1 Accounting For Management ((Module I)

TKM Institute of Management, Kollam Study Notes, Semester I Accounting for Managers Module I

Syllabus
Introduction to Financial Accounting; Purpose, use and role. Financial

Accounting rules, Concepts and Conventions; Financial Accounting Transactions, The process of recording, rules of book-keeping, Journalizing, Primary and Secondary books. Financial Accounting and Management Accounting; Generally Accepted Accounting Principles (GAAP); Accounting standards; International accounting standards; Regulatory framework of financial reporting in India. THE ACCOUNTING SYSTEM
Accounting is an ancient art, certainly as old money itself which conveys the language of business by recording, classifying and summarizing money transactions & events in a significant manner and interpreting the results thereof. In modern age the scope of business has been widen. The production and the sales are made at large scale due to division of labor, specialization and scientific management. The customers of a seller are spread over throughout the country. Usually the seller sells their goods for cash but to increase their sales the number of credit transactions increases. The memory of human being is limited. Therefore, it is not possible to remember all the transactions of a business. To overcome this problem, the work of recording the business transactions started which develops. Different methods of bookkeeping were used in different periods. Today we can say that the bookkeeping is a foundation on which the whole structure of modern business is based.

Need for Accounting

Accounting has rightly been termed as the language of business. It communicates the business operations to various parties who have some stake in the business viz., the proprietor, creditors, investors, Government and other agencies. The need for accounting is mainly for a person who is running a business. He should know: (i) what he owns? (ii) What he owes? (iii) Whether he has earned a profit or suffered a loss on account of running a business? (iv) What is his financial position? i.e. whether he will be in a position to meet all

Prepared by Asst. Prof. Rajesh Janardhanan

2Accounting For Management ((Module I) his commitments in the near future or he is in the process of becoming a bankrupt. In India, Chanakya in his Arthashastra has emphasized the existence and need for proper accounting and auditing. However the modern system of accounting owes its origin to Pacoili, who lived in Italy, in the 18th century.

MEANING OF ACCOUNTING Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the users of information In the beginning the main objective of accounting was to ascertain the result of the business (whether profit has been earned or loss has been suffered) during a year and to show the financial position of the business as on a particular date. But which the lapse of time more and more being expected from accounting. At present accounting has to meet the requirements of taxation authorities, investors, government regulations, management and owners. This has resulted in widening to scope of accounting and may be defined as follows: With greater economic development resulting in changing role of accounting, its scope became broader. In 1966 the American Accounting Association (AAA) defined accounting as the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of information. In 1970 the, Accounting Principles Board of AICPA also emphasized that the function of accounting is to provide quantitative information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions. Accounting can therefore be defined as the process of identifying, measuring, recording and communicating the required information relating to the economic events of an organization to the interested users of such information. In order to appreciate the exact nature of accounting, we must understand the following relevant aspect of the definition: Economic events Identification, Measurement, Recording and communication Organization Interested users of information.

Definition and Functions of Accounting

In 1941, the American Institute of Certified Public Accountant (AICPA) defined accounting as follows:

Prepared by Asst. Prof. Rajesh Janardhanan

3 Accounting For Management ((Module I) Accounting is the art of recording, classifying and summarising in 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.

In 1966, the American Accounting Association (AAA) defined accounting as follows: Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information. Accounting is the art of recording, classifying, analyzing, summarizing and interpreting and the financial transactions and communicating the results thereof to the persons interesting in such information. Thus accounting cycle involves the following stages: 1. Recording of Transactions. This is done in the book termed as Journal. 2. Classifying the Transactions. This is done in the book termed as Ledger. 3. Summarizing the Transactions. This includes preparation of the trial balance, profit and loss account and balance sheet of the business. 4. Interpreting the Result. This involves computation of various accounting ratios, etc., to know about the liquidity, solvency and profitability of business.

An analysis of the definition brings out the following functions of accounting:

1. Recording
This is the basic function of accounting. Recording is done in the book Journal. This book may be further subdivided into various subsidiary books such as Cash Journal (for recording cash transactions), Purchase Journal (for recording credit purchase of goods), Sales Journal (for recording credit sales of goods), etc. the number of subsidiary books to be maintained will be according to the nature and size of the business.

2. Classifying
Classification is concerned with the systematic analysis of the recorded data, with a view to group transactions or entries of one nature at one place. The work of classification is done in the book termed as Ledger.

3. Summarising
This involves presenting the classified data in a manner which is understandable and useful to the internal as well as external end-users of

Prepared by Asst. Prof. Rajesh Janardhanan

4Accounting For Management ((Module I) accounting statements. This process leads to the preparation of the following statements: (i) Trial Balance, (ii) Income Statement, and (iii) Balance Sheet

4. Dealing with Financial Transactions

Accounting records only those transactions and even in terms of money which are of a financial character. Transactions which are of a financial character are not recorded in the books of accounts.

5. Analysing and Interpreting

The recorded financial data is analysed and interpreted in a manner that the end-users can make a meaningful judgement about the financial condition and profitability of the business operations. The term Analysis refers to the methodical classification of the data given in the financial statements. The term Interpretation means, explaining the meaning and significance of the data simplified.

6. Communicating
The accounting information after being meaningfully analysed and interpreted done through preparation and distribution of accounting reports, which includes besides the usual income statement and the balance sheet, additional information in the form of accounting rations, graphs, diagrams, funds flow statements, etc. the initiative, imagination and innovative ability of the accountant are put to test in this process.

ACCOUNTING SYSTEM Business transactions may be recorded in any system, which will enable the ascertainment of the profit or loss of a business and its financial position. The following are the main systems adopted by business people:

1) Cash System of Accounting: Under this system, only actual cash receipts
and payments transactions will be entered into the Books of Accounts. No entry will be made for credit transactions. Government system of accounting is mostly on cash basis. Certain professional organizations also record their income on cash basis, but while recording expenses they take into account the outstanding expenses also and prepare Income and Expenditure Account instead of Profit and loss Account.

