Accounting Zoubida SAMLAL - MBA , CFA Member, PHD candidate for HBS program
Fundamentalconcepts What is accounting? • the language of business • a process of identifying, recording, summarizing, and reporting economic information to decision makers in the form of financial statements • a mean to communicate financial information. • a way to convey information about a business to users.
Definitions of Accounting • “The process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information.” —American Accounting Association (AAA) • “A service activity whose function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions.” —American Institute of Certified Public Accountants (AICPA)
Primary Functions of Accounting • Recording data about business transactions • Summarizing results of business activity into useful report- However, managers in today's environment demand more detailed reports like sales by district or sales by product type. • Providing assurances that the business is operating as intended and that the assets of the organization are protected
Accounting as an Aid to Decision Making • Accounting helps in decision making by showing where and when money has been spent, by evaluating performance, and by showing the implications of choosing one plan instead of another. • Fundamental relationships in the decision-making process: Accountant’s analysis and recording Financial statements Event Users
Fundamental concepts Who uses accounting information? • Owners • Managers • Investors (including potential) • Analysts on their behalf • Creditors (including potential) • Government (tax assessment) • Regulators • Customers
Fundamental concepts • Accounting has two main divisions: 1- Financial accounting Primarily prepared for users external to the company: Revenues, earnings, assets, etc. 2- Management accounting Primarily for internal purposes : Costing, budgeting, net present value, etc.
Fundamental concepts There are several ways that cash gets into a company: • Investment by owners • Investment by creditors (loans) • Payments from customers • Repayment of amounts loaned to other entities • Return on investments (interest and dividend) • Proceeds from selling assets
Fundamental concepts Cash going in can be organized into three categories: Operations • Payments from customers • Refunds from suppliers Financing • Investment by owners • Investment by creditors (loans) Investing • Return on investments (interest and dividend) • Proceeds from selling assets • Repayment of amounts loaned to other entities
Fundamental concepts Similarly, money going out of an entity can be categorized: Operations • Payments to suppliers • Refunds to customers Financing • Payment of dividends or capital to owners • Repayment of creditors Investing • Purchase of assets • Amounts invested in other entities (debt or equity)
Fundamental concepts Financial accounting categorizes all transactions and events based on their substance because the users of the information are using it with the assumption that these categorizations are being made accurately. If money invested by owners was reported as revenue, this would be counter to the fundamental definition of revenue (i.e. that it results from the operations of the company). The separation of income and capital is a fundamental concept of financial accounting.
Securities and Exchange Commission • Established by federal government • Accounting and reporting for public companies Securities Act of 1933 Securities Act of 1934 • Encouraged private standard-setting body • SEC requires public companies to adhere to GAAP aka IFRS • Oversight • Enforcement Authority
Financial Accounting Standards Board Wheat Committee’s recommendations resulted in the creation of a the Financial Accounting Standards Board (FASB)in 1973. Financial Accounting Foundation Selects members of the FASB Funds their activities Exercises general oversight. Financial Accounting Standards Board Mission to establish and improve standards of financial accounting and reporting. Financial Accounting Standards Advisory Council Consult on major policy issues.
Financial Accounting Standards Board Missions is to establish and improve standards of financial accounting and reporting. Differences between FASB and APB include: • Full-time, Remunerated Membership • Greater Autonomy • Increased Independence • Broader Representation
Standard-Setting Organizations • Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time. • Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S. • Sarbanes-Oxley Act responded to cases of accounting fraud. • Created the Public Accounting Oversight Board, which sets audit standards and investigates and sanctions accounting firms that certify the books of publicly traded firms. • Senior executives must personally certify that the financial information reported by the company is correct. • Resulted in increase in demand for accountants.
Financial Reporting Challenges IFRS in a Political Environment
Financial Reporting Challenges The Expectations Gap What the public thinks accountants should do vs. what accountants think they can do. Significant Financial Reporting Issues • Non-financial measurements • Forward-looking information • Sort assets • Timeliness
Financial Reporting Challenges Ethics in the Environment of Financial Accounting • Companies that concentrate on “maximizing the bottom line,” “facing the challenges of competition,” and “stressing short-term results” place accountants in an environment of conflict and pressure. • IFRS does not always provide an answer. • Doing the right thing is not always easy or obvious.
Financial Reporting Challenges International Convergence • In 2002 the IASB and the FASB formalized their commitment to the convergence of U.S. GAAP and international standards. The Boards agreed to: • Make their existing financial reporting standards fully converged as soon as practicable, and • Coordinate their future work programs to ensure that once achieved, convergence is maintained.
1) BUSINESS ENTITY CONCEPT • Business is treated as separate & distinct from its members • Separate set of books are prepared. • Proprietor is treated as creditor of the business. • For other business of proprietor different books are prepared.
