COURSE TITLE: ACCOUNTING FOR FINANCIAL SERVICES

 Accounting is called the language of Business

 Accounting is called the language of business because many people from within and outside the
organization use accounting information for making economic and financial decisions.
Accounting information is useful in all types of organizations for example a sole proprietorship
and partnership business, a corporation, a not-for-profit organization, and even a government
agency. The survival and growth of an organization depend largely on supplying effective
accounting information to internal and external users. The size of an organization determines
the appropriate volume and complexity of accounting information for example, managerial
decisions in such areas as purchasing, production, hiring, borrowing, and investment.

 Users and Uses Of Accounting Information: The users of financial statements include the
following-

 Investors
 Employees
 Lenders
 Customers
 Governments and their agencies
 Public
1) Internal Users of Accounting Information System

 Internal users of accounting information work for the organization. They usually have some
managerial or supervisory responsibilities in a line or staff functions. A production foreman, a
line supervisor, a plant manager, a division manager, and a production vice president are
examples of internal users.

2) External Users of Accounting Information System

 External users are interested in the accounting information of a firm for a variety of reasons.
External users include present and potential stockholders, government agencies, banks, trade
unions, and professional institutions. Government agencies commonly include tax authorities,
and the capital market authorities Securities and Exchange Commission (SEC).

 The following are the users of accounting information system-

 Shareholders of a company
 Government
 Suppliers/ Creditors
 General public
 Students
 Employees
  Management
 Tax authority
 Trade union
 Professional bodies
 Potential investors

 Functional and Operational definition of accounting

 Accounting is a set of concepts and techniques that are used to measure and report financial
information about an economic unit. The economic unit is generally considered to be a
separate enterprise. The information is reported to a variety of different types of interested
parties. These include business managers, owners, creditors, governmental units, financial
analysts, and even employees. In one way or another, these users of accounting information
tend to be concerned about their own interests in the entity.

 FUNCTIONAL-BASED ACCOUNTING focuses on organizational units such as departments

and plants, uses financial outcome measures and static standards and benchmarks to
evaluate performance, and emphasizes status quo and organizational stability. On the other
hand, activity-based accounting focuses on processes, uses both operational and financial
measures and dynamic standards, and emphasizes and supports continuous improvement.
Activity-based accounting adds a process perspective.

 The systematic recording, reporting, and analysis of financial transactions of a business.

 Accounting is the system of recording and summarizing business and financial transactions
and analyzing, verifying, and reporting the results.

 Major Accounting concepts and Principles: Following is a list of the major accounting concepts
and principles-

1) Relevance
2) Reliability
3) Matching Concept
4) Timeliness
5) Neutrality
6) Faithful Representation
7) Prudence
8) Completeness
9) Single Economic Entity Concept
10) Money Measurement Concept
11) Comparability/Consistency
12) Understandability
13) Materiality
14) Going Concern
15) Accruals
16) Business Entity
 17) Substance over Form
18) Realization Concept
19) Duality Concept

 Basic Accounting Principles and Guidelines: The table below lists the ten main accounting
principles and guidelines together with a highly condensed explanation of each.

 Economic Entity Assumption

 Monetary Unit Assumption
 Time Period Assumption
 Cost Principle
 Full Disclosure Principle
 Going Concern Principle
 Matching Principle
 Revenue Recognition Principle
 Materiality
 Conservatism
 Other Characteristics of Accounting Information

 We expect the accounting information to be reliable, verifiable, and objective.

 We expect consistency in the accounting information.
 We expect comparability in the accounting information.
 Bookkeeping vs Accounting: Although they both involve the process of recording the financial
transactions of a business, bookkeeping and accounting are two different topics-

 Bookkeeping is the process of recording, in chronological order, the daily transactions of a

business entity. It forms part of the accounting information system.

 On the other hand, accounting is an information system – includes the process of recording,
classifying, summarizing, reporting, analyzing and interpreting the financial condition and
performance of a business – in order to communicate it to stakeholders for business
decision making.

 Define Ethics. Why ethics is very important in business?

 Ethics deals with the ability to distinguish right from wrong.

 Ethics is a term that refers to a code or moral system that provides criteria for evaluating
right and wrong. An ethical dilemma is a situation in which an individual or group is faced
with a decision that tests this code. Many of these dilemmas are simple to recognize and
resolve.
 Importance of Ethics-

 Accountability: Businesses are accountable to a range of shareholders, from partners, to

investors, to customers.

 Planning: This obligation involves providing accurate information and providing it in a time
frame that is prompt enough to be relevant.

