M&F-I (2006-08)

Accounting for Managers

Chapter I
Fundamental Concepts of Accounting:
In business numerous transactions takes place everyday. It is humanly impossible to remember all of them.
The recording of business transactions is the main function served by accounting. With the help of
accounting records the businessman is able to ascertain the profit or loss and the financial position of his
business at the end of a given period and communicate such information to all interested parties.
Accounting is often referred to as the language of business. It records business transactions taking place
during the accounting period with a view to prepare financial statements. One of the important objectives of
accounting is to measure the profit of the business & the other is to ascertain the financial position of the
business. The first is done through the preparation of the P & L A/c (or income statement) and the second
requires the preparation of B/s. All accounting is done and designed to prepare these financial statements
periodically, usually once a year. These statements provide vital information to several groups of affected
parties like shareholders, creditors, employees and others like: Govt. researchers, bankers, prospective
investors, financial analysts etc. The basic overall purpose of these statements is to communicate quantitative
information, generated by financial accounting process, to the various groups as mentioned above. Therefore
these statements are designed to suit the general needs of these diverse groups to enable them to make use of
the information for making certain economic decisions.

Definition of Accounting:
The subject of accounting has been defined in different ways by different authorities and there is no
unanimity among accountants as to its precise definition. Therefore it is very difficult to define the subject
through a single definition. However, the following definitions would give a general understanding of the
subject:
According to American Accounting Association: Accounting is the process of identifying,
measuring and communicating economic information to permit informed judgments and
decisions by users of the information.
According to the committee on Terminology, appointed by the American Institute of
Certified Public Accountants (AICPA) Accounting is the art of recording, classifying and
summarizing in a significant manner and in terms of money, transaction and events which
are in part at least, of a financial character and interpreting the results thereof.
The later is a popular definition and it outlines fully the nature and scope of Accounting activity.

Objectives of Accounting:
(1)

To maintain systematic records: Accounting is used to maintain systematic record of all financial
transactions like purchase and sale of goods, cash receipts and cash payments etc. It is also used for
recording various assets and liabilities of the business.

(2)

To ascertain Net profit / Net loss of the business: A businessman would be interested in periodically
finding the net result of his business operations i.e. whether the business has earned profit or incurred
some loss. A proper record of all incomes and expenses helps in preparing P & L A/C and ascertain
the net result of the business operations during a particular period.

(3)

To ascertain the financial position of the business: The businessman is also interested in ascertaining
the financial position of his business at the end of a particular period i.e. How much it ownes and
how much it owes to others. He would also like to know what happened to his capital, whether it has
increased / decreased or remained constant. A systematic record of assets and liabilities facilitates the
preparation of a position statement called B/S, which provides the necessary information.

(4)

To provide accounting information to interested parties: Apart from owners, there are various parties
who are interested in the accounting information. These are bankers, creditors, tax authorities,
prospective investors etc. They need such information to assess the profitability and the financial
soundness of the business. The accounting information is communicated to them in the form of an
annual report.

Functions of Accounting: Accounting embraces the following functions:

(1)

Keeping systematic records: The first function of accounting is to keep a systematic record of
financial transactions to post them to ledger accounts and ultimately prepare final statements from
them.

(2)

Protecting properties of the business: The second function of accounting is to protect the property of
the business. An unauthorized dissipation of assets of the firm will bring it to the threshold of
insolvency. An accountant thus has to design such a system of accounting, which will protect its
assets from an unjustified and unwarranted use.

(3)

Communicating the results: The third function of accounting is to communicate the results obtained
from arraying of data to interested parties like proprietors, investors, creditors, employers, Govt.
officials and researchers.

(4)

Meeting legal requirements: The fourth function of accounting is to devise such a system as will
meet the legal requirements. Under the provisions of law, a businessman has to file various
statements e.g. Income tax returns, returns for sales tax purpose and so on.

