ACCOUNTING AND ITS ROLE

Learning Objectives

After studying this chapter you should be able to:

1. Explain the meaning of accounting

2. Identify the users of accounting

3. Describe the nature of information required by the decision makers

4. Explain the development of modern accounting practices

5. Identify the main fields of accounting and their functions

Scenario

Have you ever thought how the mechanism of market works that ensures the
availability of things you need? The Electricity is being generated; the airlines
and railways are operating; the food is available on shelves; the jobs are being
created; the houses are being built; the industry is being established and run; the
agriculture is producing food and many other essential goods and services are
being produced. How is it all happening?
It is because someone somewhere is making an economic decision. Hundreds of
millions of such decisions make a co-ordinated system work to make these
things possible for us.
These decisions are based on information generated by information systems.
Accounting is one of the most important information systems. It provides
quantitative, generally financial, information about the past events and activities
of an organisation. This information is used to make economic decisions having
present and future implications not only for the organisation itself but also for the
economy at large. Therefore an efficient, effective and reliable accounting system
plays a vital role in the growth of an organisation. Growth of hundred of
thousands of organisations results in stronger economies.
A business works in a dynamic set of environments. It is a system comprising of
many subsystems whose efficiency is directly influenced by changes in
different environments. These environments include economic, political, legal,
financial, cultural and religious environments. The quantity and quality of information
about these changes have a direct relationship with the quality of decisions made by the
business managers. Similarly, the quality of information generated by the accounting
systems directly or indirectly affects these environments. The decisions to invest and lend
are based upon the information provided by the financial reports. The prices of shares on
the stock market and therefore, the flow of funds in the capital markets is influenced by
the financial reporting. These in turn affect the economic environment. Successful
business organisations make successful economies. Success is the primary objective of
every enterprise. The optimum utilisation of the available economic resources is the key
to success and it depends on timely and reliable information. Financial information plays
the most significant role in the success of an enterprise and accounting is supposed to
provide a major part of this information. Therefore, accounting is one of the tools of
decision-making process. The modern business has many stakeholders and all of them
need reliable information to make better economic decisions.
The indicator of success for a business organisation is of course the profit or loss
calculated by accounting reports at the end of the period. These reports become the basis
for long term future planning. In addition, accounting is supposed to provide information
during the period as well in the form of different reports to make both day-to-day
operational as well as short-term decisions. The role of financial information generated
by accounting reports is gaining increasing importance as the world shrinks to a global
village through information technologies. The capital has no boundaries anymore and it
flies to areas generating timely and reliable information about their successes.

ACCOUNTING HISTORY
The origin of accounting is traced back to ancient times. Five thousand years before the
appearance of double entry, the Assyrian, Chaldaean-Babylonian and Sumerian
civilizations were flourishing in the Mesopotamian Valley, producing some of the oldest
known records of commerce. The palace of Nector in ancient Greece maintained not only
accounting records, but also income tax computations and detailed inventory records of
grain, sheep and other assets. However, the origin of modern accounting is found in the
14th century. The first book describing the double entry bookkeeping system was written
by an Italian mathematician Friar Luca Pacioli and was published in 1494. The book
named Summa d Arithmetica Geometrica, Proportioni et Proportionalita was primarily a
mathematical work containing a section on double entry bookkeeping. It discussed the
rationale of keeping accounting records and provided detailed description and
codification of the double-entry system. Joint-stock companies started getting established
in mid 1600s. The investors or shareholders started demanding financial reports.
Accounting became more than record keeping, it added calculation, disclosure and
analysis. The growth of trade and industry and other economic events that took place in
the 19th century played an important role in the development of accounting. The
accounting techniques developed according to the needs of business. The principles on
which these techniques were based generally lacked conceptual framework and,
therefore, were not usually articulated explicitly and varied not only from one industry to
another but from one accountant to another within the same industry. The financial
reporting was thus not comparable and reliable. Efforts continued to reduce these
variations in order to achieve some uniformity. These efforts however varied greatly in
form and direction from one country to another. As a result two distinct systems evolved,
one in market economies and other in centralised economies. Many variations are even
available within these two extremes. For example, although being the market economies
the German accounting practices are very different from Anglo-Saxon or American
practices. The accounting framework and techniques we are going to learn in this book
have their origin in Anglo-Saxon and American thought.
The 1929 New York stock market crashed. Many companies that were profitable and
financially sound on paper went bankrupt and investors suffered heavy losses. It became
the starting point of the modern accounting. The need to develop uniform accounting
practices was strongly felt and efforts began at different levels in this direction. The main
objective of these efforts was to promote the dissemination of timely and useful financial
information by the companies to different groups of stakeholders so that they could make
rational and informed decisions for their stakes - investors for shareholding, lenders for
extending loans etc. The term "Generally Accepted Accounting Principles- (GAAP)"was
introduced at this stage. Institutes of chartered accountants in different countries played a
key role in developing these practices. They started issuing guidelines in the early forties.
These guidelines assumed the status of accounting standards for the respective countries.
Many countries have their own standard-setting committees or boards. However, they
still lack a uniform conceptual framework.
"Standard setters disagree over just what information is likely to be
'useful'. Differences in the institutions, traditions and legal systems from
one country to another give rise to differences in national accounting
standards".1
In Pakistan the accounting practices are inherited from British origin. However, they are
gradually being changed to conform to International Accounting Standards.