 Taxes: This is a legal obligation for a company to report financial information fairly and
accurately on tax forms. Ethical accounting practices ensure that your tax forms will be
completed in a way that keeps your conscience clear and keeps you out of trouble.

 Perception: Honest and ethical accounting helps to create a positive image for your
business. When a company makes news for dishonest accounting, it loses the trust of
current and potential customers.

 Accounting Cycle: The accounting workflow is circular: entering transactions, manipulating the
transactions through the accounting cycle, closing the books at the end of the accounting
period, and then starting the entire cycle again for the next accounting period.

 Stages of Accounting Cycle: The accounting cycle has eight basic steps, which you can see in the
following illustration. These steps are described in the list below.
1) Transactions: Financial transactions start the process.

2) Journal entries: The transaction is listed in the appropriate journal, maintaining the journal’s
chronological order of transactions.

3) Posting: The transactions are posted to the account that it impacts. .

4) Trial balance: At the end of the accounting period (which may be a month, quarter, or year
depending on a business’s practices), you calculate a trial balance.

5) Worksheet: Unfortunately, many times your first calculation of the trial balance shows that the
books aren’t in balance. If that’s the case, you look for errors and make corrections called
adjustments, which are tracked on a worksheet.

6) Adjusting journal entries: You post any corrections needed to the affected accounts once your
trial balance shows the accounts will be balanced once the adjustments needed are made to the
accounts. You don’t need to make adjusting entries until the trial balance process is completed
and all needed corrections and adjustments have been identified.

7) Financial statements: Preparing the balance sheet and income statement using the corrected
account balances.

8) Closing the books: Close the books for the revenue and expense accounts and begin the entire
cycle again with zero balances in those accounts.

 Principles of Double Entry System

 Before deciding which account is to be debited or credited, it is necessary to decide the nature
of accounts which are influenced by the business transactions. The rules of Debit and Credit are
given below-

 Personal Accounts: (Natural Persons and Artificial Person)

1) Rule : Debit the Receiver

Credit the Giver

 According to the above principle, the benefit receiver’s account is to be debited and
the benefit giver’s account is to be credited.

 Real Accounts:(Assets)

2) Rule : Debit What comes in

Credit what goes out
  According to real accounts principle, when an assets is received by the business, the
asset account is to be debited, when any asset goes out of the business, the asset
account is to be credited.

 Nominal Accounts: (Expenses, Losses, Incomes, Gains)

3) Rule : Debit all Expenses and Losses.

Credit all Incomes and Gains.

 According to normal account principle, expenses and losses are to be debited and all
incomes and gains of the business are to be credited.

 Accounting Equation: The financial position of a company is measured by the following items:

 Assets (what it owns)

 Liabilities (what it owes to others)
 Owner’s Equity (the difference between assets and liabilities)
 The accounting equation (or basic accounting equation) offers us a simple way to understand
how these three amounts relate to each other. The accounting equation for a sole
proprietorship is: Assets = Liabilities + Owner’s Equity

 The accounting equation for a corporation is: Assets = Liabilities + Stockholders’ Equity

 Assets are a company’s resources—things the company owns. Examples of assets include cash,
accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and
goodwill.

 Liabilities are a company’s obligations—amounts the company owes. Examples of liabilities

include notes or loans payable, accounts payable, salaries and wages payable, interest payable,
and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in
two ways:

1) as claims by creditors against the company’s assets, and

2) a source—along with owner or stockholder equity—of the company’s assets.

 Owner’s equity or stockholders’ equity is the amount left over after liabilities are deducted from
assets: Assets – Liabilities = Owner’s (or Stockholders’) Equity.

 Define- (i) Assets, (ii) Liability, (iii) Equity, (iv) Owner’s equity

 Assets
 Assets are items that are owned and have value. Assets would include cash, investments, money
that is owed to the person or entity (accounts receivable), inventory of items for sale, supplies,
pre-paid expenses, land, land improvements (buildings), equipment, etc.
 CURRENT ASSETS
 Cash
  Short-term investments
 Accounts Receivable
 Inventory
 Prepayments (Prepaid expenses)
 Liabilities:
 Liabilities are obligations or items that are owed to others. Liabilities are the accounting
opposite of assets. Liabilities would include accounts payable, accrued interest and principle on
bonds issued, accrued interest and principal on mortgages outstanding, etc.
 Current Liability
 Accounts Payable
 Notes Payable
 Short-term portion of long-term debts
 Income Tax Payable
 Wages Payable
 Accruals/accrued expenses
 Long-Term Liabilities: The following are the Long-Term Liabilities -
 Debt to Financial institutions
 Bonds
 Debentures
 Mortgages