2) Mercantile

System of Accounting: This system is based on Double Entry principle. This Book Profit System of Accounting takes into consideration all the aspects of business transactions (BOTH CREDIT AND CASH TRANSACTIONS). This system is followed by most of the industrial and commercial firm. This system owes its origin to an Italian Merchant Luco Pacioli who wrote a book

Prepared by Asst. Prof. Rajesh Janardhanan

5 Accounting For Management ((Module I) entitled De Computis et Scripturis on Double Entry Accounting in the year 1494. SYSTEM OF BOOK KEEPING

The art and technique of recording the business transactions in a set of books is called as Bookkeeping. It is the process of analyzing, classifying and recording transactions in accordance with a preconceived plan.
This recording may be done according to two ways: 1) Single Entry System: which is an incomplete maintenance of books of accounts without following the Double Entry Concepts and Conventions, where some business houses maintains for their convenience keeping only some of the essential Books of Records. Thus it is referred as incomplete double entry recording of business transactions.

2)

Double Entry System: Where the transactions are recorded according to the Golden Rules of Accounting taking into consideration both the aspects of a transaction (Debit and Credit) and following the Accounting Concepts and Conventions. This system maintains both Book of Original Entry (Journal / Subsidiary Books) and Book of Final Entry (Ledger) according to the classification of Accounts into Real, Personal & Nominal, in order to know the state of affairs of the business by preparing the Profit and Loss Account and Balance Sheet from the Trial Balance.

BRANCHES OF ACCOUNTING The subject of accountancy has become important for all the business organization in the present time. Its subject matter has been increased and it has taken the form of accounting. Accounting subject has the following branches: FINANCIAL ACCOUNTING 1. Journal 2. Ledger 3. Trial Balance 4. Final Accounts COST ACCOUNTING 1. 2. 3. 4. Cost sheet Job and contract costing Process costing Operating costing

MANAGEMENT ACCOUNTING

Prepared by Asst. Prof. Rajesh Janardhanan

6Accounting For Management ((Module I) 1. 2. 3. 4. TAX ACCOUNTING 1. Sales Tax 2. Income Tax 3. Wealth Tax 4. Excise Duty GOVERNMENT ACCOUNTING 1. Budget 2. Consolidated Fund 3. Contingency Fund 4. Public Accounting SOCIAL RESPONSIBILITY ACCOUNTING 1. Social Fund 2. TQM 3. Environmental Accounting HUMAN RESOURCES ACCOUNTING Employee Inventory Management HRD Operational & Administrative Aspects Profitability and Work Measurement (1) Financial Accounting: Financial Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are at least in part, of a financial character, and interpreting the results thereof. In financial accounting we record the business transactions in the books of accounts. Its object is to ascertain the profit or loss and to know the financial position of the business. In this Journal, Subsidiary books, Ledger, Trial balance, trading account, Profit & loss account and Balance sheet are prepared. (2) Cost Accounting: This branch of accounting has attained good importance in recent days. Under it, the raw materials, labors and other expenses incurred in the industrial production and business activities are recorded regularly so that production cost and per unit cost can be ascertained and the unnecessary expenses can be checked out to control the cost. Cost accounting helps in maintaining a desirable margin between cost and price so that business can earn profit. It also include job and contract costing, process costing, operating costing and cost sheet preparation. Ratio Analysis Break event Point Analysis Standard costing Analysis Of Financial Statements

Prepared by Asst. Prof. Rajesh Janardhanan

7 Accounting For Management ((Module I) (3) Management Accounting : This branch of accounting supplies necessary information to the managers. On the basis of these information the evaluation of policies is done and decisions for future are taken. It includes Ratio Analysis, Analysis of financial statements, Fund flow Analysis, Cash flow Analysis etc. (4)Tax Accounting: Every businessman has to pay various types of taxes such as sales tax, Income tax, excise duty etc. Financial Accounting helps only in determining the taxable income of the business. Some specific separate adjustments are needed for determination of tax liabilities. Moreover various types of deductions and provisions of Acts are also taken into consideration for tax accounting. (5) Government Accounting: Central government, state government and local bodies also undertake the work of accounting and it is called Government Accounting. It differ from financial accounting. It explains the Budget and various other types of accounts such as consolidated fund, contingent fund and public fund account. (6)Social Responsibility Accounting: The society provides infrastructure and the facilities without which business cannot operate at all. Therefore the business also has a responsibility towards the society. Social responsibility accounting is the process of identifying, measuring and communicating the contribution of a business to the society. The contribution of a business to the society consist of providing employment to under privileged, providing financial and manpower support for public utility programmes, environmental and ecology contribution, product quality, product safety, product durability and customer satisfaction etc. In social responsibility accounting techniques have been developed for measuring the cost of these contributions and the benefit to the society (7) Human Resources Accounting: HR Accounting is an art and science of evaluating the worth of human resources of a business organization in a systematic manner as a whole to the concern and the society and recording them for presenting the information in the financial statements to communicate their worth to the readers of financial statements. It is the process of identifying and measuring data about human resources and communicating this information to interested parties

Role of an Accountant
Accountants are persons who practice the art of accounting. The Accounting system and the Accountants, who maintain it, provide useful services to the society. Accountants can broadly be classified into two categories:

1. Accountants in Public Practice

The accountants in public practice are also known as professional accountants. They offer their services for conducting financial audit, cost audit, designing of accounting system and rendering other professional

Prepared by Asst. Prof. Rajesh Janardhanan

8Accounting For Management ((Module I) services for a fee. In India, there are two recognised professional bodies for this purpose. They are: (i) the Institute of Chartered Accountants of India and (ii) the Institute of Cost and Works Accountants of India.

2. Accountants in Employment
These are accountants who are employed in non-business entities or business entities. Non-business entities are diverse set of organisations including Educational Institutions, Government, Churches, Museums, Hospitals, etc. their object is not to earn profit. The accountants employed by business entities arte frequently called Management Accountants since they report to, and are part of, the entitys management. These accountants provide information for tax returns, budgeting, routine operating decisions, investment decisions, performance evaluation and external financial reporting of the business.

