock of raw materials, semi-finishedgood and finished products. This is known as stock in trade or inventory.

Debtors:

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These are persons or companies from whom money is to be collected on account of previouslymade credit sale.Sales: its the prime source of revenue. It means exchange of goods and services for money.Every business starts with the basic assumption that it will make profits. By getting profits it willsurvive and make further investments to expand the current business. But profits can be achievedonly if the sales value is higher than the cost of manufacturing or cost of acquiring it.

Income:

Income is a broad term but covers all transactions which will result in gross inflow of benefits tothe enterprise. Income is subdivided into revenues and gains.Revenue is the gross inflow ineconomic benefits in ordinary activities of an enterprise like sales, dividends ,interest, royalties orrent while gains represents other items that meet the definition of income and may, or may notarise in the ordinary course of an enterprise. i.e. profit made on the disposal of non current assets.

Expenses

Expenses are gross outflow of economic benefits arising in ordinary course of business. Expensesare incurred in order generate revenue for the enterprise. Any expense to acquire a new asset orenhance the capacity of an existing asset is called capital expenditure and should be included aspart of the value of such asset. For example Rent,Salaries,Postages,Printing/stationery,Repairs,Electricity,Audit fees etc. these aredifferent kinds of expenses paid by the business organization in a given period of time to differentservice providers. Only expenses related to a current period are considered for preparing thefinancial statements of a particular year.

Commission received: its an income because the business receives the commission for any workdone for others.

Discount received: its an income because the organization pays less to others for purchasesmade regarding raw materials or other assets.Rent received:If the business organization has surplus space available and it has given that on rent-then it will

receive rent from the users. If this is the case then it will be a source of income.

Term loans:

Its a Long term liability. It is normally payable after a period of 5, 10 or 15 years. Sourced frombanks at a relatively lower rate of interest.

Debentures:

Its a Long term liability. Its like a fixed deposit received from the public at a particular rate ofinterest.

Creditors:Its a Short term liability. When the organization purchases goods or raw materials from themarket-it has to be paid in a short period of time .they are known as creditors.

Bank overdrafts:Its a Short term liability. When somebody draws more than what he has deposited in a bankcurrent account, its known as bank OD.its a very short term arrangement and its given to thoseaccountholders who are valued customers of a bank.

Outstanding expenses:

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Its a Short term liability. When something is not paid after it has become payable-its known asoutstanding liability.

Drawings: it means the cash or other assets withdrawn from business by the owner for hispersonal use.

Purchase: it means acquisition of raw materials by a manufacturing concern for the purpose ofconverting them into finished goods and then to sell them. But in case of a trading concern,purchase means acquiring by it goods in which it deals for the purpose of sale. The purpose in boththe situations is to make gains.

Accounts receivables: it means Owings by debtors as well as amount receivable against bills. Buttrade debtors means goods or services sold on credit in the course of ordinary trade.Accounts payable: it means Owings to creditors as well as amount payable against bills. Buttrade creditors means goods or services purchased on credit in the course of ordinary trade.

Bills of exchange: a bill of exchange is an instrument in writing containing an unconditional order,signed by the maker, directing a certain person to pay a certain sum of money.Bills payable:

BILLS PAYABLE, in merchant accounts, are all bills which have been accepted, and promissorynotes which have been made, are called "bills payable," and are entered in a ledger account underthat name, and recorded in a book bearing the same title.

Bills receivable:

BILLS RECEIVABLE, in merchant accounts, are all promissory notes, bills of exchange, bonds,and other evidences or securities which a merchant or trader holds, and which are payable to him.

Long Term liabilities:

As the name indicates, long term liabilities are paid off after a long period. All liabilities maturingafter one year are considered current liabilities. These liabilities can be settled either by payment of

cash, or by delivery of fixed assets or by conversion of liabilities into equity.Examples of long term liabilities are: mortgage loans and debentures.

Contingent liabilities:

Contingent liabilities are not actual liabilities. They are probable liabilities on the happening of acertain contingency. For example a claim against the business in court is a contingent liability. Ifthe court decides against the business the claim becomes a real liability to pay. Other liabilities areloan guaranteed by the business, bills receivable discounted with the bank etc.

Revenue

Revenue is the increase in assets without a corresponding increase in liability or ownersinvestment. According to The Financial Accounting Standards Board (FSAB) revenue is inflow orother enhancements of assets to an entity from delivering or producing goods, rendering

services, or other activities that constitute the entitys ongoing major or central operations.Revenue brings in assets to a business. Revenue comes from production or sale or rendering or

service. Revenue is creation of wealth by the process of doing business. It is the reward for doingbusiness while expense is the sacrifice. Revenue represents what the company charges itscustomers for the goods and services it provides. Revenue is generated from production, trade andservice. A manufacturing company generates revenue from production. A merchant generatesrevenue from trade and service firms such as audit firms advocates etc. earn revenue fromservice

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Accounting involves gathering of financial data, recording classifying, summarizing andcommunicate the results to the owners of the business, or to others allowed to receive thisinformation. Accounting should not be confused with Book keeping as Book keeping is the part ofaccounting concerned with recording of financial data. Book keeping is the process of recordingdata relating to accounting transactions in the books of accounts.

Some of the parties interested in bookkeeping

1. Management and managers

These include board of directors, managers and other officers of the business organization. Theyneed this information for decision making on the sales price, profitability and solvency of thebusiness enterprise. Management is interested in assessing the capacity of the business to earnprofits of the business in future. It is responsible for the profitable operation of the business in thelong run. Through various ratios i.e. debt-equity ratio, current ratio etc management canunderstand the short term or long term solvency of the business. Similarly with the help of cashflow statement and funds flow the need for short term and long term funds can be assessed.

Managers owe the shareholders duty of trust. They are supposed to run the business as agents of

the shareholders as such they also take keen interest in the operation the business so as to be ableto control the operations of the business.Most senior managers are rewarded based on the level of profit performance. This gives managersadditional incentive to ensure that accounting information is accurate but also that the business isperforming well. Managers need to control the operations of the business and to be able to performsuch task they need accounting information. They use the information in their budget preparation,analyzing performance of various products or services but also analyzing the divisionperformance.Managers are also required to produce final set of accounts which shows a true andfair view and without keeping records of accounting information it is almost impossible to producethese sets of accounts.

2. Creditors and lenders

Creditors and suppliers of goods are interested in the financial strength of the business, so that

they can extend credit for goods accordingly. They are always anxious to know the capacity of thebusiness to meet the payment deadlines .To gets all these information, financial statements areused. Both existing and prospective lenders need accounting information, mainly to assess thefinancial risk of the business. As existing lenders they have invested money in the business andwould want to be assured that what ever money the entity owes them would be repaid togetherwith the interest. Suppliers of various materials would always want to be assured that once theystart trading with the entity there will be continuity of trading. One way of monitoring this isthrough assessment of the going concern of the business which can be done through the analysisof financial information. Prospective lender would like to assess the past credit records for entitybefore committing any funds to the entity.