Branches of Accounting:
Accounting as we know today has evolved over many centuries in response to the changing economic, social
and political conditions. The economic development and technological improvements have resulted in an
increase in the scale of operations and the advent of the company form of business organisation. This has
made the management function more and more complex and increased the importance of accounting
information. This gave rise to special branches of accounting. These are briefly explained below.
1)

Financial accounting: The purpose of this branch of accounting is to keep a record of all

2)

financial transactions so that:

a) The profit earned or loss incurred by the business during an accounting period can be
worked out.
b) The financial position of the business as at the end of the accounting period can be
ascertained, and
c) The financial information required by the management and other interested parties can be
provided.
Financial accounting is mainly confined to the preparation of financial statements and their
communication to the interested parties.
Cost Accounting: The purpose of Cost Accounting is to analyse the expenditure so as to
ascertain the cost of various products manufactured by the firm and fix the prices. It also helps in
controlling the costs and providing necessary costing information to management for decisionmaking.
Management Accounting: The purpose of management accounting is to assist the
management in taking rational policy decisions and to evaluate the impact of its decisions and
actions. Examples of such decisions are: pricing decisions, make or buy decisions, capital
expenditure decisions, etc. This branch of accounting is primarily concerned with providing the
necessary accounting information about funds, costs, profits, etc., to the management which may
help them in such decisions and also in planning and controlling business operations.

3)

Advantages of Accounting:
(1)

Replaces Memory: Since all the financial events are recorded in the books, there is no need to rely on
memory. The books of A/C will serve as historical records. Any information required at any time can
be easily had from these records.

(2)

Provides control over Assets: Accounting provides information about cash in hand; cash at bank the
stock of goods, amounts receivable assets. Information about such matters helps the owners and the
management to make use of the assets in the best possible way.

(3)

Facilitates the preparation of financial statements: with the help of information contained in the
accounting records the P & L A/C and the B/S can be easily prepared. This financial statement
enables the businessman to ascertain the net results of business operations during the accounting
period and the financial position of the business as at the end of the accounting period.

(4)

Meets the information requirements: Various interested parties such as owners, lenders, creditors etc.
get the necessary information at frequent intervals, which help them in their decision-making.

(5)

Facilitates a comparative study: With the help of the accounting information one can compare the
present performance of the enterprise with that of its past and with that of similar organizations. This
enables the management to draw useful conclusions about the business and make efforts to improve
the performance.

(6)

Assists the management in many other ways: The accounting information provided to the
management helps them in taking rational decisions and in planning and controlling all business
activities.

(7)

Difficult to conceal fraud or theft: It is difficult to conceal fraud theft etc. because of the periodic
balancing of the books of a/c. Further in big organizations the book keeping work is divided among
many persons, which minimizes the chances for committing fraud.

(8)

Tax matters: The Govt. levies various taxes such as customs duty, excise duty, sales tax, income tax
etc. Properly maintained accounting records will help in the settlement of all tax matters with the tax
authorities.

(9)

Ascertaining value of business: In the event of sale of a business firm, the accounting records will
help in ascertaining the correct value of the business.

(10)

Acts as reliable evidence: Systematic record of business transactions in generally treated by courts as
good evidence in case of disputes.

Limitations of Accounting:
(1)

They do not record transactions and events, which are not of a financial character. Facts like quality
of HR, licenses / patents possessed, locational advantage, business contracts etc. do not find any
place in the books of accounts. Hence they do not reveal a complete picture.

(2)

The data is historical in nature. Accountants adopt historical costs as basis in valuing and reporting
all assets and liabilities. They do not reflect current values. It is quite possible that L & B & other
such items may have much more real than what is stated in the B/S.

(3)

Facts recorded in financial statements are generally influenced by accounting conventions and
personal judgements. Hence they do not reveal the time picture. In many cases, estimates may be
used to determine the value of various items. E.g. Drs are estimated in terms of collectibility
investments are based on marketability and fixed assets are based on useful working life. All these
estimates are materially affected by personal judgements.

(4)

Data provided in the finance statements is insufficient for proper analysis and decission making. It
only provides information about the overall profitability of the business. No information is given
about the cost and profitability of different activities .