2) MONEY MEASUREMENT CONCEPT • Transactions of monetary nature are recorded. • Transactions of qualitative nature, even though of great importance to business are not considered.
3) GOING CONCERN CONCEPT • Business will continue for a long period. • As per this concept, fixed assets are recorded at their original cost & depreciation is charged on these assets. • Because of this concept, outside parties enter into long term contracts with the enterprise.
4) ACCOUNTING PERIOD CONCEPT • Entire life of the firm is divided into time intervals for ascertaining the profits/losses are known as accounting periods. • Accounting period is of two types- financial year(1st Apr to 31st March) & calendar year(1st Jan to 31st Dec). • For taxation purposes financial year is adopted as prescribed by the Govt. • Companies having their shares listed on stock exchange publishes their quarterly results.
5) HISTORICAL COST CONCEPT • Assets are recorded at their original price. • This cost serves the basis for further accounting treatment of the asset. • Acquisition cost relates to the past i.e. it is known as historical cost.
JUSTIFICATION FOR HISTORICAL COST CONCEPT • This cost is objectively verifiable. • Justified by going concern concept. • Current values are difficult to determine. • Difficult to keep track of up down of the market price.
DRAWBACKS OF HISTORICAL CONCEPT • Assets for which nothing is paid will not be recorded like reputation, brand value, etc. • Information based on historical cost may not be useful to its members.
6) DUAL ASPECT CONCEPT • Every transaction recorded in books affects at least two accounts. • If one is debited then the other one is credited with same amount. • This system of recording is known as “DOUBLE ENTRY SYSTEM”. • ASSETS = LIABILITIES + CAPITAL
7) REVENUE RECOGNITION/REALISATION CONCEPT • Revenue means the addition to the capital as a result of business operations. • Revenue is realized on three basis-: • Basis of cash • Basis of sale • Basis of production
8) MATCHING CONCEPT • All the revenue of a particular period will be matched with the cost of that period for determining the net profits of that period. • Accordingly, for matching costs with revenue, first revenue should be recognized & then costs incurred for generating that revenue should be recognized.
Following points must be consideredwhile matching costs with revenue • Outstanding expenses though not paid in cash are shown in the P&L a/c. • Prepaid expenses are not shown in the P&L a/c. • Closing stock should be carried over to the next period as opening stock. • Income receivable should be added in the revenue & income received in advance should be deducted from revenue.
9) ACCRUAL CONCEPT • In this concept revenue is recorded when sales are made or services are rendered it is immaterial whether cash is received or not. • Same with the expenses i.e. they are recorded in the accounting period in which they assist in earning the revenues whether the cash is paid for them or not.
10) OBJECTIVITY CONCEPT • Accounting transactions should be recorded in an objective manner, free from the personal bias of either management or the accountant who prepares the accounts. • It is possible only when each transaction is supported by verifiable documents & vouchers such as cash memos, invoices.
11) TIMELINESS • This principle states that the information should be provided to the users at right time for the purpose of decision making. • Delay in providing accounts serves no usefulness for the users for decision making.
12) COST BENEFIT PRINCIPLE • This principle states that the cost incurred in applying the principles should be less than the profits derived from them.
ACCOUNTING CONVENTIONS • An accounting convention may be defined as a custom or generally accepted practice which is adopted either by general agreement or common consent among accountants.
1) CONVENTION OF FULL DICLOSURE • Information relating to the economic affairs of the enterprise should be completely disclosed which are of material interest to the users. • Proforma & contents of balance sheet & P&L a/c are prescribed by Companies Act. • It does not mean that leaking out the secrets of the business.
2) CONVENTION OF CONSISTENCY • Accounting method should remain consistent year by year. • This facilitates comparison in both directions i.e. intra firm & inter firm. • This does not mean that a firm cannot change the accounting methods according to the changed circumstances of the business.
3) CONVENTION OF CONSERVATISM • All anticipated losses should be recorded but all anticipated gains should be ignored. • It is a policy of playing safe. • Provisions is made for all losses even though the amount cannot be determined with certainty
4) CONVENTION OF MATERIALITY • According to American Accounting Association, “An item should be regarded as material if there is reason to believe that knowledge of it would influence decision of informed investor.” • It is an exception to the convention of full disclosure. • Items having an insignificant effect to the user need not to be disclosed.
The Nature of Accounting • The accounting system is a series of steps performed to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their effects on an organization and to prepare the financial statements.
Accounting as an Aid toDecision Making • Fundamental relationships in the decision-making process: Accountant’s analysis & recording Financial Statements Event Users
Financial and Management Accounting • The major distinction between financial and management accounting is the users of the information. • Financial accounting serves external users. • Management accountingserves internal users, such as top executives, management, and administrators within organizations.