3. Institutional investors:

Lenders and financial institutions like banks and other financial companies are interested to know the shortterm as well as the long term financial position of the business organization. They analyze to be assured of thesecurity of their loan repayments and also the interest payment schedule.

4. government and tax regulators:On the basis of financial statements, government authorities decide about the solvency positions of theconcern and decide need for financial help. Sometimes the government also restricts the trade which is usingthe unfair trade practices and charging more prices for essential goods. Tax authorities rely on thesedocuments to decide the net profitability of the business and the imposition of tax thereon. these taxauthorities can be income tax authority, sales tax authority and department of customs and excise.

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5. Shareholders, Investors and Security AnalystsThey are those people who are the owners of the business, lifeline of every modern business. theyhave invested money in the business by purchasing the shares of the company either from thecompany direct through public offerings or purchased those shares from others in open marketthrough stock exchanges. they are concerned with the profitability of the company because of thefact that as the company goes on to earn more profit it would end up paying more dividends to

them. So higher the earning of the company , higher the earnings of the shareholders.

Shareholders, investors and security analysts are major recipients of the financial statements ofcorporations. These may be individuals or large institutional inventors operating as multi nationalcompanies such as Insurance firms and pension fund entities. These stakeholders may haveinvested in the enterprise or are about to committee large funds into the entity. They may alsohave other investment opportunities available to them and are in process of choosing an opportuneway of investing their funds. Most of these stakeholders may be making the decision on behalf ofother investors like incase of Pension fund entities. As seen above, the investors have importantdecision to make and usually the accounting information will be used as the main basing of theirdecision making. As such information in accounts should be produced accurately but also containall relevant information which can enable them to make sound and informed decisions.

Information in the accounting records also affects the value of the entitys share value. Anyinformation relating to the performance of the entity will directly define the share price. Rememberthe wealth of the shareholders in the business is represented by the share value. Shareholdershaving entrusted the Directors with the running of the business want to assess whether or not thebusiness is profitable. This information can be used when deciding whether to extend their stake inthe business or assessing a possible take over bid.

6. Customers:On the basis of the accounting information, customers can be sure of the continuous existence ofthe business enterprises and continuous supply of quality goods year after year. Accountinginformation provides the stability of the business and this also assist the trading partners to assessthe viability and continued trading with the organization.

7. Employees:Just like Managers, employees also take keen interest in monitoring the financial performance oftheir entity as it is the source of their income. An entity which is making persistent losses mayfound it self out of business and this will cut the livelihood of the employees. Employees takes pridein working for a profitable and entity of sound financial status as they are assured of continuedservice of employment but also have a good social status in the community. Profit levels and otherfinancial information assist the trade unionists in collective bargaining on wage increases. In someorganization it is a standing policy that once the entity makes profit it will share with its employeesin form of bonus. This also drives the employees to be on the look out for the financialperformance.

8. Governments and their Agencies

Government is interested in the activities of the enterprise owing to their concern with theallocation of resources and economic policy, with taxation policy and collection and with companyregulation. Accounting information is crucial as it directly affect the tax which the government isexpected to collect for the business.

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Types of accounting:

Financial accounting Management accounting Cost accounting

Management accounting is the process of identification, measurement, accumulation, analysis,preparation, interpretation and communication of information used by management to plan,evaluate and control within an entity and to assure appropriate use of and accountability for itsresources. Management accounting also comprises the preparation of financial reports for nonmanagement groups such as shareholders, creditors, regulatory agencies and tax authorities.(CIMA official terminology.)

The core activities of management accounting include;

a)Participation in the planning process at both strategic and operational levels. This involves theestablishment of policies and the formulation of plans and budgets which will subsequently beexpressed in the financial terms.

b) The initiation of and the provision of guidance for management decisions. This involves thegeneration, analysis, presentation and interpretation of appropriate information.

c)

Contributing to the monitoring and control performance through the provision of reports onorganisational performance, including comparisons of actual with planned or budgetedperformance, and their analysis and interpretation. Financial accounting is the periodic reportingof accounting as required by statue for shareholders, government agencies and other partiesexternal to the business. As such, various conventions and rules are necessary to ensureconsistency between the sets of accounts.

Management Accounting Compared with Financial Accounting: The following tablesummarizes the main differences between management accounting and financial accounting.

Management accounting Financial accountingA management accounting system producesinformation that is used within an organization,by managers and employees.

A financial accounting system producesinformation that is used by parties external tothe organization, such as shareholders, bankand creditors.

Management accounting helps management torecord, plan and control activities and aids thedecision making process.

Financial accounting provides a record of theperformance of an organization over a definedperiod and the state of affairs at the end of thatperiod.

Management accounting information may bemonetary or alternatively non monetary.

Most financial accounting information is of amonetary nature.

Management accounting provides both an

historical record of the immediate past and afuture planning tool

Limited companies must, by law prepare

financial accounts.

Management accounting can focus on specificareas of an organisations activities. Informationmay aid a decision making rather than be anend product of a decision.

Financial accounting concentrates on theorganization as a whole, aggregating revenuesand costs from different operation. Financialaccounts are an end themselves.

Management accounting provides both anhistorical record of the immediate past and afuture planning tool

Financial accounting presents an essentiallyhistorical picture of past operation.

No time span for producing financial Financial Financial statements are required to be

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statements produced for the period of 12 monthsNo strict rules govern the way in whichmanagement accounting operates. Themanagement accounts and information areprepared in a format that is of use to managers

Financial accounting must operate within aframework determined by law and IASs. Inprinciple the financial accounts of differentorganizations can be easily compared.

Management accounting has no specified

format. There are no specific statements whichshould be produced.

Financial accounts are supposed to be produced

in accordance with a specified format by IAS orlaw.

Feature of useful management accounting

It should be relevant for its purpose. It should be complete for its purpose. It should be sufficiently accurate for its purpose. It should be clear to the manager using it. The manager using it should have confidence in it. It should be communicated to the appropriate manager. Its volume should be manageable. It should be timely. It should be communicated through appropriate channel of communication. It should be provided at a cost which is less than the value of the benefits it provides.

The Role of Management Accountant

Assistance in planning: The management accountant assists planning by providing information.This information may be about pricing, capital expenditure projects, product costs or competition.In the short-term planning process of budgeting, the management accountant provides informationon past costs and revenues which may be used as guidance. The management accountant is alsoinvolved in the budgeting process itself.

Assistance in controlling: The management accountant supplies performance reports whichcompare actual performance with the planned performance and which therefore highlight thoseactivities which are not conforming to plan.