Stages of Accounting System:

Accounting system has the following two stages:
(I)

Making routine records, in prescribed form and according to established rules, of all events which
affect the financial state of the organization

(II) Summarizing from time to time of the information contained in the records, and its presentation in a
significant form to intended parties and its interpretation as an aid to decision making by these
parties.
Stage 1 is called Book Keeping and Stage II is called Accounting.
Book Keeping is a narrow term concerned mainly with the maintenance of the books of account and covers
the following four activities, viz. identifying the transactions and events to be recorded, measuring them in
terms of money, recording them in the books of prime entry, and posting them into Ledger.
Book keeping is defined as an activity concerned with the recording of financial data relating to business
operations in a significant and orderly manner. It is the record-making phase of accounting. Accounting is
based on a careful and an efficient book keeping system. The objective of book keeping is mainly the
following:

To have a permanent record of each transaction of the business and to show its financial effect to the
business.

To ascertain the combined affect of all the transactions made during an accounting period upon the
financial position of the business as a whole.

Accounting on the other hand is concerned with summarizing the recorded data, interpreting the financial
results and communicating them to all interested parties. Accounting starts where book keeping ends but in
practice, the accountants also direct and review the works of book keepers and therefore the term accounting
is generally used in a broader sense covering all the accounting activities, thus Book Keeping is regarded as a
part of Accounting.

Distinction between Book keeping and Accounting:

Book keeping is concerned with the technique of recording the financial data, classifying the recorded items
of information, and summarizing them in the form of financial statements. It is essentially clerical in nature.
Accounting is a wider term and includes the analysis and interpretation of the recorded data. Thus, a
bookkeeper may be held to record a firms daily financial transactions, where as it is the task of an accountant
to set up an organizations overall bookkeeping system.

Accounting Process:
The Accounting Process consists of the following four Stages:
I.
Recording the Transaction
II.
Classifying the Transaction
III.
Summarizing the Transaction
IV.
Interpreting the results
I.

Recording the Transactions: The accounting process begins with recording of all transactions
in the book of original entry. This book is called Journal. All transactions are recorded in the
Journal in a chronological order (date wise) with the help of various vouchers such as cash
memos, cash receipts, invoices, etc.

II.

Classifying the Transactions: The second stage consists of grouping the transactions of similar
nature and posting them to the concerned accounts in another book called Ledger. For
example, all transactions related to cash are posted to Cash Account and the transactions related
to different persons are entered separately in the account of each person. The objective of
classifying the transactions in this manner is to ascertain the combined effect of all transactions
of a given period in respect of each account. For this purpose, all accounts are balanced
periodically.

III.

Summarizing the Transactions: The next step is to prepare a year-end summary known as
Final Accounts. But before preparing the final accounts, we prepare a statement called Trial
Balance in order to check the arithmetical accuracy of the book of account. If the Trial Balance
tallies, it means that the transactions have been currently recorded and posted into ledger. Then,
with the help of the Trial Balance and some other relevant information we prepare the final
accounts. The objectives of preparing the final accounts are (I) to know the net result of business
activities and (ii) to ascertain the financial position of the business. The final account consists of
an income statement called Trading and Profit and Loss Account gives us the information about
the amount of profit made or the loss incurred during the year and the Balance Sheet shows the
position of assets and liabilities of the business as at the end of the year.

IV.

Interpreting the Results: The last stage consists of analyzing and interpreting the results shown
by the final accounts. This involves computation of various accounting ratios to assess the
liquidity, solvency and profitability of the business. Such analysis is meant for interested parties
like management, investors, bankers, creditors, etc. The balances on various accounts appearing
in the Balance Sheet will then be transferred to the new books of account for the next year.
Thereafter the process of recording transactions for the next year starts again.

Chapter I(b)
Accounting Concepts and Conventions:
Any activity that one performs is facilitated if one has a set of rules to act as a guide. The accountants have
also, over a period of time, developed certain rules and conventions, which serves as guidelines. These rules
and conventions are termed as Generally Accepted Accounting Principles. To explain these principles,
writers use a variety of terms such as concepts, postulates conventions, underlying principles, basic
assumptions etc. These concepts and conventions help in bringing about uniformity, consistency and
homogeneity in the practice of accounting.
The word concept and convention are synonymous to the words: principle postulates, doctrines, tenets,
axioms assumptions etc. However there is a demarcation between the word concept and convention.
Concept: The term concept is used to connote the accounting postulates i.e. necessary assumptions and
ideas, which are fundamental to accounting practice.
Convention: The term 'convention' is used to signify customs or traditions as a guide to the preparation of
accounting statements.