 Equity: The equity accounts include all the claims the owners have against the company.
Clearly, the business owner has an investment and it may be the only investment in the firm. A
more complex balance sheet will show a more crowded section on shareholders' equity. It may
look something like this:
 Preferred Stock
 Common stock, par value $1:
a) Authorized shares
b) Issued shares
 Additional Paid-In Capital
 Retained earnings
 Treasury stock
 Foreign currency translation adjustment
 Preferred stock Preferred stock is usually defined as a hybrid between debt and equity. It's a
hybrid because it maintains the dividend-paying characteristic of common stock, as well as the
fixed interest payment of debt. Unlike common stockholders, preferred stockholders are usually
not given voting rights.
 Common stock Common Stock has no predetermined dividend payout rate or time, but the
holders maintain the rights to vote and the right to share in the residual value of the company
upon liquidation.
 Additional Paid-In Capital Additional Paid-In Capital represents the excess paid for the
company's stock above the par value.
 Treasury stock Treasury stock, which is always a negative value, represents the company's
purchase of its own stock.
 Bank Reconciliation
 Bank reconciliation statement is a report which compares the bank balance as per company's
accounting records with the balance stated in the bank statement.
 The purpose of preparing a Bank Reconciliation Statement is to detect any discrepancies
between the accounting records of the entity and the bank besides those due to normal timing
differences. Such discrepancies might exist due to an error on the part of the company or the
bank.
 Importance of Bank Reconciliation
 Preparation of bank reconciliation helps in the identification of errors in the accounting
records of the company or the bank.
 Cash is the most vulnerable asset of an entity. Bank reconciliations provide the necessary
control mechanism to help protect the valuable resource through uncovering irregularities
such as unauthorized bank withdrawals. However, in order for the control process to work
effectively, it is necessary to segregate the duties of persons responsible for accounting and
authorizing of bank transactions and those responsible for preparing and monitoring bank
reconciliation statements.
 If the bank balance appearing in the accounting records can be confirmed to be correct by
comparing it with the bank statement balance, it provides added comfort that the bank
transactions have been recorded correctly in the company records.
 Monthly preparation of bank reconciliation assists in the regular monitoring of cash flows of
a business.

 Trial balance: The trial balance summaries all business transactions into assets, expenses,
liabilities, revenue and equity or capital contributions by owners.
 Objectives of Trial Balance: A trial balance is prepared with the following objectives.
 To ascertain the arithmetical accuracy of ledger accounts
 Completion of double entry
 Ledger account balances

 Features of trial balance

 Trial balance can be prepared anytime during the accounting period.
 It is prepared to check the arithmetical accuracy of posting of entries from journal to ledger,
in other words it is an instrument for carrying out the job of checking and testing.
 It is not a part of the double entry system of book keeping but only for checking the
accuracy of posting. However it does not reveal all errors.
 Objectives of preparing trial balance
 It ensures that all transactions have been recorded with the same debit and credit amounts
 It makes the preparation of trading, profit and loss account and balance sheet easy by
making available the balances of all account at single place.
 By identifying errors in the books of accounts it helps in rectifying those errors before the
preparation of the final accounts.
 Accounting Errors that Affect the Trial Balance
 The debit entry entered on the ledger is not equal to credit entry for the corresponding
entry.
 When two debit entries or two credit entries are simultaneously made for the same
transaction. The imbalance will be caused because double entry rules will not have been
applied correctly
  When a singl- sided transaction is posted in the ledger.
 Under casting or over casting of individual general ledger or nominal ledger accounts.
 If the balance on the suspense is a debit balance it can be treated as either an asset or
expense, however prudent companies usually treat them as expenses.
 Errors not revealed by the trial balance
1) Error of omission: This is an error where a transaction is completely omitted from the
books. No entries were made at all for the transaction. It is as if the transaction has not
existed.
2) Error of commission: In this case, double entry was observed but the transaction was
posted to a wrong account of the same class.
3) Error of principle: Double entry observed but an entry made in the wrong class of
account.
4) Error of original entry: The transaction was correctly according to the double entry
system but with the wrong amount.
5) Complete reversal of entries: For a given transaction, the account to be debited was
credited and the account to be credited was debited.
6) Compensating errors: Errors on the debit side of the ledger have been set off by errors
on the credit side of the ledger
7) Error of duplication: transaction was recorded twice in the ledger. Double entry was
observed in each case.
8) Error of transposition: For a given transactions, double entry was correctly observed but
the figures in amount were not written in the correct order.