Assistance in organizing: By ensuring that the accounting system is tailored to theorganisational structure, the management accountant reinforces the objectives of theorganisational framework.

Assistance in motivating: Budgets prepared by the prepared by the management accountantserve to motivate managers and subordinates to attempt to achieve the organisations objectives.Formalized targets are more likely to motivate than vague comments.Performance reports produced by the management accountant for the control process also

motivate by communicating performance information in relation to the targets which have beenset.

Assistance in decision making: The management accountant is a vital cog in the organisationsdecision making process. He or she collects and analyses data, and presents information tomanagers to help in the decision making.

Comparison of Financial and Managerial Accounting. Financial and managerial accountingboth rely on the same basic accounting database, although managerial accountants often

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accumulate and use additional data. However, important differences exist between the twodisciplines:

Financial Accounting:

1. Is concerned with reports made to those outside the organization.

2. Summarizes the financial consequences of past activities.3. Emphasizes precision and verifiability.4. Summarizes data for the entire organization.5. Must follow GAAP since the reports are made to outsiders and are audited.6. Is required for publicly held companies and by lenders.

Managerial Accounting:

1. Is concerned with information for the internal use of management.2. Emphasizes the future.3. Emphasizes relevance and flexibility of data.4. Places more emphasis on non-monetary data and timeliness and less emphasis on precision.

5. Emphasizes the segments of an organization rather than the organization as a whole.6. Is not governed by GAAP.7. Is not required by external regulatory bodies or by lenders.

Qualitative Characteristics of accounting information:

Accounting information is meaningful only when it posses the essential qualities of reliability,relevance understandability and comparability.1. ReliabilityThe basic purpose of accounting is to provide information to the management, owners or whoevergenuinely interested in it. The information is meaningful only if it is reliable. The reliableinformation enables accurate decision making. It should be verifiable. I should lead to same orsimilar conclusion, when analyzed by different accounting professionals.2. Relevance

There is lot of information about a business having no practical use. Accounting should be conciseand precise. Meaningless information makes the analysis difficult. A report stuffed with immaterialinformation simply wastes time. A decision is made on the basis of facts. Therefore it is essential toensure that a person searching for it does not have to search the facts hidden deep in the garbageof irrelevant information.3. Understandability

Information is useful only when it is understandable. This does not mean that every layman shouldbe able to understand every information presented in an accounting report. Understandability

means the information is presented in universally accepted accounting format which everyaccountant is able to understand and explain. International accounting standards enable o ensureaccounting information is processed and presented in a uniform manner, which paves way toaccurate analysis and interpretation.4. Comparability

Accounting information should enable comparison between the results of different years of thesame company. It should also enable comparison between different business houses in the sameindustry.



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Accounting ProcessFollowing are the steps in accounting process:1. Recording in the Journal (Journalizing)

Journal is the first book of entry. Transactions are first recorded in the Journal Book. This book is

also known as the book of original entry. The journal has a prescribed format. The purpose of journal is formatting accounting information for convenient transfer of information into LedgerAccounts. Journal also helps to organize related documents in the office according to the sequenceof journal entry. Journal has a specific format. When the number of transactions to be recorded islarge, special journals are maintained for each major activity. Purchases Book is a special journalmeant for recording credit purchases only. Sales Book is the special journal for credit sales.

2. Recording in the Ledger (Posting to Ledger)

The ledger is the main book of accounting information. Under double entry book keeping, everyjournal entry is subsequently entered into at least two accounts. At this stage the transactions arerecorded at the appropriate side of the ledger as mentioned in the journal. The left hand side of anaccount is known as debit side and the right hand side is known as credit side. Making and entryon the debit side is known as debiting the account and on the credit side is known as crediting theaccount. Debiting or crediting a ledger account on the basis of journal entries is known as postingthe transactions.3. Summarizing the Activities

This is the process of re-grouping or summarizing the ledger accounts to help easy understandingof facts. This involves listing of all accounts with their respective balances in one statement calledTrial Balance. A trial balance contains all accounts of a business. Thus it is a list of Assets,Liabilities, Capital, Incomes and Expenses. This trial balance is further summarized by taking out allincomes and expenses into a profit and loss account which indicates the result of business activityfor the accounting period. The rest of the items in trial balance which are assets, liabilities andcapital along with the net result of profit and loss accounts are presented in a statement called

Balance Sheet. This is the statement of financial position of a business. The balance sheet containscomplete list of Assets, Liabilities, and Capital of the business.4. Analysis and Interpretation

This is the final stage of accounting process. Business information has value only when they areeffectively used for decision making. Analysis of information will help the management to identifythe result of their past decisions. The business can run smoothly by paying full attention to theright spots. The wrong decisions can be corrected for better performance in future. Other businessassociates such as suppliers and customers can decide the nature of their relationship on the basisof information presented by the financial statements.Objectives of Accounting

The following are the important objectives or purpose of Accounting1. Maintaining Records

The most important objective of accounting is to record financial information systematically. Sincethe number of transactions that takes place in a business is large, it is impossible to keep all thedetails in memory. An unscientific recording does not serve any useful purpose, as the informationwill not be readily available when it is needed. It is essential that the businessman is able to referto the details of relevant information from time to time while running the business. Systematic



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accounting involves preserving the business information on the basis of well defined rules, whichenables maintaining large volume of data in a easily accessible format.2. Estimating Profit or Loss

Profit is the aim of any business. The businessman should have clear information regarding theresult of his business activity. If there is accurate measure of profit of loss, the businessman will

take blind actions that will ultimately fail.

3. Presenting the Financial Position

Financial position of the business is presented in the form of Balance Sheet. This is an essentialstatement sought by banks, creditors and prospective investors to find out exactly what thebusiness owns and what owes.Types of Accounting Information

Accounting information may be divided into balance sheet information or profit and loss informationetc. for name sake. But actually this classification does not make much sense.

