project imi

Chapter-1

The nature and functions of financial accounting

Financial accounting may be defined as the process of designing and operating an information system for collecting, measuring and recording an enterprise’s transactions, and summarizing and communicating the results of these transactions to users to facilitate making financial economic decisions.

The first part of this definition, relating to collecting and recording transactions, refers to

double-entry bookkeeping, which consists of maintaining a record of the nature and money value of the transactions of an enterprise. In many organizations this may be done using a computer. The second part of the definition, relating to communicating the results, refers to preparing final accounts and statements from the books of account (or any other system of recording), showing the profit earned during a given period and the financial state of affairs of a business at the end of that period.

Tracking and recordingof data

Processing of data

Reporting

Decision makers

Businesstransactions

Financial accounting system

Data Information

FA as IS.

The recording and control of business transactions

This includes records of the following:1 The amount of cash and cheques received, for what and from whom.

2 The amount of cash and cheques paid, for what and to whom. Records of money receivedand paid are kept so that the enterprise knows how much money it has at any time.

3 Assets, expenses and goods purchased on credit. This is so that the enterprise knows towhom it owes money and how much. These are referred to as creditors.

4 Assets and goods sold on credit. This is so that the enterprise knows who owes it moneyand how much. These are referred to as debtors.

The accountant has been traditionally regarded as the ‘holder of the purse strings’ andresponsible for ‘safeguarding’ the assets of the enterprise. The control aspect of this function

includes ensuring that the correct amounts are paid to those entitled to them at theappropriate time, collecting the enterprise’s debts when due, safeguarding against fraud andmisappropriation of assets such as goods or cash. The latter function is often referred to as

internal control.

To maintain accuracy in recording

Double-entry bookkeeping is generally regarded as the most accurate method of bookkeeping, primarily because each transaction is entered in the books twice. This duplication, referred to as a form of internal check, highlights any errors.

To meet the requirements of the law

The law, in the form of the Companies Acts, states that companies must keep proper records of their transactions and send their shareholders a set of annual final accounts. There is also tax legislation that requires sole traders and partnerships to provide the Inland Revenue with details of their income and expenditure. The self assessment procedure used by the Inland Revenue allows traders to deduct various expenses from their income in arriving.

To present final accounts to the owners of the businessThese comprise a profit and loss account showing the amount of profit and thus the financialperformance of a business for a given period, and a balance sheet showing its financialposition at the end of that period. The latter will include the following items:

1 The amount of cash and money at the bank.2 Other assets that the business owns, such as goods for resale, vehicles and machinery.3 Debtors and creditors.4 The amount of capital that has been invested in the business by its owner(s).5 Any money that has been borrowed by the business.

In the case of a sole trader, these final accounts show the owner his or her ‘earnings’ forthe period and may be used to evaluate the profitability of the business. However, they areoften primarily used to determine the owner’s tax liability. Final accounts perform similarfunctions in the case of companies. However, company final accounts are also designed to

give information to third parties to enable them to evaluate the profitability and financial stability of the company.These include prospective shareholders, trade unions and employees, creditors and those who have lent the company

money, government departments and social pressure groups.

This function of financial accounting is often referred to as stewardship, which may bedefined as the accountability of an enterprise’s management for the resources entrusted to

them. Accountability refers to the management’s responsibility to provide an account reporton the way in which the resources entrusted to them have been used.

To present other financial reports and analyses

This includes the use of ratios to evaluate the following matters:

1 The profitability of the business.2 The level of activity and productivity.3 The solvency and liquidity position (i.e. whether the

business will be able to pay its debts).4 The efficiency of credit control procedures.5 The efficiency of stock control procedures.6 The effect of any loans on the business’s profitability

and financial stability.To

To facilitate the efficient allocation of resources

Viewing the function of financial accounting at a more general, abstract level, its ultimateraison d’être is usually described as being to facilitate the efficient and effective allocation ofresources. This is generally given a macroeconomic interpretation as providing informationto investors so that capital is directed towards more efficient firms. A less common but similarinterpretation would be to extend this to providing information to prospective employeesso that labour is directed towards more efficient firms. The same interpretation could alsoTHE NATURE AND OBJECTIVES OF FINANCIAL ACCOUNTING 5be extended to other potential users of final accounts and providers of resources in a broadsense that embraces quality of life and environmental considerations, etc. This wouldinclude others such as bank lenders, creditorssuppliers, the government and the public ingeneral.This function of financial accounting can also be viewed at a microeconomic or individualfirm level. One of the main purposes of financial accounting may be said to be to enable anorganization’s management to operate the enterprise efficiently and effectively. Thisembraces at least three of the functions referred to above, namely, the recording and controlof business transactions, accuracy in recording and the preparation of final accounts (formanagement use). However, this function of accounting is more commonly attributed tomanagement accounting, particularly in larger organizations.

Accounting Concepts and Principles

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The GAAP principles are divided into two categories:

1. Accounting Concepts: Accounting Concepts are basic assumptions or conditions upon which science of accounting is based.

2. Accounting Conventions: Accounting Conventions include those customs and traditions which are followed up by an accountant while preparing a financial statement.

GAAP Principles:

GAAP (Generally Accepted Accounting Principles):

The rules that govern accounting are called GAAP (Generally Accepted Accounting Principles).

GAAP (Generally Accepted Accounting Principles):

• The common set of accounting principles, standards and procedures.

• Combination of authoritative standards (set by policy boards) and simply, the commonly accepted ways.

GAAP (Generally Accepted Accounting Principles):

Explanation:• Provides a fair financial image of the company.• Provides with different Information:

– Revenue recognition.– Balance sheet item classification.– Outstanding share measurements.

3 Main Categories of GAAP:• Assets: An asset is an item of value

owned by a company.• Liabilities: In

accounting, liabilities are obligations of the company, to transfer something of value to another party.

• Equity: Equity is the owner's value in an asset or group of assets.

Introduction

• Actually there are a number of accounting concepts and principles based on which we prepare our accounts

• These generally accepted accounting principles lay down accepted assumptions and guidelines and are commonly referred to as accounting concepts

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Users of Financial Statements

• Investors– Need information about the profitability, dividend yield and price

earnings ratio in order to assess the quality and the price of shares of a company

• Lenders– Need information about the profitability and solvency of the

business in order to determine the risk and interest rate of loans• Management

– Need information for planning, policy making and evaluation• Suppliers and trade creditors

– Need information about the liquidity of business in order to access the ability to repay the amounts owed to them

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• Government– Need information about various businesses for statistics and

formulation of economic plan• Customers

– Interested in long-tem stability of the business and continuance of the supply of particular products

• Employees– Interested in the stability of the business to provide employment,

fringe benefits and promotion opportunities• Public

– Need information about the trends and recent development

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Limitations of conventional financial statements

• Companies may use different methods of valuation, cost calculation and recognizing profit

• The balance sheet does not reflect the true worth of the company

• Financial statements can only show partial information about the financial position of an enterprise, instead of the whole picture

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Accounting Concepts

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Accounting Concepts

• Business entity• Money Measurement/stable monetary unit• Going Concern• Historical Cost• Prudence/conservatism• Materiality

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• Objectivity• Consistency• Accruals/matching• Realization• Uniformity• Disclosure• Relevance

Business Entity

• Meaning– The business and its owner(s) are two separate

existence entity– Any private and personal incomes and expenses of

the owner(s) should not be treated as the incomes and expenses of the business

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Business Entity

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• Examples– Insurance premiums for the owner’s house

should be excluded from the expense of the business

– The owner’s property should not be included in the premises account of the business

– Any payments for the owner’s personal expenses by the business will be treated as drawings and reduced the owner’s capital contribution in the business