 Classification of Accounts: All accounts may be grouped in two broad categories or

classifications. These are personal and impersonal.
 Personal Accounts: These are the accounts that have the names of debtors (customers) or
creditors (suppliers). They are therefore personal to this extent. Personal accounts may further
be classified as :
1) Natural person's personal accounts: The accounts recording transactions relating to
individual human beings
2) Artificial person's personal account: The accounts recording transactions relating to limited
companies. bank, firm, institution, club. etc.
3) Representative personal accounts: The accounts recording transactions relating to the
expenses and incomes are classified as nominal accounts.
 Impersonal Accounts: These non-personal accounts may be divided into Real Accounts and
Nominal Accounts.
 Real Accounts - These accounts are tangible in nature and represent accounts that records
possession such as machinery, furniture, premises and stock.
 Nominal Accounts – These accounts are intangible in nature and represent accounts that in
which expenses, revenues and capital are recorded.
 Rules of Entry for general Accounts: An account is divided into two sides, a left side called the
debit side and a right side called the credit side. The title of the account is written in the center
at the top of each account.

 When increasing an asset account we make a debit entry.

 When decreasing an asset account we make a credit entry.
 When increasing a capital/liability account we make a credit entry.
 When decreasing a capital/liability account we make a debit entry.

 Rules of Debit and Credit (classification based)

 Personal Accounts: Debit the receiver, Credit the giver (supplier)

 Real Accounts: Debit what comes in, Credit what goes out
 Nominal Accounts: Debit expenses and losses, Credit incomes and gains.

 Concept, Features And Objectives Of Financial Statements

 Concept of Financial Statements: Financial statements are the summary reports of a company's
financial transactions. They report the end results of accounting activities during a given period
of time.

 Financial Statements Include

1) Income Statement: The income statement, sometimes called as the trading and profit and
loss account or an earnings statement, reports the profitability of a business organization for
a stated period of time.

2) Statement of Retained Earnings: The statement of retained earnings explains the changes
in retained earnings between two balance sheet date.

3) Balance Sheet: The balance sheet, sometimes called statements of financial position, lists
the company's assets, liabilities and stockholder's equity as on a particular date.

4) Statement of Cash Flows: The statement of cash flows shows the cash inflows and outflows
from operating, investing and financing activities.

 Features Of Financial Statements: The following are the features of financial statements-

 Financial statements are always expressed in monetary terms. They ignore qualitative
aspects. In other words, the non-monetary events do not come under the scope of financial
statements.

 Financial statements are always prepared for a certain period of time. They generally cover
the period of one year.

 Financial statements are historical in nature since they always present the past
performance. Hence, they do not carry the futuristic approach.
 Objectives of Financial Statements: The major objectives of the financial statements are as
follows:

1) To provide the financial information to the internal and external users.

2) To provide the information, which are useful in the decision making process.

3) To reveal the profitability and solvency of the company.

4) To help to evaluate the financial position and efficiency of the management.

5) To show the financial health of the company.

 IASB Framework for Presentation and Preparation of Financial Statements states FOUR
principal characteristics as follows:

1. Understandability
2. Relevance
3. Reliability
4. Comparability

 Understandability: Users cannot use such financial information that they cannot understand.
Problems in understanding may arise due to user’s inabilities or because of the information
itself. Definitely entity cannot do anything about users and its upon the user to have at basic
level of understanding about financial statements. Also, users are not required to be
professional accountants and that is why where we expect to have complex information then its
neither fault on part of user nor from the side of the entity preparing financial statements.

 Relevance: Information is considered relevant which adds value to the decision making process
by providing the required bits and pieces of past, present and future times. Through relevant
information users can evaluate whether they are moving along the right path i.e. making correct
decisions. Information is also said to be relevant when it is capable of confirming or correcting
the existing thought process and information.

 Reliability: Information is reliable when it is dependable and this is possible if it is:

 free from errors, especially material errors

 complete

 free from bias

 Information may be relevant but this alone does not suffice for reliability as well. Information
must be reliable as well as relevant in order to be useful for decision making. There are many
other factors that contribute towards the reliability of the financial information.
 Comparability: Comparability of information refers to its ability to stand useful overtime and
against the financial information from other sources. Users cannot evaluate different aspects of
entity’s financial position and financial performance if they are unable to compare the financial
information of one period with another or financial information of one entity with another
entity’s financial information.