Advantages

1. Availability of informationSystematic recording enables easy retrieval of information. Modern business required quick andaccurate decisions. Proper accounting information helps management decision making at the righttime.2. Identify the strength and weakness of business

Accounting helps the management to identify the strength and weakness of the business byanalyzing past performance. Management can focus on areas that are crucial and therebymaximize profit.3. Enables comparison

Proper accounting enables the business to compare results of different periods. Comparison can bemade between different branches of the business and between different businesses in the sameindustry.4. Evidence in the court of law

In the event of a legal dispute the audited accounts are recognized as the primary source offinancial information. This helps fair settlement of disputes and prevents a lot of interference buthe authorities. This also enables recovery of debts from defaulted customers, prevents undueclaims by creditors.5. Payment of tax

Income tax is paid on the basis of profit earned by the business. Proper accounts help accurateestimate of tax due to Government. Moreover it enables the business to claim all legal rebates and

deductions allowed in the tax law.6. Helps in realisation of debtsAccounting helps to prove debts. Accounting statements and convenient record of transactionswhich can be convince the debtor in the first place and the court of law in case the matter isreferred in there.Limitations

1. Financial accounting is not absolutely exact



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Accounting information is not necessarily exact. Lot of information presented in the books ofaccount are based on personal judgment. There cannot be absolute guarantee of accuracy whenassumptions are based on personal opinion.2. Financial accounting does not show the exact worth of businessThe values of most of the assets in the books are presented on the basis of their purchase price,which is known as historic figures. Their present market values or realizable values are usually

quite different. In other words the books of accounts fail to show the exact value of assets orliabilities.3. Problem of window dressingBalance sheet figures are often modified to make it look better. This process conceals manyweaknesses of the business. Thus the accounting information becomes unreliable for accuratejudgment.4. Worthless assets often shown in the balance sheetSeveral worthless items can appear in the balance sheet as asset. This will project a wrong pictureof the business.5. No effect of inflationary trendsCurrency is not a stable unit of measurement of value. Inflation can make the value of currencyitself different. Measurement with this elastic tape can give conflicting results.



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Accounting concepts and conventionsChapter two

Accounting is the science of business .with a view to make it sound and understandable to all itsusers some principles are developed over a period of time. It is difficult to write or codify theprinciples of accountancy because accountancy is not a science like physics or mathematics. Rather

these are general guidelines for sound accounting practices. These guidelines are known asgenerally accepted accounting principles (GAAP).Generally accepted accounting principles (GAAP) comprise a set of rules, concepts and guidelinesused in preparing financial accounting reports.

To make the accounting language convey the same meaning to all people, as far as possible and tomake it meaningful, accountants have agreed on a number of concepts which are followed by all inthe preparation of financial statements. These concepts not specifically stated because their useand acceptance are usually assumed.

In drawing up accounting statements, whether they are external "financial accounts" or internally-focused "management accounts", a clear objective has to be that the accounts fairly reflect the

true "substance" of the business and the results of its operation.The theory of accounting has, therefore, developed the concept of a "true and fair view". Thetrue and fair view is applied in ensuring and assessing whether accounts do indeed portrayaccurately the business' activities.

To support the application of the "true and fair view", accounting has adopted certain concepts andconventions which help to ensure that accounting information is presented accurately andconsistently.

The followings are some of the accounting concepts.

Business entity concept Dual aspect concept Going concern concept Accounting period concept Money measurement concept Cost concept Realization concept Accrual concept Disclosure concept Materiality concept Consistency concept Conservative concept Matching concept

1. Business entity concept:From the point of view of accounting a business and its owners are separate entities. Once abusiness is set up, it runs itself through natural persons. Keeping in view this accountingassumption, business transactions are recorded in the books of accounts from the point of view ofthe business organization and not from the view of the owners, management and others. Assetsand liabilities of the owners is set aside while preparing the statements of the enterprise.



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This assumption is applicable to all types of business organizations like sole proprietorship,partnership firms, companies etc. If this assumption is not used then it would be very difficult toseparate the incomes of the business enterprise and to divulge the exact details of the expensesrelated to the enterprise and the owners.so once a business is set up it will be treated as adifferent entity from its owners. The assets / liability and profit /loss will be calculated and derivedseparately from that of its owners.

2. Dual aspect concept:

Duality means double effect. This assumption provides the basis for recording all businesstransactions in the books of accounts, so it is regarded as one of the basic principles of accounting.

According to this principle every business transaction has two effects. Basically duality arisesbecause of business entity concept. As it proposes that the owner and the business are two distinctentities, it brings two different entries. For example if a business enterprise purchases a building onloan, it would have two effects. One of increase in the amount of fixed assets and the other that ofincreasing the liability of the concern. This duality concept can be expressed in the form of anaccounting equation.

Assets = capital + liability

This equation shows that the assets of any organization are equal to that of claims of the ownerplus claim of outsiders. This equation remains balanced at all the time. This is because everyaccounting transaction has two effects and it automatically balances the equation.

3. Going concern concept:

This is one of the fundamental accounting assumptions. It is assumed that the enterprise hasneither the desire nor the need to liquidate the scale of operations. So once the operations arestarted, its highly unlikely that the business is going to be closed down. It is assumed that thebusiness will be continuing for a long period of time into the future. The concept of going concern isrelevant for valuation of assets and liabilities. This concept results in uniformity and consistency ofassets valuation. This also facilitates comparability of financial statements of different businesses.

The Going concern assumption inspires and motivates the entrepreneurs to work with their fullenthusiasm, full potential. If the entrepreneur is, himself doubtful about the longevity of thebusiness then he will not reinvest in his venture and the business will wear out quickly

4. Accounting period concept :Accounting period is normally of one year. it is known as financial year. Each financial year startsfrom 1st of April of one year and ends on 31st march next year. (For example 1-4-2007 to 31-3-2008).this is also a basic requirement from taxation point of view. For knowing the profitability,feasibility of the business the different user groups cant wait for indefinite time and if it is knownat the end, it will not be of much use. so if the analysis is made every year then management shallhave sufficient material and proof of continuation of business and can be able to take correctivesteps. The aim is to make it possible for the proprietors and different user groups to have the

financial statements at a particular period of time and analyze it in time.

As per income tax act, taxes on income shall be calculated on annual basis of financial year.Companies which are not listed in a stock exchange are required to publish their financial positionquarterly.

5. Money measurement concept:

According to money measurement concept a fact or a transaction will be recorded in the books ofthe enterprise only if they are capable of being expressed in terms of money or its equivalents. So



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even if some of the matters are very urgent and important, they cant be entered into the books ofaccounting because they cant be expressed in terms of money. For example any loss of goods byfire can be recorded in the books but lack of cooperation of management matters cant beexpressed in it. The salary paid to a manager can be expressed in the books but his honesty andintegrity cant be expressed.

This concept plays a very vital role in accounting, because critical decisions like fixing of the sellingprice of the product, paying the dividend to the shareholders etc are possible in terms of moneyonly.

6. Cost concept:

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cashequivalent) when an item was originallyobtained, whether that purchase happened last year orthirty years ago. For this reason, the amounts shown on financial statements are referred to ashistoricalcost amounts.

Because of this accounting principle asset amounts are notadjusted upward for inflation. In fact, asa general rule, asset amounts are not adjusted to reflect anytype of increase in value. Hence, an

asset amount does not reflect the amount of money a company would receive if it were to sell theasset at today's market value. (An exception is certain investments in stocks and bonds that areactively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statementsyou need tolook elsewhere, perhaps to a third-party appraiser.