Money Measurement

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Money Measurement

• Meaning– All transactions of the business are recorded in

terms of money– It provides a common unit of measurement

• Examples– Market conditions, technological changes and

the efficiency of management would not be disclosed in the accounts

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Going Concern

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Going Concern

• Meaning– The business will continue in operational existence

for the foreseeable future– Financial statements should be prepared on a

going concern basis unless management either intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so

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• Example – Possible losses form the closure of business

will not be anticipated in the accounts– Prepayments, depreciation provisions may be

carried forward in the expectation of proper matching against the revenues of future periods

– Fixed assets are recorded at historical cost

Historical Cost

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Historical Cost• Meaning

– Assets should be shown on the balance sheet at the cost of purchase instead of current value

• Example– The cost of fixed assets is recorded at the date

of acquisition cost. The acquisition cost includes all expenditure made to prepare the asset for its intended use. It included the invoice price of the assets, freight charges, insurance or installation costs

Prudence/Conservatism

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Prudence/Conservatism

• Meaning– Revenues and profits are not anticipated. Only

realized profits with reasonable certainty are recognized in the profit and loss account

– However, provision is made for all known expenses and losses whether the amount is known for certain or just an estimation

– This treatment minimizes the reported profits and the valuation of assets

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• Example– Stock valuation sticks to rule of the lower of

cost and net realizable value– The provision for doubtful debts should be

made– Fixed assets must be depreciated over their

useful economic lives

Materiality

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Materiality

• Meaning– Immaterial amounts may be aggregated with

the amounts of a similar nature or function and need not be presented separately

– Materiality depends on the size and nature of the item

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• Example– Small payments such as postage, stationery

and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses

– The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to the profit and loss account as revenue expenditures, although they can last for more than one accounting period

Objectivity

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Objectivity

• Meaning– The accounting information should be free from

bias and capable of independent verification– The information should be based upon verifiable

evidence such as invoices or contracts

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• Example– The recognition of revenue should be based on

verifiable evidence such as the delivery of goods or the issue of invoices

Consistency

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Consistency• Meaning

– Companies should choose the most suitable accounting methods and treatments, and consistently apply them in every period

– Changes are permitted only when the new method is considered better and can reflect the true and fair view of the financial position of the company

– The change and its effect on profits should be disclosed in the financial statements

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• Examples– If a company adopts straight line method and

should not be changed to adopt reducing balance method in other period

– If a company adopts weight-average method as stock valuation and should not be changed to other method e.g. first-in-first-out method

Accruals/Matching

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Accruals/Matching

• Meaning– Revenues are recognized when they are

earned, but not when cash is received– Expenses are recognized as they are incurred,

but not when cash is paid– The net income for the period is determined

by subtracting expenses incurred from revenues earned

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• Example– Expenses incurred but not yet paid in current

period should be treated as accrual/accrued expenses under current liabilities

– Expenses incurred in the following period but paid for in advance should be treated as prepayment expenses under current asset

– Depreciation should be charged as part of the cost of a fixed asset consumed during the period of use

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Problems in the recognition of expenses

• Normally, expenses represents resources consumed during the current period. Some costs may benefit several accounting periods, for example, development expenditures, depreciation on fixed assets.

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Recognition criteria for expenses

• Association between cause and effect– Expenses are recognized on the basis of a direct

association between the expenses incurred on the basis of a direct association between the expenses incurred and revenues earned

– For example, the sales commissions should be accounted for in the period when the products are sold, not when they are paid

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• Systematic allocation of costs– When the cost benefit several accounting periods,

they should be recognized on the basis of a systematic and rational allocation method

– For example, a provision for depreciation should be made over the estimated useful life of a fixed asset

• Immediate recognition– If the expenses are expected to have no certain future

benefit or are even without future benefit, they should be written off in the current accounting period, for example, stock losses, advertising expenses and research costs

Realization

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Realization

• Meaning• Revenues should be recognized when the

major economic activities have been completed

• Sales are recognized when the goods are sold and delivered to customers or services are rendered

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Recognition of revenue

• The realization concept develops rules for the recognition of revenue

• The concept provides that revenues are recognized when it is earned, and not when money is received