Services Rendered by an Accountant

1. 2. 3. 4. Maintenance of Books of Accounts Auditing of Accounts Taxation Financial Services

OBJECTIVES OR FUNCTIONS OF ACCOUNTING Now a days accounting becomes a subject of practical importance for every business concern that may be a marketing firm, manufacturing firm, bank, transport agency, insurance company or a professional organization. Accounting attains the importance every where. Various persons are interested in accounting work of a business concern e.g. shareholders, investors, banks, government, creditors, employees, customers etc. Therefore accounting has to fulfill their objectives also. For this accounting perform various functions. Some of the important objectives or the functions of accounting are as follows: (1)To keep systematic record of business transactions: The main objective of accounting is to keep complete record of business transactions according to rules. For this purpose all the business transactions are firstly recorded in the journal or subsidiary books and then posted into the ledger. This helps to avoid the possibility of omission and fraud; moreover we can get the financial information at any time during the year. (2) To calculate profit or loss of the business: The second main objective or the functions of accounting is to ascertain the net profit earned or loss suffered by a business concern. For this purpose a Trading and Profit and loss

Prepared by Asst. Prof. Rajesh Janardhanan

9 Accounting For Management ((Module I) account is prepared at the end of each accounting period. When revenue of the business is more than expenditure the difference is said to be profit. In addition to it, a businessman is able to get the following information from accounting. 1. How much goods have been purchased during a particular period 2. How much goods have been sold during a particular period 3. How much goods have been remained unsold and what is its value. 4. How much amount has been spent and earned on various heads (3) To depict the financial position of the business: For this purpose a balance sheet is prepared on the last day of the accounting year which shows the values of various assets on one side and the liabilities and capital on the other side. Balance sheet shows the financial position of the business. Besides this, from accounting a businessman can get the following information: 1. How much amounts the business has to recover from debtors. 2. How much amount the business has to pay to creditors. 3. Amount of opening capital and closing capital 4. Amount of cash receipts and cash payments from the cashbooks. (4) To provide informations to various parties: Various persons have vested interests in a business firm. Accounting provides useful information to all the interested parties such as: owners, managers, investors, creditors, researchers, employees, customers, banks, government departments, etc. (5)Other objectives: Accounting functions also fulfill the following objectives: To keep systematic and permanent record of all financial transactions To use accounting records for future reference To fulfill the legal requirements To provide information about various tax liabilities To check the accounting errors, frauds, and misappropriations of funds To know the requirements of the business To help in fulfilling tenders and quotations To provide information about profitability of various products To facilitate rational decision-making. To control over expenditures to minimize them. ADVANTAGES OF ACCOUNTING Accounting has many objectives and fulfillments of these objectives are the advantages and usefulness of accounting: (A) Advantages to businessman: (1) Recording of transactions: It is a systematic and complete record of business transactions whether they are personal, real, or nominal. Permanent recording of business transactions make the results more realistic. (2) Replacement of memory: In a large business it is very difficult for a businessman to remember all the transactions. Accounting provides

Prepared by Asst. Prof. Rajesh Janardhanan

10 Accounting For Management ((Module I) records which will furnish information as and when required and thus it replaces human memory. (3) Provides information: Every trader wants to get the information about his business from time to time so accounting provides all these information. (4) Availability of net results: In accountancy at the end of the year final accounts are prepared from the accounts of business transactions .Gross profit is ascertained by Trading A/c and net profit is ascertained by profit and loss A/c. Other financial statements make available the net results of income and expenditure items also. (5) Knowledge of financial position: Accounting helps a businessman to know the financial position of his business. (6) Reference in future: When the work of accounting has been performed properly then the businessman can present the old ledgers as references in future. Posting up the books if accounts are treated as business evidences and can be used in future as references. Books of accounts can be presented in the courts as evidences. (7) Comparative study: When business transaction are recorded in a proper manner then the business results can be inferred easily and the result of different years can be compared to take proper decisions for the future. (8) Check the errors and frauds: When the business transactions are recorded regularly and systematically in the books of accounts then the chances of errors minimize. Moreover accounting also checks the frauds in stock and cash. (9) Helpful in management: Mangers of business need various information to manage the business. These information are supplied by the Accounts Department only. In a good business the Accounts Departments has a special importance. (10) Helpful in the sale of business: If accounts are properly maintained it helps to ascertain the purchase price in case the businessman is interested to sell business. (B) Advantages to customers

(1)

(2)

Proper price: A manufacturer can determine the proper cost if his product through an adequate and complete recording. This further helps in proper price determination and the product can be made available at proper price to the consumer. Quality goods: An indirect advantage is accounting is that when accounting is that when Accounts Department of a business is good then the quality of its product will also be good which benefits the consumers.

(C ) Advantages to Government

Prepared by Asst. Prof. Rajesh Janardhanan

11 Accounting For Management ((Module I)

(1)

(2)

(3) (4) (5)

Financial assistance: Govt. also gets various advantages from accounting. Govt. gives financial assistance in the form of subsidies and grants to the business firms. We can take advantages of their financial assistance only when we have recorded properly our business transactions .So it helps to attain the advantages of govt. policies. Knowledge of financial position of the country: Govt. can ascertain the commercial and industrial progress of the country as a whole through the knowledge of progress of various trades. It is possible when all the business units have proper accounting work. Granting license: If the work of accounting is performed properly it will help the govt. in granting import, export and production licenses to the enterprises. Commercial Laws: Accounting also makes possible to frame and amend the various commercial laws such as Company Act, MRTP Act, Consumer Protection Act etc. Tax Assessment: Traders have to pay various taxes such as Sales tax, Income tax, Excise duty etc. These taxes be determined properly if the recording in the books of accounts is done properly. Government officers also recommend the accounting .Thus businessman and the govt. both are benefited by the accountancy.

(D ) Advantages to employees (1) Control: It is very important in a business that workers should be employed according to work. How much employees can be employed at a fixed wages is also related with the Accounts Department. Thus accounting controls the employees indirectly. (2) Increase in salary and bonus: Accounting also helps in determining the salaries, bonus and other payments to the employees. With the participation of employees in the management the importance of accounting has also special status.