7. Realization concept:

With this convention, accounts recognise transactions (and any profits arising from them) at thepoint of sale or transfer of legal ownership - rather than just when cash actually changes hands.For example, a company that makes a sale to a customer can recognise that sale when thetransaction is legal - at the point of contract. The actual payment due from the customer may notarise until several weeks (or months) later - if the customer has been granted some credit terms.

8. Accrual concept:

The effects of transactions and other events are recognised when they occur (and not as cash or itsequivalent is received or paid) and they are recorded in the accounting records and reported in thefinancial statements of the periods to which they relate.

Example : Company A has received cash of RS 4,00,000 from his customers. However, thecompany actually has done all work satisfactorily and the customers have acknowledged the workdone which the company can billed for another RS2,00,000. Furthermore, the expenses for the RS2,00,000 work-done has been taken up into the books of account.

Question: Should the company just close their accounting book by presently its income as RS

4,00,000 for the cash received or should it be RS 4,00,000 + RS 2,00,000 = Rs 6,00,000$60,000

Answer: Based on this concept, the company has actually completed all work done, also, the workdone have being acknowledged by the customers, hence income of RS 6,00,000 should be takenup and not just the cash received.

9. Disclosure concept:



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If certain information is important to an investor or lender using the financial statements, thatinformation should be disclosed within the statement or in the notes to the statement. It is becauseof this basic accounting principle that numerous pages of "footnotes" are often attached to financialstatements.

As an example, let's say a company is named in a lawsuit that demands a significant amount of

money. When the financial statements are prepared it is not clear whether the company will beable to defend itself or whether it might lose the lawsuit. As a result of these conditions andbecause of the full disclosure principle the lawsuit will be described in the notes to the financialstatements. A company usually lists its significant accounting policies as the first note to itsfinancial statements.

10.Matching concept:

This accounting principle requires companies to use the accrual basis of accounting. Thematching principle requires that expenses be matched with revenues. For example, salescommissions expense should be reported in the period when the sales were made (and notreported in the period when the commissions were paid). Wages to employees are reported as an

expense in the week when the employees worked and not in the week when the employees arepaid. If a company agrees to give its employees 1% of its 2006 revenues as a bonus on January15, 2007, the company should report the bonus as an expense in 2006 and the amount unpaid atDecember 31, 2006 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as advertisements (andthereby we cannot match the ad expense with related future revenues), the accountant chargesthe ad amount to expense in the period that the ad is run.

http://www.accountingcoach.com/accounting-terms/accounting-dictionary/accounting-terms-A.html#accrual%20basis%20of%20accountingmailto:[email protected]:[email protected]://www.accountingcoach.com/accounting-terms/accounting-dictionary/accounting-terms-A.html#accrual%20basis%20of%20accounting


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GAAP EXPLAINED

The phrase "generally accepted accounting principles" (or "GAAP") consists of three importantsets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and

standards issued by FASB and its predecessor the Accounting Principles Board (APB), and (3) thegenerally accepted industry practices.

The common set of accounting principles, standards and procedures that companies use to compiletheir financial statements. GAAP are a combination of authoritative standards (set by policy boards)and simply the commonly accepted ways of recording and reporting accounting information.

GAAP are imposed on companies so that investors have a minimum level of consistency in thefinancial statements they use when analyzing companies for investment purposes. GAAP coversuch things as revenue recognition, balance sheet item classification and outstanding sharemeasurements. Companies are expected to follow GAAP rules when reporting their financial datavia financial statements. If a financial statement is not prepared using GAAP principles, be verywary!

That said, keep in mind that GAAP is only a set of standards. There is plenty of room within GAAPfor unscrupulous accountants to distort figures. So, even when a company uses GAAP, you stillneed to scrutinize its financial statements.

Accounting conventions

Convention of disclosure Convention of materiality Convention of consistency Convention of conservatism

The Convention Of Disclosure means that all material facts must be disclosed in the financialstatements. For example, in case of sundry debtors not only the total amount of sundry debtorsshould be disclosed, but also the amount of good and secured debtors, the amount of good, butamount of unsecured debtors and amount of doubtful debts should be stated. Full disclosure doesnot mean disclosure of each and every item of information. It only means disclosure of suchinformation which is of significance to owners, investors & creditors.

Materiality is a concept or convention within auditing and accounting relating to the importance ofan amount, transaction, or discrepancy. The objective of an audit of financial statements is toenable the auditor to express an opinion whether the financial statements are prepared, in allmaterialrespects, in conformity with an identified financial reporting framework such as GenerallyAccepted Accounting Principles (GAAP). The assessment of what is material is a matter of

professional judgment.

Materiality is defined in the International Accounting Standards Boards "Framework for thePreparation and Presentation of Financial Statements" in the following terms:

"Information is material if its omission or misstatement could influence the economicdecision ofusers taken on the basis of the financial statements. Materiality depends on the size of the item orerror judged in the particular circumstances of its omission or misstatement. Thus, materiality

http://www.accountingcoach.com/accounting-terms/accounting-dictionary/accounting-terms-G.html#generally%20accepted%20accounting%20principles%20(GAAP)http://en.wikipedia.org/wiki/Convention_of_disclosurehttp://en.wikipedia.org/wiki/Materiality_(auditing)http://en.wikipedia.org/w/index.php?title=Convention_of_consistency&action=edit&redlink=1http://en.wikipedia.org/wiki/Convention_of_conservatismhttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Auditinghttp://en.wikipedia.org/wiki/Accountinghttp://en.wikipedia.org/wiki/Audithttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Auditorhttp://en.wikipedia.org/wiki/Auditor's_reporthttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/w/index.php?title=Financial_reporting_framework&action=editredlinkhttp://en.wikipedia.org/wiki/Generally_Accepted_Accounting_Principleshttp://en.wikipedia.org/wiki/Generally_Accepted_Accounting_Principleshttp://en.wikipedia.org/wiki/International_Accounting_Standards_Boardhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Decision_theorymailto:[email protected]://www.accountingcoach.com/accounting-terms/accounting-dictionary/accounting-terms-G.html#generally%20accepted%20accounting%20principles%20(GAAP)http://en.wikipedia.org/wiki/Convention_of_disclosurehttp://en.wikipedia.org/wiki/Materiality_(auditing)http://en.wikipedia.org/w/index.php?title=Convention_of_consistency&action=edit&redlink=1http://en.wikipedia.org/wiki/Convention_of_conservatismhttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Auditinghttp://en.wikipedia.org/wiki/Accountinghttp://en.wikipedia.org/wiki/Audithttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Auditorhttp://en.wikipedia.org/wiki/Auditor's_reporthttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/w/index.php?title=Financial_reporting_framework&action=editredlinkhttp://en.wikipedia.org/wiki/Generally_Accepted_Accounting_Principleshttp://en.wikipedia.org/wiki/Generally_Accepted_Accounting_Principleshttp://en.wikipedia.org/wiki/International_Accounting_Standards_Boardhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Decision_theorymailto:[email protected]


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provides a threshold or cut-off point rather than being a primary qualitative characteristic whichinformation must have if it is to be useful."The preparation of accounts involves a high degree of judgments. Where decisions are requiredabout the appropriateness of particular accounting judgments, the "materiality" conventionsuggests that this should only be an issue if the judgment is "significant" or "material" to a user ofthe accounts. The concept of "materiality" is an important issue for auditors of financial accounts.