Concepts:
(1)

Business Entity Concept:

The proprietor of an enterprise is always considered to be separate and distinct from the business,
which he controls. Without such a distinction the affairs of a firm will be mixed up with the private
affairs of the proprietor and the true picture of the firm will not be available. All the transactions of
the business are recorded in the books of the business from the point of view of the business
enterprise. In this way it becomes possible to record transactions of the business with the proprietor
also. In the case of companies the entity concept is more apparent as in the eyes of law it has separate
legal entity independent of the persons who contributes towards its capital.

(2)

Money Measurement Concept:

Money has been adapted by the accounting system as its basic unit of measurement. Business deals
in a variety of items having different physical units such as kilograms, quintals, metres, litres etc. so
recording them and finally adding them will pose problems. But, if these are recorded in a common
denomination, there total becomes homogeneous and meaningful. Therefore we need a common unit
of measurement, which is MONEY.
Also, since money is the medium of exchange and the standard of economic value, this concept
requires that those transactions alone which are capable of being measured in term of money are only
to be recorded in the books of accounts and those facts or events which can't be expressed in terms of
money do not find a place in the accounting books like the death of an efficient manager or receipt
of an award etc.
The concept, although indispensable, has two major drawbacks:
The monetary unit is an inelastic measuring yardstick as because the purchasing power
of money hardly remains stable.
Many important events can't be recorded simply because they could not be expressed in
monetary terms.

(3)

Historical record Concept:

According to the historical record concept, we record only those transactions, which have actually
taken place and not those, which may take place in the future. It is because accounting record
presupposes that the transactions are to be identified and objectively evidenced. This is possible only
in the case of past (actually happened) transactions. The future transactions can hardly be identified
and measured accurately.

(4)

Cost Concept:
The idea underlying the cost concept is that:
(i) Assets are recorded at the price paid to acquire it (i.e. at cost) and
(ii) This cost remains the basis for all subsequent accounting for that asset.
The values of the assets are shown in the balance sheet at their acquisition values rather than their
disposition values or realization values. The change in the real worth of a cost with the passage of
time is not ordinarily recorded in the account books. For example, a piece of land that has been
purchased for Rs. 80,000 will be recorded at that price. Whether its market price increases to Rs.
1, 80,000 or falls to Rs.50, 000 at the time of making the statement will not be considered.

Thus, according to the cost concept, all assets are recorded in books at their original purchase price
and continue to be recorded thus. However, it must be clearly understood that, we do not continue to
take down the same figure year after year. The original purchase price only serves as the basis for all
subsequent accounting for that asset. We know that with the passage of time the value of most of the
assets decrease. Hence it may be systematically reduced from year to year, by charging depreciation
at an appropriate rate to the original cost.

(5)

Going Concern Concept:

This concept assumes that an enterprise (except for terminable ventures) will continue to exist in the
foreseeable future. (The going concern concept is basic to the valuation of assets and the provision of
depreciation thereon according to the I.A.S - 1). Thus this concept can be regarded as supporting the
valuation of asset at historical cost or replacement cost and assets are to be depreciated on the basis
of expected life rather than on the basis of market value. [IAS: International Accounting Standard]

(6)

Dual Aspect Concept:

This is the basic concept of accounting. The recognition that every transaction has two sides to it is
the leading principle of the dual aspect concept. One represented by the asset of the business and the
other by the claims against them. These two aspects are always equal to each other.
In other words Assets = Liability + Capital or Capital = Asset - Liability. This concept forms the
basis for the whole of financial accounting the two sides of the equation will always have the same
totals as we are dealing with the same thing from two different points of view.