(E ) Other Advantages (1) Helpful in planning: Managers of business require the estimates of purchase, sales expenses, costs and cash receipts for the next year, so that future plans can be framed. These information are received from Accounts Department due to accounting. (2) Helpful in decision making: Every trader has to take decisions about production, sales etc. For e.g. whether price can be reduced to increase sale or not. Gifts is to be presented with product or not etc. The information related to these decisions can be obtained from the Accounts department only. (3) Helpful in borrowing: We need additional capital for expansion of the business. This is provided by the accounting.

Prepared by Asst. Prof. Rajesh Janardhanan

12 Accounting For Management ((Module I) (4) Determination of goodwill: on the basis of accounts for various years Goodwill of the business can be calculated. Helpful in partnership: In partnership a new partner can know the financial position of the firm through the accounts of the firm. An outgoing partner with the help of accounts of the firm can easily ascertain his share to be received from the firm. In partnership there are more than one manager hence for confidence must prevail among them proper recording of business transactions is required. In large-scale business: Today every product is produced and sold at large scale. Thus business activities also enlarge. Accounting helps in easy control of such large business. In case of insolvency: When a businessman fails to pay his liabilities he becomes insolvent, then the creditors torture the businessman. If he has maintained proper record of business transactions he can take the protection of the court. The court declares a businessman solvent on the basis of books of accounts. Assessment of progress: By knowing about the profit and loss, assets and liabilities, purchases and sales income and expenditure of last many years we can assess the progress made by a business. It is possible only by the accounting.

(5)

(6) (7)

(8)

LIMITATIONS OF ACCOUNTING Though accounting has a number of advantages yet it has some limitations also. Following are the major limitations of accounting. (1)Incomplete information: In accounting only those transactions are recorded which can be expressed in terms of money. Other events, e.g. efficiency of managers, changes in tastes of consumers, popularity of product and ability of employees, Economic and political conditions of the country, level of competition etc though affect the success of business and financial position and managers continuously try to collect these information, yet they cannot be expressed in terms of money and thus not represented in accounting. (2) Influenced the by personal judgments: In accounting some principles and concepts are obeyed. But at the end of an accounting year to ascertain the net profit or loss some estimates are used. To charge depreciation life of an asset and its scrap value are to be estimated, Bad debts are also estimated etc. The liking and disliking of the accountant affect these estimates. Thus the results are also affected. (3) Realizable value of business is not shown: The balance sheet which is prepared at the end of the period to present the financial position of the business shows the assets at their historical costs and not at their

Prepared by Asst. Prof. Rajesh Janardhanan

13 Accounting For Management ((Module I) realization price. Thus it is not possible to estimate the present realizable value of the business. (4)Complete control on frauds is impossible: Accountancy can check the arithmetic accuracy of books accounts but cannot check the frauds completely. The profit and loss at the end of the year can also be manipulated by manipulating the value of closing stock. (5)Manipulation in accounts: If an owner shows the items of his own interest in the books of accounts the result obtained by the accountant will be biased and wrong. (6)Does not provide timely information: Final accounts are prepared at the end of the accounting year. Thus they contain the information of historical importance. While managers need current information for management and planning, which are not supplied by the accounting easily.. FINANCIAL ACCOUNTING Financial Accounting is concerned with the provisions of informations to external parties outside the organization. The outsiders who use accounting information have a variety of interests. Investors and shareholders want to know the companys profit potential. The suppliers, banks, and other lenders want to know whether a business is credit worthy. Government agencies regulate and tax businesses and analyze the published financial statements to make decisions. Financial accounting is concerned with recording and summarizing financial transactions and preparing statements relating to the business according to Generally Accepted Accounting Principles agreed on by the accounting profession. Financial Accounting is the basis of external reporting. Limitations Of Financial Accounting Financial accounting works as a postmortem of business affairs of an enterprise during the accounting year. It cannot fulfill the needs of modern management as A.C.Littleton has aptly said that providing of significant data regarding market demand, state of competition, general business conditions, engineering, personal information, legal and regulatory limitations are out of the sphere of financial accounting. In the changed business scenario various new requirements such as future planning, evaluation of plans and policies, cost control, timely decisions etc. have emerged on account of increasing size of business, technical complexities, government interferences and public awareness towards social responsibilities of business. Financial accounting has the following limitations. 1) Financial accounting gives only limited information to the management. It is inadequate for management in the task of decision making. 2) Managerial decisions relate to future. Hence they are made on the basis of estimates and projections. Financial accounting is inadequate for making future projections because it provides only historical information.

Prepared by Asst. Prof. Rajesh Janardhanan

14 Accounting For Management ((Module I) 3) The present day management is of three tier system. Different levels of management needs different information. Financial accounting fails to meet the information needs of different levels of management. 4) Financial accounting considers only quantifiable information. Nowadays business decisions are influenced by a number of social factors. For this many of them are ignored in financial accounting. 5) The rapid change in technology and fast growth of business units have made the task of modern management highly complicated. Financial accounting with its simple structure is not in a position to cater the needs of modern management. Difference between Accounting. Management Accounting and Financial

Management accounting cannot replace financial accounting. It takes a major part of the information from financial accounting and modifies the same for managerial uses .Therefore Both branches of accounting are complementary to each other. But there are certain points of differences between the two. They are given below. (1) The primary objective of financial accounting is recording business transactions in a systematic way and ascertains the business results and financial position of a business concern. The objective of management accounting is to provide necessary information to the management for the efficient discharging of its functions. (2)Financial accounting is an external accounting because it presents information to the external parties like shareholders, creditors, bank etc. Management accounting is an internal accounting because it presents information to the management. (3)Financial accounting is concerned with historical records relating to the past, where as Management accounting is mainly concerned with future plans and policies. (4)Financial accounting is compulsory, while Management accounting is optional. (5)Financial accounting relates to the business as a whole. Management accounting deals with reports about a particular department or division of an enterprise. (6)In financial accounting there is more emphasis on precise data. In Management accounting there is less emphasis on precision. Estimates and future data are mostly used. (7) Financial accounting is prepared in accordance with the GAAP. Management accounting is prepared according to the internal requirements of the management. (8) Financial accounting presents annual reports, while management accounting reports are of both shorter and longer durations. (9)Financial accounting is based on measurements while management accounting is based on judgment. Thus financial accounting is more objective and management accounting is more subjective.