Consistency concept: Transactions and valuation methods are treated the same way from year toyear, or period to period. Users of accounts can, therefore, make more meaningful comparisons offinancial performance from year to year. Where accounting policies are changed, companies arerequired to disclose this fact and explain the impact of any change.

In business, investment, and accounting, the principle or convention ofConservatism has at leasttwo meanings.In investments and finance; it is a strategy which aims at long-term capitalappreciation with low risk. It can be characterized as moderate or cautious and is the opposite ofaggressive behavior.In accounting; it states that when choosing between two solutions, the onethat will be least likely to overstate assets and income should be selected.

Modifying Accounting PrinciplesMaterialityFinancial statements should disclose all items that are material enough to influence decisionmaking. Items are accounted on the basis of significance rather than accurate adherence toprinciples. Purchase of a pencil is treated as an expense, not as an asset, but purchase of Machineis treated as purchase of asset not as expense. Unless we apply the principle of materiality weneed to treat pencil as asset, and write off depreciation every time we sharpen the pencil.Consistency

A business should follow accounting rules consistently for a reasonable period to make accountingresults meaningful. Suppose the company keeps on changing the rate or method of depreciation

every year, the item of depreciation becomes confusing and meaningless. Consistency eliminatespersonal bias. We must follow consistent rules year after year.Conservatism (Prudence)

The principle of conservatism requires a business to be extremely cautious about possible losses. Itshould guard against any possible losses. If there is an anticipated loss there should be accurateprovision in the account. There need not be any provision for anticipated revenue or gain. Provisionfor bad debts is created on the basis of this principle. When a business says they have debtors, ourexperience reminds us that a part of this can be lost while collecting the money by way of baddebts. We reduce bad debts from debtors to present a conservative estimate of realizable value ofdebtors. Creating a provision for discount on creditors is against the principle of conservatism. Thefollowing examples indicate the application of conservatism in accounting:

a. valuation of closing stock at cost price or market price whichever is lessb. creating provision for bad debts and discount on debtors, but not creating provision for

discount on creditorsc. not showing assets such as goodwill in the booksd. writing off fictitious assets from the books as early as possiblee. treating small capital expenditure as revenue item (principle of materiality is also involved

here)

Timeliness

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According to this principle accounting information should be recorded in time and supplied in time.Decisions can be taken only if the current information is available. Accounting information shouldbe presented to management before the loss of its utility. On account of this reason, mostcompanies in western countries have started supplying quarterly financial statements.

Substance over Form

According to this principle the real fact of a matter is taken into account not the strict form orformat. When goods are purchased on hire purchase, the purchaser becomes owner only after thelast installment is paid. But for practical purpose the asset is with the purchaser right from the timeof paying first installment. It is acceptable to treat this item as the asset of the purchaser and theinstallments due as loan.

Variations in Accounting Practices

In some cases prevailing industry practice should be taken in to account rather than the strictaccounting principles. For example agricultural stock is generally valued at predetermined price orsupport price, rather than its cost price or market price.List of accounting standards issued by ICAI



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Key Characteristics of Accounting Information

There is general agreement that, before it can be regarded as useful in satisfying the needs of various usergroups, accounting information should satisfy the following criteria:

Criteria What it means for the preparation of accounting information

Understandability This implies the expression, with clarity, of accounting information in such a way that itwill be understandable to users - who are generally assumed to have a reasonableknowledge of business and economic activities

Relevance This implies that, to be useful, accounting information must assist a user to form,confirm or maybe revise a view - usually in the context of making a decision (e.g.should I invest, should I lend money to this business? Should I work for this business?)

Consistency This implies consistent treatment of similar items and application of accounting policies

Comparability This implies the ability for users to be able to compare similar companies in the sameindustry group and to make comparisons of performance over time. Much of the workthat goes into setting accounting standards is based around the need for comparability.

Reliability This implies that the accounting information that is presented is truthful, accurate,

complete (nothing significant missed out) and capable of being verified (e.g. by apotential investor).

Objectivity This implies that accounting information is prepared and reported in a "neutral" way. Inother words, it is not biased towards a particular user group or vested interest



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Product Costs. Product costs are added to units of product (i.e., inventoried) as they areincurred and are not treated as expenses until the units are sold. This can result in a delay of oneor more periods between the time in which the cost is incurred and when it appears as an expenseon the income statement. Product costs are also known as inventoriable costs. The discussion inthe chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated asproduct costs.

C. Cost Classifications to Describe Cost Behavior. Managers often need to be able to predicthow costs will change in response to changes in activity. The activity might be the output of goodsor services or it might be some measure of activity internal to the company such as the number ofpurchase orders processed during a period. In this chapter, nearly all of the illustrations assumethat the activity is the output of goods or services. In later chapters, other measures of activity willbe introduced.

While there are other ways to classify costs according to how they react to changes in activity, inthis chapter we introduce the simple variable and fixed classifications. A variable cost is constantper unit of activity but changes in total as the activity level rises and falls. A fixed cost is constantin total for changes in activity within the relevant range. (Just about any cost will change if there is

a big enough change in activity. Fixed costs do not change for changes in activity that fall withinthe relevant range.) When expressed on a per unit basis, a fixed cost is inversely related toactivitythe per unit cost decreases when activity rises and increases when activity falls.

There is some controversy concerning the proper definition of the relevant range. Some refer tothe relevant range as the range of activity within which the company usually operates. We refer tothe relevant range as the range of activity within which the assumptions about variable and fixedcosts are valid. Either definition could be usedour choice was dictated by our desire to highlightthe notion that fixed costs can change if the level of activity changes enough.

D. Cost Classifications for Assigning Costs. Managers often want costs to be assigned to costobjects such as products, customers, departments, etc. for pricing or other purposes. A direct costis a cost that can be conveniently and easily traced to a particular cost object. Indirect costs areeverything else. A cost would be considered indirect for one of two reasons: either it is impracticalor it is impossible to trace the cost to the cost object.

1. Common costs. For example, it is impossible to trace the factory managers salary in a multi-product plant to any particular product made in the plant. Even if a product were dropped entirely,we would ordinarily expect the factory managers salary to remain the same. This is an example ofa common cost and later in the text we emphasize that such costs should not be allocated fordecision-making or performance evaluation purposes.