1
Readings and Notes on Financial Accounting- Issues and Controversies by Zeff and Dharan
(McGraw-Hill 1994) p.2
British Accounting
In the United Kingdom the first royal charter was issued to the Association of
Accountants in 1850 in Scotland. However, five major accounting bodies got established
with time. They are
1. Institute of Chartered Accountants of England and Wales
2. Institute of Chartered Accountants of Scotland
3. Institute of Chartered Accountants of Ireland
4. Chartered Institute of Management Accountants (previously known as Institute
of Cost and Management Accountants)
5. Association of Chartered Certified Accountants
All the above bodies have been the part of standard setting process. The standard issued
required the consensus of all of them before it could be implemented. In sixties there
came a lot of criticism in the press on accounting practices, mainly on the reliability of
financial statements due to non-availability of uniform principles for business to follow.
The Institute of Chartered Accountants of England and Wales issued a 'statement of
intent of Accounting Standards' in December 1969. In 1975 the Institute in collaboration
with other accountancy bodies of the UK started issuing Statement of Standard
Accounting Practices (SSAPs). The Accounting Standards Committee was the issuing
body of the SSAPs. Each SSAP issued was approved by six professional accounting
bodies being members of the committee.
In 1990 the Accounting Standards Board (ASB) was established which replaced ASC as
a standard setting body. It is officially recognised by the British Companies Act 1985 as
an independent standard setting body. The Standards developed by the ASB are known as
'Financial Reporting Standards' (FRSs). The SSAPs issued by ASC were adopted as
standards by the ASB, so that they also fall within the legal definition of accounting
standards. Some of the SSAPs have been superseded by FRSs while others remain in
force. The ASB has issued 16 FRSs by August 2000 while ASC issued 25 SSAPs in total.
Before issuing a FRS generally two formal consultation documents, a 'Discussion Paper'
and a 'Financial Reporting Exposure Draft' (FRED) are issued. It is done to receive
comments and suggestions from different circles. The ASB collaborates with accounting
standard-setters from other countries and the International Accounting Standards
Committee (IASC) in order to ensure that its standards are developed with due regard to
international developments.
The 'G4+1' is one of the international groups in which the ASB participates for this
purpose. The G4+1 is a group of accounting standard-setters from UK, Australia,
Canada, New Zealand and the USA. The International Accounting Standards Committee
(IASC) participates as an observer. The primary purpose of the group is sharing of new
ideas, information and approaches in order to develop high quality financial standards
which may be helpful in providing useful information to the investors, lenders and other
participants of the capital market. The capital market includes the provider of long term
funds. The members of the G4+1 seek to further their shared objectives by pooling
resources and ideas in joint research efforts. 2

American Accounting
America has probably the longest history of standard setting, which is the foundation of
modern accounting. American Institute of Accountants, later known as American
Institute of Certified Accountants, issued "Statement of Accounting Principles" in 1938.
The Committee on Accounting Procedures was established as early as 1939. The
committee issued 42 Accounting Research Bulletins (ARBs) till 1953. Accounting
Principles Board replaced the committee in 1959. Later on Financial Accounting
Standard Board (FASB) was set up in 1973. The FASB issues Statements of Financial
Accounting Standards. It has issued more than 100 SFAS. In addition to SFASs the board
also issues Statements of Financial Accounting Concepts (SFACs). The SFAC No. 1
issued in 1978 was entitled "Objectives of Financial Reporting by Business Enterprises".
Prior to FASB, the pronouncements issued by the American Institute of Certified Public
Accountants (AICPA) were treated as Generally Accepted Accounting Principles
(GAAP). In addition to FASB, the Government Accounting Standard Board was also
established in 1984 to formulate accounting principles for state and local government
financial reporting. The Security Exchange Commission interacts regularly with the
FASB about various accounting problems.