Prepared by Asst. Prof. Rajesh Janardhanan

15 Accounting For Management ((Module I) (10) Financial accounting records only those transactions which can be expressed in terms of money. On the other hand management accounting records not only monetary transactions but also non-monetary events like technical changes, government policies etc (11) The scope of financial accounting is not vast as compared to management accounting. It does not include the techniques like costing, statistics, management accounting etc. It is a part of management accounting. The scope of management accounting is most wide because financial accounting, cost accounting, statistics and other techniques are used in it. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES What is GAAP ? Generally Accepted Accounting Principles (GAAP) includes accounting conventions, rules, procedures and accounting standards, accepted accounting practices both promulgated and non-promulgated. GAAP are those principles, which have substantial authoritative support. In order to maintain uniformity and consistency in accounting records, certain rules or principles have been developed which are generally accepted by the accounting profession the ICAI. These rules are called by different names such as principles, concepts, conventions, postulates, assumptions and modifying principles. The term principles has been defined by AICPA as A general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice. The word generally means in a general manner i.e., pertaining to many persons or cases or occasions. Thus, GAAP refers to the rules or guidelines adopted for recording and reporting of business transactions in order to bring uniformity in the preparation and the presentation of financial statements. The GAAP have evolved over a long period of time on the basis of past experiences, usage or customs, statements by individuals and professional bodies and regulations by the government agencies and have general acceptability among most accounting professionals. However the principles of accounting are not static in nature. These are constantly influenced by changes in the legal, social, and economic environment as well as the needs of users. These principles are also referred as concepts and conventions. The term Concept refers to the necessary assumptions and ideas that are fundamental to accounting practice, and the term convention refers to customer or tradition as a guide to the preparation of accounting statements. In practice the same rules and guidelines have been described by on author as a concept by another as a postulate and still by another as convention. This at times becomes confusing to the learners. Instead of going into the semantics of these terms, it is important to concentrate on the practicability of their usage. From this practicability view point it is observed that the various terms such as principles, postulates, conventions, modifying principles, assumptions etc have been used inter changeably and are referred to as basic accounting Concepts and Conventions.

Prepared by Asst. Prof. Rajesh Janardhanan

16 Accounting For Management ((Module I)

Basic Accounting Concepts The basic accounting concepts are referred to as the fundamental ideas or basic assumptions underlying the theory and practice of financial accounting and are broad working rules for all accounting activities and developed by the accounting profession.

The important concepts have been listed as below: Conditions on which the accounting system is based are called accounting assumptions or concepts. Accounting system is based on certain assumptions or concepts. These assumptions constitute the foundation of accounting process. No concern can prepare financial statements and accounts without considering these assumptions. Although there is no authoritative list of assumptions, some major assumptions are as follows. Accounting entity Concept Money measurement Concept Going concern Concept Accounting period Concept Historical cost Concept Dual aspect Concept Revenue recognition/Realization Concept (1) Accounting entity concept: The concept or assumptions that business has a separate entity or existence apart from the owners is an entity This concept assumes that the entity of business is distinct from the its owners. Owner is a creditor in accordance with this concept. That is why capital account is shown on the liability side of the balance sheet. Moreover business is treated as a unit or entity separate from the persons who control and associate with it. So accounts which are prepared and maintained for business entity are distinct from all categories of persons associated with it. (2) Money Measurement concept : Under money measurement concept, only transactions expressed in terms of money are recorded in the books of accounts. Money is common denominator in terms of which all transactions can be expressed in a better manner. Hence under the concept of monetary expression or money measurement concept only those transactions which can be expressed in terms of money are recorded in the books of account. This facilitates in recording various kinds of economic activities on a uniform basis. For instance, plant, furniture, land etc Which are generally expressed in terms of quantity, area etc are recorded in terms of money value. A transaction or an event which is not measurable in terms of money cannot be recorded in the books of account. For instance

Prepared by Asst. Prof. Rajesh Janardhanan

17 Accounting For Management ((Module I) dismissal of worker, strikes etc are very important events, but do not find their place in the books of account. This concept suffers from the following limitations. (1)It does not consider the changes in the value of money. (2)Human resources cannot be recorded in the books of accounts, although it is greatest asset of a concern. (3) Going concern concept: The concept that the business will continue for a fairly long period is a going concern concept. Under this concept it is assumed that the business concern will continue to exist for a fairly long period. There is no intention to shut down the particular business concern in the near future. However this concept does not imply a permanent existence of the business. But this indicates stability and continuity of a business for a long period to carry out its plan. (4) Accounting period concept: The period of interval for which accounts are prepared and presented for ascertaining the result of business is an accounting concept. The going concern concept implies that the business has a long period of life. But however the owners and others who are interested in the business cannot wait for such an indefinite period to know its results. Moreover such belated computation of financial position of a business will not serve its very purpose. Hence the accountants specify an accounting period (say 12 months, 6months, 3months,etc ) for preparing financial statements. (5) Historical/ Cost concept: Accounting based on the actual cost of a transaction is the principle of historical cost. Under this principle all the transactions should be recorded at their requisition cost. The cost of acquisition is the cost of purchasing the assets and includes expenses incurred in bringing them to the intended condition and location of use. However this concept does not mean that the assets are always shown at cost but will be reduced by decrease in value known as depreciation. (6) Dual aspect: The concept of double aspects in every transaction is a duality concept. According to this concept every transaction has two aspects. In case there is a debit then there is corresponding credit of the amount. Accounting equation is developed on the strength of dual aspect concept. For instance when there is an increase in one asset there is a corresponding decrease in other assets or increase in liabilities. Thus assets and liabilities are equal at all the times i.e. [Asset = Capital +liabilities]. The system of recording transactions with its dual concept is known as double entry system.