(7)

Realization Concept:
In accountancy, profit is treated as being realized when the goods or services are passed to the
customers and money has been realized or when a legal obligation to pay has been assumed by the
customer. Unless the above condition is fulfilled no sale can be said to have taken place and no profit
or income can be said to have arisen, and this is important because otherwise firms may record
profits which is not realized and resort to showing higher profits than is actually earned. (However it
is not always easy to determine when revenue is realized. In determining profit, credit sales are taken
into consideration, which in future may turn out to become a bad debt and the actual income may
turn out less than it was thought to be.) There are certain exceptions like in long term contract work
in progress revenue is recognized before completion of the job. Also in the case of Hire Purchase
transactions - revenue is recognized in proportion to the installment over price etc.

(8)

Accrual Concept:
Under this system revenue recognition depends on its realization and not actual receipt. Like wise
costs are recognized when they are incurred and not when paid. This necessitates certain adjustments
in the preparation of income statement. In relation to revenue the accounts should exclude amounts
relating to subsequent period and provide for revenue recognized but not received in cash. Likewise
in relation to costs: provide for costs incurred but not paid, but exclude - costs paid for subsequent
period. Under the cash system of accounting revenue recognition does not take place until cash is
received and costs are recorded only after they are paid. It is, thus, clear that the operating results
prepared on this basis are not in conformity with generally accepted accounting principles.
(Normally all transactions are settled in cash, but according to this concept it is proper to bring those
transactions/ events into the books whose cash settlement has not yet taken place). The essence of the
accrual concept lies in the fact that net profit is the difference between revenues and expenses rather
than between cash receipt and expenditure.
Any increase in owners equity is called revenue and any thing that reduces the owners equity is
expense (or loss).

(9)

Matching Concept:
Matching concept is an essential part of accrual accounting. It requires that expenses for an
accounting period should be matched against related incomes, rather than recognizing revenues as
being earned at the time when cash is received or recognizing expenses when cash is paid and
thereby making comparison by cash receipts against cash payments. As many business keep accounts
on accrual basis, i.e. keeping account on an income and expenditure basis, it is necessary
that the accounting system should match periodically the revenues earned against expenses incurred.
The result of this matching is the net income or net loss.

(10)

Accounting Period Concept / Periodicity Concept:

To find out "how the business is going on, accountants choose some convenient period of time to
ascertain income for that period. Twelve-month period in normally adopted for this purpose. This
time interval is called accounting period and is also called natural business year. Such period wise
income determination leads to comparison of the results of successive periods. A transaction should
normally be identified with a particular period but there may be transaction that relate to many

accounting periods like a plant with a life span of 5 years, purchased for, say - Rs. 10,000/=. Here,
the transaction relates to 5 accounting period shown in the form of depreciation. The main
consequence of the periodicity concept is the application of the arbitrary allocation and
apportionment of indirect costs.

(11)

Consistency Concept:
It is possible to adopt a variety of principles and procedures for recording financial events. If in
treating a given event, two or more contradictory methods are used, it may yield conflicting results
not only among similar business but also result in misleading comparisons of interpretation for a
business unit for successive years of its own operation. Therefore, it is very important that
accountants be consistent in applying principles and procedures to similar situations. [Some authors
prefer to explain the perception of consistency under the head Conventions also.]

(12)

Objectivity Concept:
As per this concept: all accounting must be based on objective evidence, i.e. to say that
the transaction recorded should be supported by verifiable documents. Only in such an event it
would be possible for the auditors to verify accounts and certify them as true or otherwise. The
evidence substantiating the business transitions should be objective i.e. free from the bias of the
accountants or others. It is for this reason that assets are recorded at historical costs and shown
thereafter at historical cost less depreciation. If the assets are shown on replacement cost basis the
objectivity is lost and it becomes difficult for authors to verify such values.

Conventions:
In order to make the message contained in the financial statement clear & meaningful the income statement
(P&L A/c) & the Statement showing the financial position (B/s) are drawn up according to the under
mentioned conventions:

(1)

Consistency:
The accounting practice should remain the same from one year to another. Changing method would
lead to distortion - for instance it would not be proper to value stock in trade according to one
method one year and another in the next year. Once a firm has fixed a method of treating an item it
should do so for like items and also maintain the same method thereafter, otherwise comparison of
one accounting period with another would not be possible. Consistency however does not mean
inflexibility. A firm can change the method used as necessary and where it is affected the effect of
such a change should be stated.