 Advantages and Limitations of Ratio Analysis: Financial ratio analysis is a useful tool for users of
financial statement. It has following advantages:

 Advantages

a) It simplifies the financial statements.

b) It helps in comparing companies of different size with each other.
c) It helps in trend analysis which involves comparing a single company over a period.
d) It highlights important information in simple form quickly. A user can judge a company by
just looking at few numbers instead of reading the whole financial statements.

 Limitations: Despite usefulness, financial ratio analysis has some disadvantages. Some key
demerits of financial ratio analysis are:

1. Different companies operate in different industries each having different environmental

conditions such as regulation, market structure, etc. Such factors are so significant that a
comparison of two companies from different industries might be misleading.
2. Financial accounting information is affected by estimates and assumptions. Accounting
standards allow different accounting policies, which impairs comparability and hence ratio
analysis is less useful in such situations.
3. Ratio analysis explains relationships between past information while users are more
concerned about current and future information.

 Importance of Ratio Analysis: The importance of ratio analysis can be summarized for various
groups of peoples vested with the diversified interests are as under:

1) For short term creditors

2) For long term creditors -They can know :
 What sources of long term are employed?
 What is the relationship between various sources of finances?
 Is there any risk to the solvency of the firm due to the employment of excessive long
term debts?
3) For the management
4) For investors
 Balance sheet: A balance sheet shows the assets, liabilities, and net worth of an individual or
entity at a given point in time. In other words, it is a snapshot or statement of financial position
on a specific date.
 Importance of Balance Sheet

 The purpose of company financial statements is to evaluate the financial position (balance
sheet), profitability (income statement), and cash flow (cash flow statement) of an entity. The
balance sheet is the foundation of the entity.

 Whether an investor is looking for dividends, value, quality, or companies with sustainable
competitive advantages, the foundation of each strategy is finding companies with a sound
balance sheet. This is because the financial position of the entity affects everything it does and is
able to achieve.

 An entity with liquidity, low debts, and sufficient cash has a higher probability of being
successful. It can fund future needs (i.e. capital investments) to grow the company or overcome
unexpected challenges. It also affects whether and how much of the cash flows can be returned
to shareholders in dividends or stock buybacks.

 Depreciation: Depreciation is the assigning or allocating of a plant asset’s cost to expense over
the accounting periods that the asset is likely to be used.

 Methods of Depreciation: Some of the most common methods used to calculate depreciation
are straight-line, units-of-production, sum-of-years digits, and double-declining balance, an
accelerated depreciation method

1) Straight-Line

 Straight-line depreciation has been the most widely used depreciation method for many years
due to its simplicity. To apply the straight-line method, a company charges an equal amount of
the asset's cost to each accounting period. The straight-line formula used to calculate
depreciation expense is: (asset's historical cost - the asset's estimated salvage value) / the
asset's useful life.

2) Units of Production

 The units-of-production depreciation method assigns an equal amount of expense to each unit
produced or service rendered by the asset. This method is typically applied to assets used in the
production line. The formula to calculate depreciation expense involves two steps: (1)
determine depreciation per unit ((asset's historical cost - estimated salvage value) / estimated
total units of production during the asset's useful life); (2) determine the expense for the
accounting period (depreciation per unit X number of units produced in the period).

3) Sum-of-years-digits

 Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than
straight line, but less accelerated than that of the double-declining balance method. Under this
method, annual depreciation is determined by multiplying the depreciable cost by a series of
 fractions based on the sum of the asset's useful life digits. The sum of the digits can be
determined by using the formula (n2+n)/2, where n is equal to the useful life of the asset.

4) Double-declining Balance

 The double-declining balance method is a type of accelerated depreciation method that

calculates a higher depreciation charge in the first year of an asset's life and gradually decreases
depreciation expense in subsequent years.

 CASH DISCOUNTS

 Merchants often sell to other businesses. Assume that Barber Shop Supply Company sells
equipment and supplies to various barber shops on open account. An open account is a standing
agreement to extend credit for purchases. In these settings, the seller would like to be paid
promptly after billing and may encourage prompt payment by offering a cash discount (also
known as a sales discount).

 There is a catch, though. To be entitled to the cash discount, the buyer must pay the invoice
promptly. The amount of time one has available to pay is expressed in a unique manner, such as
2/10, n/30. These terms mean that a 2% discount is available if the purchaser pays the invoice
within 10 days; otherwise, the net amount is expected to be paid within 30 days. Assume that
Barber Shop Supply Company sold goods for $1,000, subject to terms of 2/10, n/30.