Prepared by Asst. Prof. Rajesh Janardhanan

18 Accounting For Management ((Module I)

(7) Revenue recognition Unless money has been realized (either cash has been realized or a legal obligation to pay has been assumed by the customer) no sale can be said to have taken place and no profit or income can be said to have arisen.

(8) Accrual Concept Normally all transactions are settled in cash , but even if cash settlement has not taken place, it is proper to bring the transactions or the event concerned into the business books during the particular accounting period as it relates to that period. For eg: Rent accrued fro the last month. Rent for the last month of the accounting period may be paid only in the next accounting period, but still as the event is related to the current period it will be considered as accrued and debited in the current period itself. The International Accounting Standards Committee (IASC) of which the Institute of Chartered Accountants of India (ICAI) is an associate member, treats Going concern, Consistency and Accrual as the fundamental accounting assumptions.

Accounting Conventions regarding financial statements.

Conventions are the customs or practices, which were following for a long period. They are the practices or traditions, which guide the accountant while preparing the accounting statements. In order to make the message contained in the financial statements (Profit and Loss Account & Balance Sheet) clear and meaningful the following conventions are used: (1)Conservatism Financial Statements are usually drawn up on the assumption that anticipate no profit but provide for all possible losses i.e., showing a position better than what it is, is not permitted (which is called as Window-dressing). It is also not permitted to show a position substantially worse than what it is. In other words, secret reserves are not permitted. It is based on this convention that the inventory is valued at cost or market price whichever is less (2)Consistency The accounting practices should remain the same from one year to another- for instance, it would not be proper to value stock-in-trade according to one method one year and another method next year. If a change is required, the change& its effect should be stated clearly. (3)Materiality/Disclosure

Prepared by Asst. Prof. Rajesh Janardhanan

19 Accounting For Management ((Module I) This convention suggests that the accountant should attach importance to material details and ignore insignificant details. The accountant should regard an item as material if there is reason to believe that knowledge of it would influence the decision of the informed investor. For e.g., while sending each debtor a statement of his account, complete details up to paise have to be given. Good accounting practices demands that all significant matters or information should be disclosed.

The Process of Accounting

Accounting is the art of recording, classifying, and summerising the financial transactions and interpreting the results therefore. Thus accounting cycle involves the following stages: 5. Recording of Transactions. This is done in the book termed as Journal. 6. Classifying the Transactions. This is done in the book termed as Ledger. 7. Summerising the Transactions. This includes preparation of the trial balance, profit and loss account and balance sheet of the business. 8. Interpreting the Result. This involves computation of various accounting ratios, etc., to know about the liquidity, solvency and profitability of business.

Accounting Process Chart

Prepared by Asst. Prof. Rajesh Janardhanan

20 Accounting For Management ((Module I)

Purchases Day Book Purchases Return Book Sale Day Book Sales Return Book Cash Book Journal Proper Other End of Accounting Period Adjustment s Ledger Accounts Trial Balance

Profit & Loss A/c

Transaction s & Events

Balance Sheet

Bank Reconciliation

Rectification of Errors

Rules of Debit and Credit

1. Personal Account Includes the accounts of persons with whom the business deals. Examples: - Debtors, Creditors, proprietor etc. Rule: Debit the receiver Credit the giver

2. Real Account Includes the accounts which relate to such things which can be touched, felt, measured etc. examples of such accounts are cash account, buildings account, furniture account, stock account etc. Rule: Debit what Comes In Debit what Comes In Credit what Goes Credit what Goes Out Out 3. Nominal Account These accounts are opened in the books to simply explain the nature of the transactions. They do not really exist. For example, salary, rent, commission etc. Rule:

Prepared by Asst. Prof. Rajesh Janardhanan

21 Accounting For Management ((Module I)

Debit All Expenses and Losses Debit All Expenses and Losses Credit All Gains and Incomes Credit All Gains and Incomes

Books Maintained
I. Subsidiary Books
Subsidiary books are the subdivision of Journal usually prepared according to a set of pattern for academic pursuits. It constitutes the following: (a) Purchases Day Book (Invoice Book or Bought Book or Purchases Journal) It is the book in which all credit purchases of merchandise (goods) are recorded. (b) Sales Day Book It is the book in which all credit sale of goods are first recorded. (c) Returns Books i) Purchases Returns/Return Outward Books:- to record the purchase returns of goods ii) Sales Returns/Return Inward Books:- to record the sales return of goods. (d) Bills Receivables & Bills Payable Book These are books in which the receipt and issue of bill of exchanges are recorded. If the organization doesnt maintain such books, the receipt and issues of bill of exchanges will be recorded in the journal proper (e) Cash Book It is a book of account in which all receipts and payments of cash are recorded in the chronological order irrespective of whether they are of capital or revenue in nature. It is both a ledger as well as journal (as it is usually ruled like an ordinary ledger account, and transactions involving either receipt or payment of cash are recorded in it directly in the first instance). Sometimes it is treated as special journal. (f) Journal Proper It is a book of original entry (which retains the original form of a journal to keep a record of those transactions for which there is no separate book), in which transactions that could not be recorded in any of the subdivided/special journals are recorded. Usually, the following types of transactions are recorded in the Journal proper. i) Opening Entries ii) Closing Entries

Prepared by Asst. Prof. Rajesh Janardhanan

22 Accounting For Management ((Module I) iii) iv) v) vi) vii) Transfer Entries Rectification Entries Adjusting Entries Entries for dishonour of Bills Miscellaneous Entries

JOURNALIZING
The journal records all daily transactions of a business into the order in which they occur. A journal may therefore be defined as a book containing a chronological record of transactions. It is the book in which the transactions are recorded first of all under the double entry system. Thus, journal is the books, of original record. A journal does not replace but precedes the ledger. The process of recording transaction in a journal is termed as Journalising. Journal is known as Book of Prime Entry. A pro forma of journal is given below: Date Properties L.F Debit (Rs.) Credit (Rs.)