• A receipt in advance for the supply of goods should be treated as prepaid income under current liabilities

• Since revenue is a principal component in the measurement of profit, the timing of its recognition has a direct effect on the profit

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Recognition criteria for revenues

• The uncertain profits should not be estimated, whereas reported profits must be verifiable

• Revenue is recognized when1. The major earning process has substantially been

completed2. Further cost for the completion of the earning

process are very slight or can be accurately ascertained, and

3. The buyer has admitted his liability to pay for the goods or services provided and the ultimate collection is relatively certain

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• Example– Goods sent to our customers on sale or return

basis– This means the customer do not pay for the

goods until they confirm to buy. If they do not buy, those goods will return to us

– Goods on the ‘sale or return’ basis will not be treated as normal sales and should be included in the closing stock unless the sales have been confirmed by customers

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Problems in the recognition of revenue

• Normally, revenue is recognized when there is a sale

• The point of sales in the earning process is selected as the most appropriated time to record revenues

• However, if revenue is earned in a long and continuous process, it is difficult to determine the portion of revenue which is earned at each stage

• Therefore, revenue is permitted to be recorded other than at the point of sales

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Exceptions to rule of sales recognition 1. Long-term contracts

– Owning to the long duration of long-term contracts, part of the total profit estimated to have been arisen from the accounting period should be included in the profit and loss account

2. Hire Purchase Sale– Hire purchase sales have long collection period.

Revenue should be recognized when cash received rather than when the sale (transfer of ownership) is made

– The interest charged on a hire purchase sale constitutes the profit of transaction

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3. Receipts from subscriptions- A publisher receives subscriptions before it sends

newspapers or magazines to its customers- It is proper to defer revenue recognition until the

service is rendered.- However, part of subscription income can be

recognized as it is received in order to match against the advertising expenses incurred

Disclosure

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Disclosure

• Meaning– Financial statements should be prepared to reflect

a true and fair view of the financial position and performance of the enterprise

– All material and relevant information must be disclosed in the financial statements

Uniformity

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Uniformity

• Meaning– Different companies within the same industry

should adopt the same accounting methods and treatments for like transactions

– The practice enables inter-company comparisons of their financial positions

Relevance

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Relevance

• Meaning– Financial statements should be prepared to

meet the objectives of the users– Relevant information which can satisfy the

needs of most users is selected and recorded in the financial statement

UNDERSTANDING OF ACCOUNTING STANDARDS

AGENDA OF DISCUSSION

• Introduction of Accounting Standards• Objectives of Accounting Standards• Types of Accounting Standards

Introduction

• Written Documents issued by Government or Regulatory Body

• In India, issued by ICAI( Institute of Cost Accountants of India ) on 21st April,1977

• Initiated by Kumar Mangalam Birla, chairman committee of Corporate Governance for Financial Disclosures

• Also initiated by Chair person of NACAS( National Advisory Committee on Accounting Standard (NACAS))

Objectives

• Standardise the diverse Accounting Policies• Add the reliability to the Financial Statement• Eradicate baffling variation in treatment of

accounting aspects• Facilitate inter-firm and intra-firm comparison

Accounting Standards in Different Nations

• In India, 32 Accounting Standards as IAS under NACAS

• As per International, there are 41 Accounting Standards called as IFRS

• Adopted by 8 countries in the world• 70 to 80 countries planning to adhere IFRS(

International Financial Reporting Standards• )• Clause 50 added to the listing agreement

mandatory

Evolution and Types of AS

Accounting Standards Initiation

1. AS 1 to AS 15 1979 to 1995

2. AS 16 to AS 29 2000 to 2007

3. AS 30 to AS 32 Later part of 2007

AS 1-Disclosure of Accounting Policies

• Specific policies adapted to prepare FS• Should be disclosed at one place Purpose :-1. Better understanding of FS2. Better comparison analysis3. Mostly needed w.r.t Depreciation