2. Variable indirect costs. On the other hand, other costs are treated as indirect costs because itwould not be practical to treat them otherwise. For example, it would be possible to measure theprecise amount of solder used on each circuit board produced at a HP plant, but it wouldnt be

worth the effort. Instead, solder would typically be considered an indirect material and would beincluded in overhead.

E. Cost Classifications for Decision-Making. Every decision involves choosing from among atleast two alternatives. Only those costs and benefits that differ between alternatives are relevant inmaking the selection. This concept is explored in greater detail in the chapter on relevant costs.However, decision-making contexts crop up from time to time in the text before that chapter, so itis a good idea to familiarize students with relevant cost concepts.



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1. Differential Costs. A differential cost is a cost that differs between alternatives. The cost mayexist in only one of the alternatives or the total amount of the cost may differ between thealternatives. In the latter case, the differential cost would be the difference between the cost underone alternative and the cost under the other. Differential costs are also called incremental costs.Differential costs and opportunity costs should be the focus of decision-making. They are the onlyrelevant costs and all others should be ignored.

2. Opportunity Costs. An opportunity cost is the potential benefit that is given up by selectingone alternative over another. The concept of an opportunity cost is rather difficult for students tounderstand because it is not an actual expenditure and it is rarely (if ever) shown on theaccounting books of an organization. It is, however, a cost that must be considered in decisions.

3. Sunk Cost. A sunk cost is a cost that has already been incurred and that cannot be changed byany decision made now or in the future. Since sunk costs cannot be changed and therefore cannotbe differential costs, they should be ignored in decision making. While students usually accept theidea that sunk costs should be ignored on an abstract level, like most people they often havedifficulty putting this idea into practice.



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Invention of accounts

Fra Luca Bartolomeo de Pacioli (sometimes Paciolo) (1446/71517) was an Italianmathematician and Franciscan friar, collaborator with Leonardo da Vinci, and seminal contributor tothe field now known as accounting. He was also called Luca di Borgo after his birthplace, BorgoSanto Sepolcro, Tuscany.

Luca Pacioli was born in 1446 or 1447 in Sansepolcro (Tuscany) where he received an abbacoeducation. [This was education in the vernacular (i.e. the local tongue) rather than Latin andfocused on the knowledge required of merchants.] He moved to Venice around 1464 where hecontinued his own education while working as a tutor to the three sons of a merchant. It wasduring this period that he wrote his first book -- a treatise on arithmetic for the three boys he was

tutoring. Between 1472 and 1475, he became a Franciscan friar. In 1475, he started teaching inPerugia and wrote a comprehensive abbaco textbook in the vernacular for his students during 1477and 1478. It is thought that he then started teaching university mathematics (rather thanabbaco)and he did so in a number of Italian universities, including Perugia, holding the first chair inmathematics in two of them. He also continued to work as a private abbaco tutor ofmathematicsand was, in fact, instructed to stop teaching at this level in Sansepolcro in 1491. In 1494, his firstbook to be printed, Summa de arithmetica, geometria, proportioni et proportionalita, was publishedin Venice. In 1497, he accepted an invitation from Lodovico Sforza ("Il Moro") to work in Milan.There he met, collaborated with, lived with, and taught mathematics to Leonardo da Vinci. In 1499,Pacioli and Leonardo were forced to flee Milan when Louis XII of France seized the city and drovetheir patron out. Their paths appear to have finally separated around 1506. Pacioli died aged 70 in1517, most likely in Sansepolcro where it is thought he had spent much of his final years.

Summa de arithmetica, geometria, proportioni et proportionalita (Venice1494), a textbook for use

in the abbaco schools of Northern Italy. It was a synthesis of the mathematical knowledge of his

time and contained the first printed work on algebra written in the vernacular (i.e. the spoken

language of the day). It is also notable for including the first published description of the method of

bookkeeping that Venetian merchants used during the Italian Renaissance, known as the double-

entry accounting system. Although Pacioli codified rather than invented this system, he is widely

regarded as the "Father of Accounting". The system he published included most of the accounting

cycle as we know it today. He described the use of journals and ledgers, and warned that a person

should not go to sleep at night until the debits equalled the credits. His ledger had accounts for

assets (including receivables and inventories), liabilities, capital, income, and expenses the

account categories that are reported on an organization's balance sheet and income statement,

respectively. He demonstrated year-end closing entries and proposed that a trial balance be used

to prove a balanced ledger. Also, his treatise touches on a wide range of related topics from

accounting ethics to cost accounting.

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Users/Demanders of Financial Statements Information

Parties demanding financial statement information include:

Shareholders, investors and security analysts; Managers; Employees; Lenders and other suppliers; Customers; and Government regulatory agencies

These parties can also be grouped into internal versus external users. Internal users consist ofmanagers and employees while external users consist of the rest in the above list. These partiesdemand financial statement information:

To Facilitate decision-making, For Monitoring of management, or To Interpret contracts or agreements that include provisions based on such information.

Shareholders, Investors and Security AnalystsThese are major recipients of the financial statements of corporations. These parties range fromindividuals with relatively limited resources to large, well-endowed institutions such as insurancecompanies and mutual funds.

The decision made by these parties includes:

Shares to buy, retain, or sell, Timing of the purchase or sale of those shares.

Typically, their decisions have either an investment focus or a stewardship focus; in some cases,both will occur simultaneously. In an investment focus, the emphasis is on choosing a portfolio ofsecurities that is consistent with the preferences of the investor for risk, return, dividend yield,liquidity and so on. The information required for this choice can vary significantly.

An IllustrationConsider approaches aiming to detect mis-priced securities by a fundamental analysis approach asopposed to a technical analysis approach. The former approach examines firm,-industry-and economy-related information; financial statements play a major role in this approach. An important

aspect is predicting the timing, amounts, and uncertainties of the future cash flows of the firm. Incontrast, technical analysis aims to detect mispriced securities by examining trends in securityprices, security trading volume, and other related variables; financial statement informationtypically is not examined

When predicting the timing, amounts, and uncertainties of future cash flows of the firm, the pastrecord of management in relation to the resources under its control can be a critical variable. Theanalysis undertaken for decisions by shareholders and investors can be done by those partiesthemselves or by intermediaries such as security analysts and investment advisors.



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Note: These intermediaries can have different rankings for financial statement variables than theinvestors for whom the information analysis is conducted.

ManagersOne source of the demand for financial statement information by managers arises from contractsthat include provisions based on financial statement variables. e.g. Management incentive

contracts. When structuring agreements between the firm and other entities, management mayinclude contractual terms based on financial statement variables.

Managers also utilize financial statement information in many of their financing, investment, and/oroperating decisions. A financial-statement based variable, such as the current debt-to-equity ratioor the interest coverage ratio, is frequently important in deciding how much long-term debt toraise.

