FIN621 Official Handouts

Lesson-1 · ACCOUNTING & ACCOUNTING PRINCIPLES · Accounting

Almost every organization and individual maintains accounts and deals with accounting. In simple terms, it can be described as a record of Income and expenditure of a business organization, or budget vs. utilization, in the case of a government non-commercial organization. In the case of the business entity, accounting would deal with measuring, recording and communicating the results of business activities. That is why; Accounting is often called “Language of Business”.

Purpose of Accounting

Accounting provides decision-makers with sufficient, relevant information to make prudent and intelligent business decisions. This information is provided through accounting reports called financial statements. The whole process is called “financial reporting”

The purpose of accounting is to organize the financial details of business. To identify the financial transactions. To organize the financial data into useful information To measure the value of these information in terms of money To analyze, interpret, and communicate the information to persons or groups, both inside or outside the business.

Financial Statements Generated by a Business

A business generates four financial statements at the end of its accounting period:-

i) Income statement: shows operational results of business during/over the accounting period.

ii) Statement of owners’ equity: showing changes in owner’s equity through profit/additional investment or through losses/drawl by owner.

iii) Balance sheet showing financial position at the end of the accounting period i.e. a picture of what the business owns and what it owes.

iv) Statement of cash flows giving a picture of cash inflows (receipts) and cash outflows (payments) over/during the accounting period. It is prepared from the two major financial statements viz Income Statement and Balance Sheet.

Notes to Financial Statements:

In addition to above, notes containing additional information (financial & nonfinancial) about the business are also attached to financial statements.

Accounting Period

Accounting period is the period of time covered by an Income Statement. It is usually one year. It can either be calendar year (Jan to Dec) or financial year (July to June). Financial Statements are prepared at the end of accounting period and are the end product of accounting process/cycle.

Different Types of Business Organizations

1. Sole Proprietorship

According to D.W.T. Stafford, “It is the simplest form of business organization, which is owned and controlled by one man”

Sole proprietorship is the oldest form of business organization which is owned and controlled by one person. In this business, one man invests his capital himself. He is all in all in doing his business. He enjoys the whole of the profit. The features of sole proprietorship are:

Easy Formation Unlimited Liability Ownership Profit Management Easy Dissolution

2. Partnership

According to Partnership Act, 1932, “Partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.”

Partnership means a lawful business owned by two or more persons. The profit of the business shared by the partners in agreed ratio. The liability of each partner is unlimited. Small and medium size business activities are performed under this organization. It has the following features:

Legal Entity Profit and Loss Distribution Unlimited Liability Transfer of Rights Management Number of Partners

3. Joint Stock Company

According to S. E. Thomas, “A company is an incorporated association of persons formed usually for the pursuit of some commercial purposes”

A joint stock company is a voluntary association of persons created by law. It has a separate legal entity apart from its members. It can sue and be sued in its name. In the joint stock company, the work of organization begins before its incorporation by promoters and it continues after incorporation. The joint stock company has the following feature:

Creation of Law Separate Legal Entity Limited Liability Transferability of shares Number of Members Common Seal

Generally Accepted Accounting Principles (GAAP)

These are ‘ Ground rules’ i.e. Principles for prepar ing financial statements. These are constantly evolving. These embody accounting concepts, measurement techniques and standards of presentation of financial statements. These Accounting Principles enable comparability between various enterprises and of the operational performance of th e same enter prise over many years. These give rel iability to Financial Statements.

Following are some of the Generally Accepted Accounting Principles:

i) Entity principle/ separate entity principle: According to this principle, a business is treated as a separate entity from the owner. The owner’s private expenditure/spending are not recorded in the books of the business entity. For example money received as prize by a person have no effect on the books of accounts because no business transaction is involved.

ii) Cost principle: according to this principle an asset on the balance shee t is recorded based on its nominal or original cost when acquired by the company.

iii) Going-concern assumption: The 'going concern' concept in accounting is an assumption that the business will continue to exist for the foreseeable future. This assumption is also closely related to cost principle as without the ' going concern' concept, accountants would have to r ecord all assets at current price instead of historical cost.

iv) Objectivity principle: definite, factual basi s for ass ets valuation; measuring transactions objectively. An accounting principle according to wh ich information that is supplied in a co mpany's financial statement must be supported by actual and real evidence and should not be based on personal feeling or opinion. v) Stable currency principle. The currency remains more or less stable and rate of inflation is al most zero.

vi) Adequate disclosure concept: facts necessary for proper interpretation of state ments; “subsequent events”, lawsuits against the business, asset s pledged as securities/collaterals, contingent liabilities etc; reflected in Notes.

ASSETS = LIABILITIES + OWNER’S EQUITY

Balance Sheet is based on Accounting Equation. It is in fact, a detailed statement of the Equation. T he Equation in a way shows, utilization of Funds and Sources of Funds. In other words, it shows what a business OWNS and what it OWES. Alternately, the Accounting Equation or Balance Sheet is a description of Total Assets of a business against the claimants of these Assets. Therefore, this Equation shows financial position on a specific date. The three titles in the Equation a re Elements of Balance Sheet. Similarly Elements of Incom e Statement would be Revenues & Expenses and their net affects

Within the E lements, there would be sub-elements, for exam ple, the Element or Account “Assets” would consist of cash, Accounts Recei vable, Land, and Building etc. Each financial transaction affect s two or more elements or sub-elements of the Accounting Equation. Therefore, we can say that each financial transaction affects Balance Sheet i.e. financial position of the business. This would be clear from the following illustration.