AS 2- Accounting for Inventories

• Used for computation of Cost of inventories and to show in BS till it is sold

Consists of :-1. Raw Materials2. Work in progress3. Finished goods4. Spares, etc

Measurements of Inventories

• Determination of Cost of Inventories Cost of purchase (Purchase price, duties & taxes, freight inwards) Cost of conversion• Determination of Net realisable value• Comparison of cost and net realisable

AS 3- Cash Flow Statements

• Incoming and outgoing of cash• Act as barometer to judge surplus and deficit• Explain Cash flow under 3 heads :-1. Cash flow from operating activities2. Cash flow from financing activities3. Cash flow from investing activities

AS 4- Contingencies and events occurring after BS date

• For maintaining Provision of Bad debts• Generally uses Conservative concepts of

Accounting like Bankruptcy, frauds & errors.

AS 5- Net profit or loss for the period, prior period items and change in Accounting policies

• Ascertain certain criteria for certain items• Include income and expenditures of Financial

year• Consists of 2 component1. Profit and loss of ordinary activities2. Profit and loss of extra ordinary activities

AS 6- Accounting for Depreciation

• A non-cash expenditure• Distribution of total cost to its useful life• Occurs due to obsolescence• Different methods of computation1. Straight line method ( SLM )2. Written-down value or diminishing value

(WDV)

AS 7- Construction Contract

• Contract specifically negotiated for construction of Asset or combination of Assets closely inter-related

AS 8- Accounting for R&D

• To deal with treatment of Cost of research and development in the financial statements, identify items of cost which comprise R&D costs lays down condition R&D cost may be deferred and requires specific disclosures to be made regarding R&D costs.

AS 9- Revenue Recognition

• Means gross inflow of cash and other consideration like arising out of :-

1. Sale of goods2. Rendering services3. Use of enterprise resources by other yielding

interest, dividend and royalities.

AS 10- Accounting for Fixed Assets

• Called as Cash generating Assets• Expected to used for more than a Accounting

period like land, building, P/M, etc• Shown at either Historical or Revalued value

AS 11- Effect of change in FOREX Rates

• Classification for Accounting treatment:-1. Category I: Foreign currency transactions: a) buying and selling of goods or services b) lending and borrowing in foreign currency c) Acquisition and disposition of assets2. Category II: Foreign operations: a) Foreign branch b) Joint venture c) Foreign Subsidiary3. Category III: Foreign Exchange contracts: a) For managing Risk/hedging b) For trading and Speculation

AS 12- Accounting for Govt. Grants

• Assistance provided by Govt. in cash or in kind like

1. Grants of Assets like P/M, Land,etc2. Grants related to depreciable FA3. Tax exemptions in notified area

AS 13- Accounting for Investments• Assets held for earning incomes like dividend, interest,

rental for capital appreciation, etc• It involves:-1. Classification of Investment2. Cost of Investment3. Valuation of Investment4. Reclassification of Investment5. Disposal of Investment6. Disclosure of Investment in FS

AS 14- Accounting for Amalgamation

• Section 391 to 394 of Companies Act, 1956 governs the provision of amalgamation.

• Disclosures:1. Names and nature of amalgamating companies2. Effective date of amalgamation3. Method of Accounting used4. Particulars of scheme sanctioned under a statute

AS 15- Employees Benefits

• All forms of consideration given by enterprise directly to the employees or their spouses, children or other dependants, to other such as trust, insurance companies in exchange of services rendered.

AS 16- Borrowing Costs

• Interest and cost incurred by an enterprise in connection to the borrowed funds.

• Availed for acquiring building, installed FA to make it useable and saleable.

AS 17- Segment Reporting

• It consists of 2 segment:-1. Business segment2. Geographical segment• Information and different risk and return

reporting.