International Accounting Standards

The recent times witnessed the world shrinking into a global village. We are talking of
digital economies, information technologies, and information management etc.- all new
jargons. The Internet has changed the whole scenario of the business world. It's now e-
business. The investors and lenders are no more confined to national borders. The
mobility of capital is fast and it finds its way to the most efficient markets despite of
many constraints. The growth of multinationals has been phenomenal in the recent past.
It all increases the importance of reliable and comparable financial information which is
possible only by bringing uniformity in the accounting practices at international level.
The preparation of financial reports involves principles and procedures. As common
conceptual framework is lacking these principles and procedures vary widely from
country to country, and sometimes even within a country. The financial statements,
therefore, generally lack comparability. From the point of view of company management,
this is highly unsatisfactory because:
a) it can cause preparation costs for financial reports that are much higher than
necessary - a multinational company may have to prepare different reports on
its operations for use in different countries; and

2
Adopted from ASB website
 b) businesses will want to have a uniform system for assessing financial
performance in their operations in different countries. They will also want their
external reports to be consistent with internal assessments of performance. 3
In June 1973, accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico,
the Netherlands, the United Kingdom and Ireland, and the United States of America
formed International Accounting Standards Committee (IASC) to work for the
improvement and harmonization of financial reporting. The objectives of IASC are set
out in its constitution as follows.
a) To formulate and publish in the public interest accounting standards to be
observed in the presentation of financial statements and to promote their world-
wide acceptance and observance.
b) To work generally for the improvement and harmonization of regulations,
accounting standards and procedures relating to the presentation of financial
statements.
The members of IASC are the professional accountancy bodies, which are members of
the International Federation of Accountants (IFAC). As of August 2,000 the 153
professional accounting bodies were members of IASC in 112 countries. These member
bodies represent over one million accountants in industry and commerce, public practice,
academic institutions and governments. International Accounting Standards are also used
in many countries that are not represented within IASC's membership. The IASC has
issued 40 standards by July 2,000.

Point to Think
It was not until the 1970s that many students of the subject began to study
how the standard-setting process actually worked, and they came to the
realisation that accounting standard setting was, despite the best efforts of
the standard-setters themselves, an integral part of the American political
process.
W.T. Baxter argues that standards should be a guide to, and not a substitute
for, judgement. The essence of a profession, he writes, surely is that each
member is willing to think and judge for himself.
Walter Schuetze argues that accounting standards have become so complex
- as have transactions themselves - that few accountants and users really
understand them.4

Because of the historical facts the development of accounting standards have been highly
influenced, particularly at its earlier stages, by the UK and the US accounting practices.
Even the conceptual framework adopted by IAS portrays this influence clearly. A tacit
compromise between the then existing accounting practices in these two countries, which
3
Adopted from IAS website.
4
Readings and Notes on Financial Accounting- Issues and Controversies by Zeff and Dharan
(McGraw-Hill 1994) p.1-5
represent capitalist economies, is very obvious in the standards developed up to 1980
(e.g. IAS-2 for inventories). The terms used in IAS are of British and American origin.
It was after the 1980s that serious efforts were made to reduce options and flexibility of
IAS. As a result many standards were revised. As many as ten revised standards were
issued in 1993 to be effective from 1995. The revision of standards is a continuous
process. It is done when the changes in environment so demand.
Certain Asian countries faced crisis in their stock markets in 1998. Their impact spread to
other regions of the world. It once again showed the need for reliable and transparent
accounting to support sound decision-making by investors, lenders and regulatory
authorities. Many countries following capital economies have adopted International
Accounting Standards as their own. In certain cases minor amendments have also been
made. The European Union, Austria, Belgium, France, Germany, Italy, and Spain have
passed laws allowing certain companies to use IASC standards for domestic reporting
purposes, subject to certain conditions. In June 2000, the European Commission issued a
Communication proposing that all listed companies in the European Union would be
required to prepare their consolidated financial statements using International Accounting
Standards. The G7 countries have assured to encourage their private sector institutions to
comply with internationally agreed principles, standards and codes of best practice.
The Securities and Exchange Authority of Pakistan-SEAP (previously known as
Corporate Law Authority -CLA) and the Institute of Chartered Accountants of Pakistan
are the two main bodies to decide about the accounting practices to be followed in
Pakistan. According to the Companies Ordinance 1984, International Accounting
Standards are to be followed by the companies registered in Pakistan except where any
change or modification is recommended by the accounting profession and approved by
the SEAP.