(2)

Disclosure:
Apart from legal requirements good accounting practice also demands that all significant information
should be disclosed. It implies that accounts must be honestly prepared and all material information
must be disclosed therein. The term disclosure does not imply that all information that anyone could
conceivably desire is to be included in accounting statements. The term only implies that there is to
be a sufficient disclosure of information, which is of material interest to proprietors, present and
potential creditors and investors. The practice of appending notes relative to various facts or items,
which do not find place in accounting statement, is in pursuance to the convention of full disclosure
of material facts. Like contingent liabilities appearing as a note, market value of investments
appearing as a note. The concept of disclosure also applies to events occurring after the B/s date and
the date in which the financial statements are authorized for issue. Such events include bad debts,
destruction of plant and equipment due to natural calamities, major acquisition of another enterprise
etc. Such events are likely to have a substantial influence on the earnings and financial position of
the enterprise. Their non-disclosure would affect the ability of the users of such statements to make
proper evaluations and decisions.

(3)

Materiality:
This convention states that accounting records should consists of only those transactions that are
significant from the point of view of determination of income materiality. The American Accounting
Association (AAA) defines the term materiality, in the following words: "An item should be
regarded as material if there is reason to believe that knowledge of it would influence the decision of
informed invertors". As per IAS-1 financial statements should disclose all items, which are of
material importance and effects evaluations or decisions. This is also reiterated in IAS-5, which
states that all material information should be disclosed that is necessary to make the financial
statements clear & understandable. Some of the examples of material financial information to be
disclosed are: Loss of market due to competition or Govt. regulation, likely fall in the value of
stocks, increase in wage bill under recently concluded agreement etc. It is now agreed that
information known after the date of B/s must also be disclosed. Another example of materiality is the
question of allocation of costs. An item of small value may last for more years and technically its
cost must be spread over this period. Since the amount involved is small, it may be treated as an
expense in the year of purchase. (It should be noted that an item material for one concern should be
immaterial for another and similarly an item material in one year may be immaterial in the next.)

(4)

Convention of Conservatism:
This is the policy of 'playing safe'. It takes into consideration all prospective losses but leaves all
prospective profits. This Accounting principle is given recognition in IAS-1, which recommends the
observance of prudence in the framing of accounting policies. It is true that uncertainties surround
many transaction and therefore exercise of prudence in financial statement - becomes necessary, but
prudence does not justify the creation of secret or hidden reserves. E.g. of application of convention
of conservatism are:

Provision for bad and doubtful debts.

Valuation of stock in trades at Market Price / Cost Price whichever is less.
Creating provision against fluctuation in the price of investments.
Charging of small capital items like crockery to revenue.
Adoption of WDV method of depreciation, rather than straight-line method, which is less
conservative in approach.
Amortization of intangible assets like Goodwill, which has indefinite life.
Showing JLP (joint life policy) at surrender value against the amount paid.
Not providing for discount on creditors.

Application of the principle:

Where there is an uncertainty inherent in the activity e.g. useful life of an asset, occurrence
of loss, realization of income, estimated liability etc.
When there are two equally accepted methods, then: the one, which is more conservative,
will be accepted.
When judgment is to be based on estimates, and doubts exist as to which of the several
estimates is correct, the most conservative estimate should be selected.
When there is possibility of the occurrence of a loss or profit, losses will be considered and
profits will be overlooked.
The principle has effect on:
(a)
Income statement: Here the principle results in lower net income than would otherwise
be the case.
(b)
B/S: When applied to the B/s the approach results in understatement of assets and capital
and overstatement of liability and provisions.
The principle of conservation, however, should be applied cautiously. If the principle is stretched
without reservation it results in the creation of secret reserves, which is in direct conflict with the
doctrine of full disclosure. Since the main aim of published accounts is to convey and not to conceal
the information the policy of secrecy is being abandoned in favour of the modern and more logical
policy of disclosure.