1. Date: - The date on which the transaction was entered is recorded here. 2. Particulars: - the two aspects of transactions are recorded in this column, i.e., the details regarding accounts which have to be debited and credited. 3. L.F.:- it means the Ledger Folio. The transactions entered in the journal are later on posted to the ledger. 4. Debit: - in this column, the amount to be debited is entered. In Real account, it is Debit what comes in; in Personal account, it is Debit the receiver; in Nominal account, it is Debit all expenses or losses. 5. Credit: - in this column, the amount to be credited is shown. In Real account it is Credit what goes out; in Personal account, it is Credit the giver; in Nominal account it is Credit all incomes and gains.

II. Main/Principal Book of Account (Ledger)

Ledger is a Book of Secondary Entry or Principal Book of Account, which contains various accounts. In other words, ledger is a set of accounts. It contains all accounts of the business enterprise whether Real, Nominal or

Prepared by Asst. Prof. Rajesh Janardhanan

23 Accounting For Management ((Module I) Personal. It is usually prepared after the journal and therefore it is a secondary or derived record. It is the most important book for a businessman, as it is from the ledger that a trial balance can be prepared and from the trial balance, the final accounts are prepared. Because of the importance of the ledger it is called the King of Books of Accounts.

Posting
The term Posting means transferring the debit and credit items from the journal to their respective accounts in the Ledger. It should be noted that the exact names of accounts used in the Journal should be carried to the Ledger. Posting may be done at any time. However, it should be completed before the financial statements are prepared. It is advisable to keep the more active ac counts posted to date. The examples of such accounts are the cash account, personal account of various parties etc. The Ledger Folio (L.F) column in the journal is used at the time when debits and credits are posted to the Ledger. The page number of the Ledger on which the posting has been done is mentioned in the L.F. column of the Journal. Similarly a folio column in the Ledger can also be kept where the page from which posting has been done from the journal may be mentioned. Thus, there are cross references in both the Journal and the Ledger.

Form of Ledger Accounts

Dr. Dat e Particulars J.F ----------------- Account Amoun Dat Particulars t e (Rs.) J.F Cr. Amoun t (Rs.)

Relationship between Journal and Ledger

Both Journal and Ledger are the most important books used under Double Entry System of book-keeping. Their relationship can be expressed as follows: 1. The transactions are recorded first of all in the Journal and then they are posted to the Ledger. Thus, the Journal is the book of first or original entry, while the Ledger is the book of secondary entry. 2. Journal records transaction in a chronological order, while the Ledger records transaction in an analytical order. 3. Journal is more reliable in compared to the Ledger since it is the book in which the entry is passed first of all. 4. The process of recording transactions is termed as Journalising while the process of recording transactions in the Ledger is called as Posting.

Balancing of an Account
Prepared by Asst. Prof. Rajesh Janardhanan

24 Accounting For Management ((Module I) The technique of finding out the net balance of an account, after the end of a period (say a month, a quarter or a year), by considering the totals of both debits and credits appearing in the account is known as Balancing the Account. The balance is put on the side of the account which is smaller and a reference is given that it has been carried forward or carried down (c/f or c/d) to the next period. On the other hand, in the next period a reference is given that the opening balance has been brought forward or brought down (b/f or b/d) from the previous period.

ACCOUNTING STANDARDS Accounting Standards are written documents, policies issued by expert accounting body or Government or other regulatory body covering the aspects of recognition, measurement, treatment, presentation and disclosure of accounting transaction in the financial statement. The Institute of Chartered Accountants of India issues accounting Standards in India. Objective of Accounting Standards The main objective of AS is to standardize the diverse accounting policies and practices with a view to eliminate to the extent possible the non-comparability of financial statements and add the reliability to the financial statements.. The Institute of Chartered Accountants of India, recognizing the need to harmonize the diverse accounting policies and practices, constituted an Accounting Standard Board (ASB) on 21st April 1977. Compliance with Accounting Standards issued by ICAI Sub-section (3A) to Section 211 of The Companies Act, 1956 requires that every Profit and Loss Account and Balance Sheet shall comply with the Accounting Standards. Thus Accounting Standards means the standard of accounting recommended by the ICAI and prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards (NACAS) constituted under section 210A(1) of Companies Act, 1956. Accounting Standards and the Auditors Auditors are duty bound while discharging their attest function to ensure that the Accounting Standards issued are made mandatory by the ICAI. Section 227(3) of Companies Act, 1956 requires the auditors to report whether in his opinion the Profit/Loss Account and Balance Sheet comply with the Accounting Standards referred in Section 211(3C) of the Companies Act, 1956. Section 217(2AA)(1) of the Companies Act, 1956 states that Directors Responsibility Statement should include that, in the preparation of the annual accounts the applicable Accounting Standards had been followed along with proper explanations relating to material departure. So far the ICAI has issued 29 Accounting Standards, as given below: AS 1. Disclosure of Accounting Policies

Prepared by Asst. Prof. Rajesh Janardhanan

25 Accounting For Management ((Module I) AS 2. Valuation of Inventories AS 3. Cash Flow Statement AS 4. Contingencies and Events Occurring After Balance Sheet Date AS 5. Net Profit or Loss for the Period, Prior Period Items and Change in Accounting Policies. AS 6. Depreciation Accounting AS 7. Construction Contracts AS 8. (Withdrawn) AS 9. Revenue Recognition AS 10. Accounting for Fixed Assets AS 11. The Effects of Changes in Foreign Exchange Rates. AS 12. Accounting for Government Grants. AS 13. Accounting for Investments AS 14. Accounting for Amalgamations AS 15. Accounting for Retirement benefits in financial Statements of Employers AS 16. Borrowing Costs AS 17. Segment Reporting AS 18. Related Party Disclosures AS 19. Leases AS 20. Earning Per Shares AS 21. Consolidated Financial Statements AS 22. Accounting for Taxes on Income AS 23. Accounting for Investments in Associates in Consolidated Financial Statements AS 24. Discontinuing Operations AS 25. Interim Financial Reporting AS 26. Intangible Assets AS 27. Financial Reporting of Interests in Joint Ventures AS 28. Impairment of Assets AS 29. Provisions, Contingent Liabilities and Contingent Assets Advantages and Disadvantages of Accounting Standards Advantages: Standards reduce to a reasonable extent or eliminate altogether confusing variation in the accounting treatments used to prepare the financial statements.