Point to Think
Following is an excerpt from a speech by Jules W. Muis, Vice President and
Controller, The World Bank, on Global Accounting, Auditing and Financial
Architecture, at an SEC Conference on 12 April 1999.
"Thus, power to control the language of business is important. Standard
setters will come to a head as the world grows smaller, and economic
interdependency is no longer an option but a reality. So it happens that today
a good observer can see the battle preparations for the control of the
international language of business slowly unfold, in particular with the hour of
truth nearing for IOSCO's recognition of IASC's standards, which would put
IASC squarely as the world's only, hence most prestigious formal
international accounting standard setter. In preparation, and as part of its
exam for standard setter of the international language of business, the IASC
not only finished recently its comprehensive program on its proposed
international grammar (as well as a dictionary of approved semantics), it also
has come out with a proposal to revamp its own standard setting process and
 governance structure."

Accounting in Muslim History

The institution of bait-al-mal (state treasury) was established by Hazrat Umar, the second
Khalifa. This institution acquired significance in the state affairs particularly with the
rapid expansion of Muslim Empire in his era. The bait-al-mal was responsible to receive
money and other assets collected by the State on different counts and then disburse them
to various institutions and individuals according to the dictates of Shari'a.
Like the capital, all provinces had the office of bait-al-mal. Initially, the provincial
governor used to be the in charge of provincial Bait al-mal, but later a separate Head was
entrusted this responsibility who reported directly to the Khalifa. The bait-al-mal was
subdivided into a number of diwans (departments), which administered the different
types of taxation and expenditure. All transactions were recorded in proper books of
account.5 Each diwan was required to maintain records of its financial transactions (A'gla,
1984). Together they formed the government accounting system of the bait al-mal. All
sections were subject to the same regulations regarding internal control, the preservation
of documents and vouchers, the preparation of annual accounts (and triennial
summaries), and audit by the diwan al-azimmah (Al-Nuwairi, 1931; Shahata, 1950).
These fairly, comprehensive arrangements for compiling financial and statistical material
provide for the basic principle of National Income Accounting. 6
However, there had been no significant institutional effort by the Muslims in the
development of modern accounting conceptual framework or practices. One can find rare
individual efforts. It is mainly because Muslim countries were under colonial rule during
the time the foundation of the development of modern accounting was being laid down.
However, with the emergence of the movements of Islamisation of economies of Islamic
States and consequently the establishment of Islamic Financial Institutions the efforts
have started to develop the conceptual framework and the accounting standards, which
conforms to the shari'a.

ACCOUNTING STANDARDS FOR ISLAMIC BANKS AND FINANCIAL

INSTITUTIONS
The seventies saw the emergence of the movements for Islamisation of economies in
different Muslim countries. The main emphasis remained on elimination of Riba
(interest) from the financial transactions. This resulted in the establishment of Islamic
financial institutions. The number of such institutions has increased considerably. Many
international banks like City and Grindleys Banks have opened Islamic financing
counters. It is because of the huge amount of fund being made available by Muslims in
this sector. These institutions soon realised that many conventional accounting concepts