The financial statement of other firms can also be used in management decisions. For instance,when deciding where to re-direct the resources of a firm, the financial statement of other firms canshow areas where high profit margins are currently being earned.

EmployeesEmployees have several motivations. They have a vested interest in the continued and profitableoperations of their firm. Financial statements are an important source of information about currentand potential future profitability and solvency. They may also need them to monitor the viability oftheir pension plans.

Lenders and Other SuppliersIn the ongoing relationship that exists between suppliers and a firm, financial statements can playseveral roles. Consider the relationship between a firm and the suppliers of its loan capital, e.g. abank. In the initial loan-granting stage of the relationship, financial statements typically are animportant item.

Many banks have standard evaluation procedures that stipulate that information relating toliquidity, leverage, profitability, and so on be considered when determining the amount of the loan,interest rate and the security to be requested. Many bank loans include bond covenants that, ifviolated, can result in the bank restructuring the existing loan agreement. One effect ofincorporating a covenant into a loan agreement is to create a demand by the bank for successivefinancial statements of the firm.

CustomersThe relationship between a firm and its customers can extend over many years. In some cases,these relationships take the form of legal obligations associated with guarantees, warranties, ordeferred benefits. In other cases, the long-term association is based on continued attention tocustomer service.

Government/ Regulatory AgenciesThe demand by these bodies can arise in a diverse set of areas such as; Revenue raising, e.g. forincome tax, sales tax, or value-added tax collection. Government contracting, e.g. for reimbursingsuppliers paid on a cost-plus basis or for monitoring whether companies engaged in governmentbusiness are earning excess profits. Rate determination, e.g. deciding the allowable rate of returnthat an electric utility can earn. Regulatory intervention, e.g. determining whether to provide agovernment-backed loan agreement to a financially distressed firm.



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For instance, telecommunication regulators may demand financial statements of the telephone/ICTcompanies to make decisions on the following issues:

Competition strategy set up of the companies Monitoring interconnection charges Limit entries and incubators in the market Deciding on the coverage Setting the upper pricing limit for the services provided by the operators. For industrial/regional comparisons of the services offered by the companies and the returns

of the companies.

Other PartiesThe set of parties that make demands of the financial statements information of corporations isopen-ended. Diverse parties such as academicians, environmental protection organizations, andother special interest lobbying groups approach corporations for details relating to their financialand other affairs.

B: Suppliers of Financial Statements Information

Business firms are the suppliers of the financial statements information. Limited liability companiesare required by the company act to prepare financial statements and disclose the audited financialstatements to the public/shareholders. Listed companies are required by the regulations governingthe operation of the stock market to disclose audited financial statement information.

C: Conflicts among Diverse Parties

As explained in part A of this section, users of financial data have diversity of interests. Theseinterests sometimes conflict.

Owners/ShareholdersThe interest of these parties in financial statement information lies in the fact that it is their moneythat is invested in the firm. They would like to ensure that they are getting a good return on their

investment. This is assessed by how much profit the firm is making and whether their investmentis increasing in value. For shareholders in companies this means they will get good dividend andthe market value of their shares will increase and they can make capital gains if these were sold.

ManagementThey are responsible to the owners/shareholders in carrying out policies and directives, and inrunning the business efficiently and effectively. They however, need to be paid well and thisincreases expenses and thus reduces returns to shareholders.

Banks/Loan companiesThis group is interested not only in the firm's profitability but also in its ability to repay loans.Managers would prefer using loaned funds for a longer period.

EmployeesThey are part of the organization and feel that their efforts contributed to the firm's profits. Theywould therefore prefer to be given bonuses and salary increases. This also increases expenses tothe firm.

SuppliersSuppliers usually extend credit to the firm for goods supplied and they want to be assured of timelypayments of accounts due. Their interest will be similar to that of the banks and loan companies.



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Prospective Investors/AnalystsThese are interested in a firm's profitability and potential for growth. Prospective investors rely onfinancial statements information in making their investment decisions. In giving advice toprospective and existing investors, analysts also make use of financial statements information.

Government

Various ministries and departments have interest in the firm's payments of taxes. Also see theenactment of laws for the industry and provision of social services to the public. The governmentmay also want to ensure that the firm complies with laws on, for example, wage payments andemployee benefits.

Factors affecting Demand for financial statements information

The demand for financial statement information is derived from the improvement in decisionmaking or monitoring that arise with its use.

Potential of the Information to Reduce UncertaintyAn important element in many decisions is uncertainty. There may be, for instance, uncertaintyover the future profitability of a firm, the quality of its management, or the ability of a supplier to

fulfil obligations under a warranty agreement.

Example: A lender wishes to forecast the profitability of a loan applicant that is in a relativelystable industry, and a presumption of continuity of management appears to be reasonable. In thiscase, the past and current profitability record can be a very useful starting point when forecastingprofitability over the life of a proposed loan.

The Availability of Competing Information SourcesFinancial statements information is one of many information sources available to different partiesas mentioned earlier. Other sources however, include:

Company-oriented releases such as divided releases and production reports

Industry-oriented releases such as new wage contracts with unions, and Economy-oriented releases such as money supply announcements.

Financial statements have a comparative advantage over these other sources of informationbecause the financial statements are:

More directly related to the variable of interest. A more reliable information source. One rationale for reliability could be the existence of

auditors to certify the financial statements presented by management. A lower-cost information source. In most jurisdictions, firms do not charge individual users

when providing financial statements. A more timely information source. In some cases however, management can reduce the

value of information provided by competing sources such as outside agencies by makingprompt release of budget information, information on the impact of new events for the firm,and so forth.



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Accrual Basis vs. Cash Basis Accounting

Accrual Basis Accounting

Under the accrual basis accounting, revenues and expenses are recognized as follows:

Revenue recognition: Revenue is recognized when both of the following conditions are met:a. Revenue is earned.b. Revenue is realized or realizable.

Revenue is earned when products are delivered or services are provided.Realized means cash is received.Realizable means it is reasonable to expect that cash will be received in the future.Expense recognition: Expense is recognized in the period in which related revenue is recognized(Matching Principle).

Cash Basis Accounting

Under the cash basis accounting, revenues and expenses are recognized as follows:1. Revenue recognition: Revenue is recognized when cash is received.2. Expense recognition: Expense is recognized when cash is paid.

Timing differences in recognizing revenues and expenses.There are potential timing differences inrecognizing revenues and expenses between accrual basis and cash basis accounting.Four types

of timing differences:a. Accrued Revenue: Revenue is recognized before cash is received.b. Accrued Expense: Expense is recognized before cash is paid.c. Deferred Revenue: Revenue is recognized after cash is received.d. Deferred Expense: Expense is recognized after cash is paid.

An Example of Accrued Revenue

Example: Products are sold at $5,000 on May 1, 2006 and cash is r

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Introduction CH 1-2