Prepared by Asst. Prof. Rajesh Janardhanan

26 Accounting For Management ((Module I)

There are certain areas where important information is not required by law to be disclosed, standards may call for disclosure beyond that required by law. It facilitates comparison of financial statements of different companies situated at different places. Disadvantages of setting Accounting Standards: There may be a trend towards rigidity and away from flexibility in applying Accounting Standards. Differences in Accounting Standards are bound to be because of differences in the traditions and legal system from one country to another. Accounting Standards cannot override the law. The Standards are required to be framed within the ambit of prevailing statute even though it is not an acceptable standard. International Accounting Standards International Accounting Standards Board (IASB) issues International Accounting Standards. International Accounting Standards Committee (IASC), the London based group responsible for developing IASs has been in existence for over 20 years. The IASC comprises of the professional accountancy bodies of over 75 countries (including the Institute of Chartered Accountants of India) IASB so far have issued 41 IASs and 6 IFRS (International Financial Reporting Standards) The list of IAS includes: IAS 1 Presentation of Financial Statements IAS 2 Inventories IAS 7 Cash Flow Statements IAS 8 Accounting Policies, Change in Accounting estimates and errors IAS10 Events after the Balance Sheet Date IAS11 Construction Contracts IAS12 Income Taxes IAS14 Segment Reporting IAS16 Property, Plant and Equipment IAS17 Leases IAS18 Revenue IAS19 Employee Benefits IAS20 Accounting for Government Grants and disclosure of Government Assistance IAS21 The effect of Changes in Foreign Exchange Rates IAS23 Borrowing costs IAS24 Related Party Disclosure IAS26 Accounting and Reporting by Retirement Benefits Plan IAS27 Consolidated and Separate Financial Statements IAS28 Investments in Associates

Prepared by Asst. Prof. Rajesh Janardhanan

27 Accounting For Management ((Module I) IAS29 Financial Reporting in Hyper Inflationary Economies IAS30 Disclosure in the Financial Statements of the Banks and similar Financial Institutions IAS31 Interest in Joint Ventures IAS32 Financial Instruments: Disclosure and Presentation IAS33 Earnings Per Share IAS34 Interim Financial Reporting IAS36 Impairment Assets IAS37 Provisions, Contingent Liabilities and Contingent Assets IAS38 Intangible Assets IAS39 Financial Instruments: Recognition and Measurement IAS40 Investment Property IAS41 Agriculture

IASB has issued the following six IFRS (International Financial Reporting Standards): IFRS-1 First time Adoption of IFRS IFRS-2 Share Based Payments IFRS-3 Business Combination IFRS-4 Insurance Contracts IFRS-5 Non-current assets held for sale and discontinued operations IFRS-6 Exploration for and evaluation of mineral resources. Regulatory Framework of Financial Reporting in India The regulations that govern Financial Reporting by a business entity can vary depending on the entitys legal form. Thus regulations governing the financial reporting by limited liability companies can differ considerably from the regulations governing Partnerships. Partnership reports will cover the provisions mentioned under the Indian Partnership Act 1932. Companies registered under The Companies Act 1956 can be of several types. For example, companies registered under section 25 of the Act are essentially nonprofit entities, similarly special provisions may be applicable to Government Companies under Section 617 of the Act, and Section 3 will be applicable to Public Limited Companies. Some of the public Limited companies under the Act will also be listed on one or more stock exchanges. Such companies will cover the special provisions applicable to Financial Reporting enunciated by the SEBI (Securities Exchange Board of India) and by the various stock exchanges. Financial reports that are put by business entities in the public domain can be classified as: a) Regular Financial Reports such as the Annual Report and the Half Yearly Report and b) Financial Reports issued at the time of public offering of shares. Section 209 Sub section 3 of the companies Act 1956 requires that the Books of Account should be kept on accrual basis and according to the Double Entry System of Accounting. Sub section 4 of Section 209 requires companies

Prepared by Asst. Prof. Rajesh Janardhanan

28 Accounting For Management ((Module I) to preserve their books for a period of at least eight years. Under Section 210 of the Act it is the duty of the Board of Directors to lay before the Annual General Meeting (AGM) the Balance sheet and Profit and Loss Account of the company. Section 211 of the Act deals with the form and contents of the Financial Statements. The Balance Sheet is required to be prepared in accordance with form setout in Part I Schedule VI to the Act and the Profit and Loss Account is to be prepared in accordance with Part II of Schedule VI of the Act. Section 212 to 214 of the Act deals with accounts of Subsidiary companies. The Balance Sheet and Profit and Loss Account have to be signed by the Company Secretary and at least two of the directors of the Company. The Auditors Report like the Board of Directors report under Section 217 must cover all the annexure to the Balance Sheet and shall be attached to the Balance sheet. A Copy of the Annual Report is required to be sent to the companys shareholders at least twenty-one days before the date of the AGM. Three copies of the Balance Sheet and the Profit and loss account should be filed with the Registrar of Companies within 30 days form the date of the AGM at which financial statements were laid. According to Section 220(1), only Balance Sheet of a Private Ltd., Company is a public document. The Profit and Loss account of a private limited company is open only to the shareholders of the company. Under section 226 of the Act only Chartered Accountants within the meaning of the Chartered Accountants Act, 1949 are qualified to be appointed as the auditors of a company. Section 227 of the Act defines the powers and duties of auditors. Companies Act requires disclosing, whether its Accounting Policies are in accordance with Accounting Standards issued by the ASB of the ICAI. Sections 205 to 208 of the Act deals with the payment of Dividends, which also have bearing on the Financial Reports of Companies; which could be paid only out of profits arrived at after providing for Depreciation in accordance with the provisions of subsection 2 of Section 205. SEBI regulations also influence the contents of periodic reports of listed companies.

Prepared by Asst. Prof. Rajesh Janardhanan