5
Shalaby, 1983
6
Gambling and Karim (p 63)
and practices may not be suitable or even relevant for them. Therefore, in 1987 seven
Islamic banks formed a supervisory committee and prepared a plan to develop accounting
standards for Islamic banks. Several studies have been conducted by the accounting and
shari'a experts. The main emphasis remained on identifying the needs of the users and the
shortcomings of the financial statements prepared by the Islamic banks. Consequently, in
a meeting on Safar 1, 1410 Hijri (which corresponds to February 26, 1990) in Algiers a
body known as 'Financial Accounting Organization for Islamic Banks and Financial
Institutions' was established by Islamic Financial Institutions. Later on 'The Accounting
and Auditing Organization for Islamic Financial Institutions' replaced it. The new body
was registered on Ramazan 11, 1411 Hijri corresponding to March 27, 1991 in the state
of Bahrain as an international autonomous non profit making corporate body. The
objectives of AAOIFI are stated as:
a) To develop Accounting and Auditing thought relevant to Islamic Financial
Institution
b) To disseminate Accounting and Auditing thought relevant to Islamic Financial
Institutions and its implications through training, seminars, publication of
periodicals newsletters, carrying out and commissioning of research and other
means
c) To prepare, promulgate and interpret Accounting and Auditing Standard for
Islamic Financial Institutions in order to harmonize the Accounting practices
adopted by these institutions and in preparation of their financial statements, as
well as to harmonize the auditing procedure adopted in auditing the financial
statements prepared by Islamic Financial Institutions
d) To Review and amend Accounting and Auditing Standard for Islamic Financial
Institutions to cope with development in the Accounting and Auditing thought
and practices.
e) To prepare issue, review and adjust the statements and guidelines on the
banking investment and insurance practices of the Islamic Financial
Institutions.
f) To approach the concerned regulatory body, Islamic Financial Institutions,
other financial institutions that offers Islamic financial service and accounting
and auditing firms in order to implement the accounting and auditing standards,
as well as the statements and guidelines on the banking, investments and
insurance practices of Islamic Financial Institutions that are published by
AAOIFI.
A Financial Accounting Standards Board for Islamic Banks and Financial Institutions
was established by AAOIFI in December 1990. The board chalked out a plan to:
a) spell out the financial accounting objectives for Islamic banks and financial
institutions.
b) develop the financial accounting concepts.
 c) prepare the accounting standards.7

ACCOUNTING THEORY & CONCEPTUAL FRAMEWORK

Accounting theory has mainly developed out of generalisations from accounting practices
rather than out of a framework of objectives and principles. Accounting began as a
discipline of pragmatic techniques; by and large it is true even today.
Theory, as defined by Webster's Third New International Dictionary is 'a coherent set of
hypothetical, conceptual and pragmatic principles forming the general frame of reference
for a field of inquiry'. The American Accounting Association adopted the same definition
with a change of word 'inquiry' with the word 'study' for accounting theory. It defined
accounting theory as:
A cohesive set of hypothetical, conceptual and pragmatic principles
forming a general frame of reference for a field of study.
Thus, accounting theory, like theory of any other discipline, is expected to provide a
logical reasoning in the form of a set of broad principles, which:
a) can evaluate current financial accounting practices,
b) provide guidance for the development of new practices and procedures
whenever need arises, and
c) test the practice for its logic, consistency and usefulness.
At present, no such single theory exists in accounting, which can meet the above criteria.
According to Hendrikson:
A single general theory of accounting may be desirable but accounting
as a logical and empirical science is still in too primitive a stage for
such a development. The best that can be accomplished in this
developmental stage is set of theories (models) and sub-theories that
may be complementary or competing.
The American Institute of Certified Public Accountants formed Financial Accounting
Standards Board in 1973. The FASB assumed the responsibility of developing an agreed
conceptual framework for financial reporting. It issued Statements of Financial
Accounting Concepts (SFAC's) covering the following:
a) The objectives of financial statements
b) The qualitative characteristics of accounting information
c) Elements of financial statements
d) Recognition and measurement in financial statements
The study of first two SFAC's is important for the students of accounting to understand
the purpose and nature of accounting.
The SFAC 1 discusses the objectives of financial reporting by business enterprises. It
begins by recognizing, "financial reporting is not an end in itself but is intended to
provide information that is useful in making business and economic decisions and that
the objectives of financial reporting are not immutable. They are affected by the
7
Accounting Issues in Islamic Banking (London The institute of Islamic Banking and Insurance
1994) p.6
economic, legal, political and social environments in which financial reporting takes
place."
The SFAC 2 recognizes that all financial reporting is concerned with decision making
and thus the usefulness of financial information should be assessed in relation to its
ability to assist with the process of decision making. It identifies two most important
characteristics of the information contained in the financial statements as:
a) It must have a predictive value.
b) It must have a feedback value.