AS 18- Related party disclosure• Related party are those party that controls or significantly

influence the management or operating policies of the company during reporting period

• Disclosure:1. Related party relationship2. Transactions between a reporting enterprises and its related

parties.3. Volume of transactions4. Amt written off in the period in respect of debts

AS 19- Accounting for Leases

• Agreement between Lessor And Lessee• Two types of leases:1. Operating lease2. Finance lease• Different from Sale• Classification to be made at the inception

AS 20- Earning per share

• Earning capacity of the firm• Assessing market price for share• AS gives computational methodology for

determination and presentation of EPS• 2 types of EPS

AS 21- Consolidated Balance Sheet

• Accounting for Parent and Subsidiary company in single entity

• Disclosure:-1. List of all subsidiaries2. Proportion of ownership interest3. Nature of relation whether direct or indirect

AS 22- Accounting for taxes and income

• Tax accounted for period in which are accounted

• It should be accrued and not liability to pay• Deals in 2 measurements:-1. Current tax2. Deferred tax

AS 23- Accounting for investments in Associates in CFS

• Objectives to set out principles and procedures for recognizing the investment associates in CFS of the investors, so that effect of investments in associates on financial position of group is indicated.

AS 24- Discontinuing operations

• Establishes principles for reporting information about discontinuing operations

• Covers discontinuing operations rather than discontinued operation

AS 25-Interim Financial Reporting (IFR)

• Reporting for less than a year i.e 3 months• Clause 41 says publish financial results on

quarterly basis• Objective is to provide frequently and timely

assessment

AS 26- Intangible Assets

• No physical existence• Can not be seen or even touched• 3 featured as per AS1. Identifiable2. Non-monetary assets3. Without physical substance

AS 27- Financial Reporting of interest in Joint Venture

• What is joint venture?• Three types of JV in case of Financial reporting

AS 28- Impairment of Assets

• Weakening of Assets value• Occurs when carrying cost more than

recoverable amt• Carrying cost = Cost of assets –Accumulated Depreciation

AS 29- Provision, contingent liabilities and assets

• Provisions:- It is a Liability Settlement should result in outflow Liability is result of obligating event• Contingent liabilities:- Obligation arises of past event Existence confirmed when actually occurred of uncertain future• Contingent Asset Same as Contingent liability

Financial Instruments

• AS 30 – Recognition and Measurement• AS 31 – Presentation• AS 32 – Disclosures• Has not been made mandatory (expected in

2009)

• Generally accepted accounting principles, or GAAP for short, are the accounting rules used to prepare and standardize the reporting of financial statements, such as balance sheets, income statements and cashflow statements, for publicly traded companies and many private companies in the United States. GAAP-based income is measured so that the information provided on financial statements is useful to those making economic decisions about a company, such as potential investors and creditors.

• GAAP is implemented through measurement principles and disclosure principles. Measurement principles recognize and determine the timing and basis of items that enter the accounting cycle and impact the financial statements, such as the period in which transactions will be recorded.Disclosure principles determine what specific numbers and other information are essential to be presented in financial statements. Basically, GAAP is concerned with:

• the measurement of economic activity;• the time when such measurements are to be made and recorded;• the disclosures surrounding this activity; and• the preparation and presentation of summarized economic information in financial

statements.

The Principles of GAAP

GAAP (Generally Accepted Accounting Principles):

• The common set of accounting principles, standards and procedures.

• Combination of authoritative standards (set by policy boards) and simply, the commonly accepted ways.

GAAP (Generally Accepted Accounting Principles):

Explanation:• Provides a fair financial image of the company.• Provides with different Information:

– Revenue recognition.– Balance sheet item classification.– Outstanding share measurements.

3 Main Categories of GAAP:• Assets: An asset is an item of value

owned by a company.• Liabilities: In

accounting, liabilities are obligations of the company, to transfer something of value to another party.

• Equity: Equity is the owner's value in an asset or group of assets.

The GAAP principles are divided into two categories:

1. Accounting Concepts: Accounting Concepts are basic assumptions or conditions upon which science of accounting is based.

2. Accounting Conventions: Accounting Conventions include those customs and traditions which are followed up by an accountant while preparing a financial statement.

GAAP Principles: