ACCOUNTING FOR MANAGERS

CHAPTER I
INTRODUCTION TO FINANCIAL ACCOUNTING

High lights:
This chapter explains the in detail about the need, importance of accounting by explain
the following in detail:

Meaning of Accounting
Financial Accounting, Cost Accounting and Management Accounting
Financial Statements and Form and Contents of Financial Statements
Contents of Balance Sheet and Contents of Income Statement
Objectives of Accountancy
Users of Financial Statements
True and Fair View of Accounts
Double Entry System of Financial Accounting
Concept of Capital and Income
Generally Accepted Accounting Principles, Conventions and Concepts
Financial Reporting

Meaning of Accounting: All of us do some accounting, often without realizing it. It is a

part of our life. Let us say you realize suddenly, one morning, that you needed to buy a
book urgently. You ask one of your parents for the money. In business, however, it is a
more serious matter. The student may not be questioned by his parents or the housewife
may just meet her expenses as and when they come without bothering to find out how
much she spent, but in business it is a must. In simple words, accounting merely means,
reckoning or recounting. The American Institute of Certified Public Accountants
defines accounting as the art of recording, classifying and summarizing in a significant
manner and in terms of money transactions and events which are, in part at least, of a
financial character, and interpreting the results thereof. Financial Accounting consists of
creation of financial information and the subsequent use of such information. Creation
entails three steps namely Recording, Classifying and Summarizing which are dealt
below:
Recording: Commences when a business transaction occurs and it has been quantified. A
record of all these transactions are maintained in the order in which they occur in the
Journal.
Classifying: Refers to the rational segregation of the recorded information into related
groups so as to make the record useful.
Summarizing: After the Recording and Classification phases are complete the accounts
containing relevant information in the Ledger Book are to be balanced and the balances
listed. The Statement giving names of these accounts and their respective balances is
called the Trial Balance.
Use of Financial Statements
Decision-making requires critical analysis and careful interpretation of the published
financial statements. They reflect a combination of recorded facts, accounting
conventions and personal judgments, and the judgments and conventions applied affect
them materially. The soundness of the judgment necessarily depends on the competence
and integrity of those who make them and on their adherence to the Generally Accepted
Accounting Principles and Conventions.

Financial Accounting, Cost Accounting and Management Accounting:

Financial Accounting: Accounting involves recording, classifying and summarizing of

past events and thus is historical in nature. It is Historical accounting which is better
known as Financial accounting whose primary intention is to prepare the Statements
revealing the Income and financial position of the business on the basis of events which
have happened in the period being reckoned.
Cost Accounting: It shows classification and analysis of costs on the basis of functions,
processes, products, centers etc. It also deals with cost computation, cost saving, cost
reduction, etc.
Management Accounting: It deals with the processing of data generated in financial
accounting and cost accounting for managerial decision-making. It also deals with
application of managerial economic concepts for decision-making.

Financial Statements:

Typically, the major financial statements which result from the process of accounting are:

Profit and Loss Account

Balance Sheet
Cash Flow Statement.
A profit and loss account is an account depicting how the profits or losses come about in
a certain period. A balance sheet is a statement of what an organization owes and what it
owns at any given point of time. A cash flow statement is a statement of the sources from
which funds or cash were raised and the uses to which these funds or cash were put
during a certain period.
Accounting and Financial Analysis
Accounting data is of great importance for carrying out detailed financial analysis.
Financial analysis is usually carried out to study the financial position of the company
from the point of view of
Shareholders.
Debenture holders.
Banks (for working capital purposes).
Financial Institutions (like State Finance Corporation, IDBI, etc.)
Statutory Agencies (like Stock Exchanges, Registrar of Companies).
Others (like potential buyers of companies in takeovers or mergers).
Financial analysis is carried out using accounting data available in Profit and Loss
Account, and Balance Sheet. Hence a good grasp of the accounting logic underlying
these statements will be of immense help in financial analysis.

Form and Contents of Financial Statements:

Financial statements consist of Balance Sheet and Income Statement (Profit and Loss
Account). The Balance Sheet shows the financial status of a business at a given point of
time. As per the Indian Companies Act, 1956, the Balance Sheet of a company shall be in
either horizontal form or vertical form while the vertical form is the most commonly used
by companies in practice, pedagogically it is more convenient to explain the contents of
the balance sheet with reference to the horizontal form.
The Companies Act does not prescribe any particular format for income statement which
is also called as the Profit and Loss account. Though the Companies Act does not
prescribe a format for the income statement, it has specified that the income statement
must show specific information as required by the Schedule VI. This statement is an
adjunct to Balance Sheet because it provides details relating to net profit/loss which
represents the change in owners equity between two successive balance sheets.

Contents of the Balance Sheet:

Broadly speaking, assets represent resources which are of some value to the firm. They
have been acquired at a specific monetary cost by the firm for the conduct of its
operations. Assets are classified as follows under the Companies Act:
Fixed assets
Investments
Current assets, loans and advances
Miscellaneous expenditure
Profit and loss account.
Fixed Assets: These assets have two characteristics: they are acquired for use over
relatively long periods for carrying on the operations of the firm and they are ordinarily
not meant for resale. Examples of fixed assets are land, buildings, plant, machinery,
patents, and copyrights.
Investments: These are financial securities owned by the firm. Some investments
represent long-term commitment of funds. Other investments are short-term in nature and
may rightly be classified under current assets for managerial purposes.
Currents Assets, Loans and Advances: This category consists of cash and other
resources which get converted into cash during the operating cycle of the firm. Current
assets are held for a short period of time as against fixed assets which are held for
relatively longer periods. The major components of current assets are: cash, debtors,
inventories, loans and advances, and pre-paid expenses.
Miscellaneous Expenditure and Losses: This category consists of two items: (i)
miscellaneous expenditure, and (ii) losses. Miscellaneous expenditure represents certain
outlays such as preliminary expenses and pre-operative expenses which have not been
written off. From the accounting point of view, a loss represents a decrease in owners
equity. Hence, when a loss occurs, the owners equity should be reduced by that amount.
Liabilities
Liabilities when defined very broadly represent what the business entity owes others. The
Companies Act classifies liabilities as follows:
Share capital
Reserves and surplus
Secured loans
Unsecured loans
Current liabilities and provisions.
Share Capital: This is divided into two types: equity capital and preference capital. The
first represents the contribution of equity shareholders who are theoretically the owners
of the firm. Equity capital, being risk capital, carries no fixed rate of dividend. Preference
capital represents the contribution of preference shareholders and the dividend rate
payable on it is fixed.
Reserves and Surplus: Reserves and surplus are profits which have been retained in the
firm. There are two types of reserves: revenue reserves and capital reserves. Revenue
reserves represent accumulated retained earnings from the profits of normal business
operations. These are held in various forms: general reserve, investment allowance
reserve, capital redemption reserve, dividend equalization reserve, etc. Capital reserves
arise out of gains which are not related to normal business operations. Examples of such
gains are the premium on issue of shares or gain on revaluation of assets.
Surplus: It is the balance in the profit and loss account which has not been appropriated
to any particular reserve account. It may be noted that reserves and surplus along with
equity capital represent owners equity.
Secured Loans: These denote borrowings of the firm against which specific securities
have been provided. The important components of secured loans are, debentures, loans
from financial institutions and loans from commercial banks.
Unsecured Loans: These are borrowings of the firm against which no specific security
has been provided. The major components of unsecured loans are, fixed deposits, loans
and advances from promoters, inter-corporate borrowings, and unsecured loans from
banks.
Current Liabilities and Provisions: Current liabilities and provisions, as per the
classification under the Companies Act, consist of the following: amounts due to the
suppliers of goods and services bought on credit; advance payments received; accrued
expenses; unclaimed dividends; provisions for taxes, dividends, gratuity, pensions, etc.

Contents of the Income Statement:

Net sales appearing in the Income Statement is the sum of the invoice price of goods sold
and services rendered during the period. Sales inwards represent the invoice value of
goods returned by the customers. Excise duty refers to the amount paid to the
government.

Cost of goods sold is the sum of costs incurred for manufacturing procuring the goods
sold during the accounting period. It consists of direct material cost, direct labor cost, and
factory overheads. It should be distinguished from cost of production. The latter
represents the cost of goods produced in the accounting year, not the cost of goods sold
during the same period.

Gross profit is the difference between net sales and cost of goods sold.

Operating expenses consist of general administrative expenses, selling and distribution

expenses and depreciation.

Operating profit is the difference between gross profit and operating expenses. As a
measure of profit it reflects operating performance and is not affected by non-operating
gains/losses, financial leverage, and tax factor.

Non-operating surplus represents gains arising from sources other than normal operations
of the business. Its major components are income from investments and gains from
disposal of assets. Likewise, non-operating deficit represents losses from activities
unrelated to the normal operations of the firm.
Profit/Earnings Before Interest and Taxes (PBIT/EBIT) is the sum of operating profit and
non-operating surplus/deficit. Referred to also as earnings before interest and taxes, this
represents a measure of profit which is not influenced by financial leverage and the tax
factor. Hence, it is pre-eminently suitable for inter-firm comparison.

Interest is the expense incurred on borrowed funds, such as term loans, debentures, public
deposits, and working capital advances.

Profit before tax is obtained by deducting interest from profits before interest and taxes.
Tax means income tax expense for the year. (as defined in AS 22 accounting for taxes)

Profit after tax is the difference between the profit before tax and tax for the year.

Dividends represent the amount earmarked for distribution to shareholders.

Retained earnings is the difference between profit after tax and dividends.

Objectives of the Accountancy:

It is a means of recording the monetary transactions and events.
It required to ascertain the earnings of the company, which is achieved by
preparation of Profit and Loss account.
It is required to identify the obligations (liabilities) and resources (asset) of the
organization.
Accounting records are required to be maintained statutorily by certain government
and regulatory bodies.
Accounting records are also required by the management for taking the financial
decisions.
Generally, investors and certain lenders also require the preparation of
financial statements.

Users of Financial Statements:

Management
In a company form of organization the owners or the shareholders elect a group of people
to manage the day-to-day affairs of the company. Since these managers are ultimately
responsible for the financial performance, they must periodically compile and interpret
the financial statements.
Shareholders, Security Analysts and Investors
The major users of financial statements of business they ranges from individuals with
limited shareholding to institutions like insurance companies and mutual funds which
have high volume of funds at their disposal. The financial position of the company is
known by the shareholders through the financial statements which states the profit gained
or loss suffered and the measure of its assets and liabilities.
Lenders
Banks, financial institutions and other lenders would willingly part with their money only
if they are assured of the profitability and long-term solvency of the business in which
they are asked to invest.

Suppliers/Creditors
Suppliers of raw material, etc. to the company also would be interested in the short-term
liquidity of the company. The financial statements facilitate the creditors in ascertaining
the capacity of the organization, to pay on time the consideration for the goods/services to
be supplied.
Customers
The financial statements may be used by the customers to draw inferences about the long-
term viability of the firm.
Employees
Employees have a vested interest in the continued and profitable operations of the
organization in which they work. Financial statements can be used as important sources
for obtaining information regarding the current and future profitability and solvency.
Government and Regulatory Agencies
The correct assessment of income tax, sales-tax, excise duty, etc. requires a close scrutiny
of the financial statements of an organization especially to detect tax evasion, if any.
When contracts are entered into with the government, the business to supply all the
financial information required by the former.
Research
Scholars undertaking research into management science covering diverse facets of
business practices look into the financial statements for the information eventually used
for analysis. Such statements serve as mirrors of the entity represented by them and thus
are of great value to persons searching for company specific information.

True and Fair View of Accounts:

Since each user of accounts may have a different focus in viewing the financial
statements, it is necessary that the accounting statements are not biased in favor of any
one interested group. It is, therefore, necessary for an accountant to ensure that the
accounts represent a true and fair picture of the affairs of business.
Double Entry System of Financial Accounting:
Earlier, organizations used to maintain accounts in the single entry system which
recognizes only cash transactions. But now, accounts are invariably maintained in the
double entry system which recognizes both cash and credit transactions. Accounts are
maintained on accrual basis under this system.
Concept of Capital and Income:
The Accountants Concept of Capital and Income
Capital is the contribution made by the owner(s) in the business and is regarded as a
liability to the business in the nature of owners equity. The underlying feature for this
treatment is the distinction between the owner(s) and that of the business owned by them
as a result of which the business is vested with an implied obligation to repay such sum to
the owner(s). The income of the business is arrived at by matching the revenues of a
defined period with the expenses of the same period, and it accrues to the owner(s). This
matching of revenues and expenses can either be on an Accrual basis or Cash basis or the
Hybrid (mixture of both accrual and cash bases).
The Economists Concept of Capital and Income
According to economist J R Hicks the purpose of income calculation is to give people
an indication of the amount which they can consume without impoverishing themselves.
Income is the amount which a person can consume during a period and still remain well
off at the end of the period as he was at the beginning. This implies that only income
representing surplus can be consumed and the income determination ought not to affect
the capital.
Capital Maintenance Concept: The accountants methodology of ascertaining and
reporting results of business helps in comprehending the concept of capital maintenance.
According to both the accountant and the economist the surplus in the form of income
alone is available for consumption while the capital is to be maintained intact.Income is
the increase in capital which can be withdrawn bereft of any distortion of the capital. In
this instance, this concept of maintaining the capital is called the Financial Capital
Maintenance Concept where income shall be revenue less the historical cost of goods
sold.

GAAP, Conventions and Concepts:

The double entry system of accounting is based on a set of principles which are called
Generally Accepted Accounting Principles (GAAP). These principles enable to a certain
extent standardization in recording and reporting of information so that the users, once
they are aware of the principles, can read and understand the financial statements
prepared by diverse organizations.
While the conventions are based on what is practicable, there are certain accounting
concepts which are based on logical considerations. For example, dividing a centimeter
into ten equal parts is a convention rather than a concept. Accounting concepts are ideas
and assumptions which are fundamental to accounting practice. Some of the important
concepts are money measurement concept, business entity concept, going concern
concept, duality concept, cost concept, matching concept, realization concept and accrual
concept.
Materiality Concept
The criterion of True and Fair in the preparation of the financial statements is necessary
for arriving at a reasonable conclusion on the financial health of the company. This
condition brings us to the relative concept of materiality, which by its very nature can be
subject to variations. As the concept is relative, though important, a few established and
accepted general rules are brought in play in determining materiality:
Money Measurement Concept
In financial accountancy, a record is made only of information that can be expressed in
monetary terms. Recording, classification and summarization of business transactions
requires a common unit of measurement which is taken as money. If events cannot be
quantified in monetary terms then they do not facilitate accounting. The activities and
their attributes considered for inclusion in the financial statements will be based on the
yardstick of whether they are amenable to be translated in currency terms.
Cost Concept
Cost concept implies that in accounting, all transactions are generally recorded at cost,
and not at market value. This concept is closely related to Going Concern Concept. In
accounting, an asset is normally entered in the accounting records at the price paid for it,
i.e., cost.
Time Period Concept
Income (or) loss of the business is measured periodically. This is measured for a specified
interval of time, called the accounting period. For the purpose of reporting to outsiders,
one year is the usual accounting period.
Conservatism Concept
The idea behind this principle is that recognition of revenue requires better evidence than
recognition of expenses. This principle emphasizes that revenues are to be recognized
only when they are reasonably certain and expenses are to be recognized as soon as they
are reasonably possible.
Consistency Concept
There are in practice several ways of treating an event that may be recorded in the
accounts. The consistency concept requires that once an entity has decided on one
method, it will treat all subsequent events of the same character in the same fashion
unless it has a sound reason to change the method of treatment of that event.
Business Entity Concept
The legal entity of a corporate business, as distinct from the entity of its owners is well
understood today. Less understood, however, is the accounting entity of a business as
distinct from its owners. It is in accordance with this concept that when an owner brings
capital into the business, the business in turn is deemed to owe the capital to the owner.
Going Concern Concept
A business entity is assumed to carry on its operations forever. Seemingly
inconsequential, this is a fundamental concept which has far reaching consequences. This
is because it is difficult to envisage any economic activity on the part of a business entity
if its liquidation were shortly expected. Going concern concept implies that the resources
of the concern would continue to be used for the purposes for which they are meant to be
used.
Duality or Accounting Equivalence Concept
It can easily be seen that in business, as elsewhere, funds can be raised in any of the
following ways:
Additional capital (increases owners equity)
Additional loans (increases outside liability)
Earning revenue (increases owners equity)
Making profits (increases owners equity)
Disposing or reducing some of the assets (reduces assets).

Thus, all increases in liabilities (including owners equity) and reduction in assets
represent sources of funds. Similarly, the funds thus raised, may be put to any of the
following uses:

Purchasing of assets (increases assets)

Incurring operational expenses (decreases owners equity)
Discharging earlier liabilities (decreases liability)
Keeping idle funds so that cash balance increases (increases assets)
Suffering losses (decreases owners equity).

Thus all increases in assets and decreases in liabilities (including owners equity) are uses
of funds.
Accounting Period Concept
To be able to prepare the income statement for a business, the period for which it is to be
prepared must first be specified. Very often the accounting period chosen is a calendar
year (January 1 December 31) or a fiscal year (April 1 March 31). It is also not
uncommon to synchronize ones accounting period with ones operating periods. Under
the Companies Act, a company is normally not permitted to have an accounting period
extending beyond fifteen months.
Realization Concept
Revenue is normally recognized only when goods or services are transferred and a
reward or a promise of reward is forthcoming. If there is no transfer of goods or services,
normally no reward may be expected either now or in future and hence no revenue is
realized. Similarly, if there is no reward or a promise of reward in return for the goods or
services rendered, then such rendering of goods or services would merely be an act of
philanthropy or squandering and cannot be construed as a sale. Thus, normally revenue
is recognized at the time of transfer of goods or services when a return consideration is
either obtained immediately or there exists a reasonable certainty of receiving a return
consideration in future. However, there are exceptions to the above rule of revenue
recognition.
Matching Concept
In order to determine the profits or losses accrued in an accounting period, the expenses
must relate to the goods or services sold during the period. The revenue recognition
always precedes the matching of cost. If revenue or sale is not defined, the cost cannot
be defined either.
Financial Reporting:
The end-users of financial statements need not necessarily be those with finance
background. They might not be in a position to understand the complex technicalities of
financial statements. People who do not have detailed understanding of financial
accounting process and the related legal provisions are sure to fail to make any sense out
of the vast plethora of information presented in the annual reports. FASB has issued
several statements for improving the information provided in financial reporting. Taken
individually each newly required disclosure provides some additional useful information
to readers of financial statements. But again financial statements, footnotes,
supplementary statements, etc. complicate the entire reporting process.

Summary of Chapter -1:

All of us do some accounting, often without realizing it. It is a part of our life. Let
us say you realize suddenly, one morning, that you needed to buy a book urgently.

Financial Accounting consists of creation of financial information and the

subsequent use of such information. Creation entails three steps namely
Recording, Classifying and Summarizing.

Typically, the major financial statements which result from the process of
accounting are: Profit and Loss Account, Balance Sheet and Cash Flow
Statement.

The double entry system of accounting is based on a set of principles which are
called Generally Accepted Accounting Principles (GAAP).