USERS OF ACCOUNTING INFORMATION

A business works in a set of environments - economic, financial, legal, political, cultural
and technological environments. These environments affect the business activities.
Similarly, business activities affect these environments. There are different groups, which
have a direct or indirect interest in a business organization. In a 1975 document entitled
The Corporate Report, the IASC identified the following user groups:

The Equity Investor Group

This group includes existing and potential shareholders as well as holders of
convertible securities, options and warrants. The existing investors have an equity stake
in the business. They require information to make decisions like continuing their stake or
otherwise. They would like to compare the results with other businesses and if required
and possible, would shift their resources to a more profitable business. The prospective
investors are definitely interested in the profitability, stability and vulnerability of the
organization. Their main concern is the rate of return on their capital invested. For this
they require to analyze the investing and financing policies of the management. They
would also analyze the performance of the business before making any investment.

The Loan-Creditor Group

They include existing and potential holders of debentures and loan stock as well as
providers of short-term secured and unsecured loans. They also include long-term
lenders. The short-term creditors are mainly interested in the liquidity, i.e. the
composition and relationship of current assets and current liabilities, whereas the long-
term lenders are interested in the capital structure, i.e. the financing policies in addition to
the profitability, stability and vulnerability of the organization.
The bankers in Pakistan will also see if the requirements set by 'prudential regulations'
are being met or not. Sometimes the organizations set restrictive covenants in Articles of
Association, and loan agreements. The lenders are interested to see that these covenants
are being met properly.
The Employees Group
This group includes existing and potential employees. It is the prime
responsibility of any business organization to take care of the needs of its employees.
Keeping the employees satisfied and motivated is one major task of any business
management. As the livelihood of employees is tied up with the future of the organization
they are interested in its profitability, stability and vulnerability. The ability of the
enterprise to provide remuneration, retirement benefits and employment opportunities is
their major concern. The labour unions use the accounting information for negotiations of
remuneration packages.

The Government
This user group includes tax and local authorities. In addition, the departments and
agencies concerned with the supervision of commerce and industry are also interested in
the financial information of the organizations.
The government is interested in accounting information for the tax purposes,
safeguarding the interests of both investors and lenders, and allocation of resources in the
economy. The public limited companies are required to publish the audited financial
statements at the end of each financial period which are also submitted with the registrar
joint stock companies.

The Analyst-Advisory Group

This group includes financial analysts, journalists and other groups of advisory
services such as consultants and credit-rating agencies. The analysts are hired by stock
exchanges, banks, competitors and other agencies interested in the business. There are
freelance analysts who provide information on request to media, competitors, etc.
Reporting of financial analysis is a common feature of any good newspaper. The analysis
is used by investors, taxpayers, consumers, politicians and pressure groups etc.
The information is also required by the general public because the business enterprise
make a substantial contribution to the local economy in many ways including providing
the employment opportunities, patronage of local supplies, tax contribution, etc.

The Business-Contact Group

It includes customers, trade creditors and suppliers and competitors, business
rivals and those interested in mergers, amalgamations and take-overs.

ACCOUNTING DEFINED
In 1941, the American Institute of Certified Public Accountants defined 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."
The definitions in the early period focused on the record-keeping functions of the
accountant. The modern definitions are much broader and cover the wide range of
management activities. The American Accounting Association defines accounting as
"the process of identifying, measuring and communicating economic information to
permit informed judgement and decisions by the use of information." The information
is primarily financial, stated in money terms. Accounting, then, is a measurement and
communication process used to report the activities of profit-seeking business
organizations and also for non-profit organizations like societies, clubs, charities, etc. As
a measurement and communication process for business, accounting supplies information
that permits informed judgements and decisions by users of the data.
In 1970, the American Institute of Certified Public Accountants (AICPA) stated 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. Some people regard accounting as a highly technical field, which is practised
and understood only by professional accountants. It is true in some sense. However, all of
us practice accounting in one form or another on almost a daily basis. Accounting is the
art of measuring, interpreting and communicating the results of economic activities.

Economic Activities

Analyzing and
recording data

Classification of
data

Summarizing Information Feecback

(converting data Decision
into useful Makers
information) Information Needs

Fig 1-1 The Accounting Proces

WHY STUDY ACCOUNTING?
Regardless of the nature of business, type of the organization, accounting is an essential
part of every economic entity. Accounting, like any other discipline, has its own
assumptions, terminologies and limitations. It is only by studying accounting, that one
comes to know about the financial statements prepared by the accounting system and
make use of the information provided in these financial statements.
In the preface of an ILO publication, How to Read a Balance Sheet, it is very rightly said:
'Many bankruptcies and failures and the hardships associated with
them might be avoided if those in authority had a better understanding
of accounting and financial matters. There is little doubt also that
many problems in the field of industrial relations might be avoided if
both sides had a better understanding of the language of money and of
how to explain the position of the enterprise and how to interpret it
correctly.'

FINANCIAL STATEMENTS
The objective of financial statements is to provide information about the financial
position, past performance and changes in financial position of an enterprise which is
useful to a wide range of users in making economic decisions.
The following information is of vital importance for decision-makers:
 Economic resources owned and controlled by the enterprise
 Financial structure
 Liquidity and solvency
 Profitability
 Asset management
 Changes in financial position
The above information is needed for assessing and predicting, for example, borrowing
needs, raising of capital, ability to pay liabilities in time, capacity of an enterprise to
generate cash, the effectiveness with which the organization may employ additional
resources, operating activities, etc. However, financial statements do not provide all the
information needed by a user since they mainly provide the financial effects of past
events and do not necessarily provide non-financial information.
IAS 1 prescribes four basic financial statements with their minimum structure and
content, including certain information required on the face of the financial statements.
These statements are as follows.

Balance Sheet
It provides information about the financial position of an enterprise as at a certain date. It
indicates the economic resources owned by the enterprise and creditors' and investor's
interest against these resources.
Income statement
It indicates the operational results of a certain period of time normally a year. The British
terminology for it is Profit and Loss Account and it is commonly used in Pakistan.

Cash Flow Statement

It summarizes the cash receipt and cash payments and indicates the management's trend
in investing and financing activities.

Statement showing changes in equity

It explains the changes in the amount of owner's equity during the period covered by the
Income statement.

International
Accounting
Standards Preparation of Users:
(IAS) Financial Statements  Investors
according to:  Lenders
 IAS  Employees
Auditors
 Companies  Government
Ordinance 1984  Consultants
Securities &  Other gazette  General
Exchange notifications Public
Commission of
Pakistan (SECP)

Fig 1-2 Financial Statement Process

Characteristics Of Financial Statements

To learn how to prepare the financial statements and interpret them for effective decision
making is the main objective of this book. Therefore the mechanics of these statements
will be the main discussion subject of the succeeding chapters. At this stage it is
important to discuss their required characteristics. The IAS explains these characteristics,
which are reproduced below:

Understandability
An essential quality of the information provided in financial statements is that it is readily
understandable by users. For this purpose, users are assumed to have a reasonable
knowledge of business, economic activities, accounting and a willingness to study the
information with reasonable diligence. However, information about complex matters that
should be included in the financial statements because of its relevance to the economic
decision making needs of users should not be excluded merely on the grounds that it may
be too difficult for certain users to understand.

Relevance
To be useful, information must be relevant to the decision-making needs of the users.
Information has the quality of relevance when it influences the economic decisions of
users by helping them evaluate past, present or future events or confirming, or correcting,
their past evaluations.

Materiality
Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements. Materiality depends on
the size of the item or error judged in the particular circumstances of its omission or
misstatement. Thus, materiality provides a threshold or cut-off point, rather than being a
primary qualitative characteristic which information must have, if it is to be useful.

Reliability
To be useful, information must also be reliable. Information has the quality of reliability
when it is free from material error and bias and can be trusted by users to represent
faithfully that which it either purports to represent or could reasonably be expected to
represent.
Information may be relevant, but so unreliable in nature or representation that its
recognition may be potentially misleading. For example, if the validity and amount of a
claim for damages under a legal action is disputed, it may be inappropriate for the
enterprise to recognize the full amount of the claim in the balance sheet, although it may
be appropriate to disclose the amount and circumstances of the claim.

Faithful Representation
To be reliable, information must represent faithfully the transactions and other events it
either purports to represent or could reasonably be expected to represent.
Most financial information is subject to some risk of being less than a faithful
representation of that which it purports to portray. This is not due to bias, but rather due
to inherent difficulties either in identifying the transactions and other events to be
measured or in devising and applying measurement and presentation techniques that can
convey messages that correspond with those transactions and events. In certain cases, the
measurement of the financial effects of items could be so uncertain that the enterprises
generally would not recognize them in the financial statements; for example, although
most enterprises generate goodwill internally over time, it is usually difficult to identify
or measure that goodwill reliably. In other cases, however, it may be relevant to
recognize items and to disclose the risk of error surrounding their recognition and
measurement.
Substance over Form
If information is to represent faithfully the transactions and other events that it purports to
represent, it is necessary that they are accounted for and presented in accordance with
their substance and economic reality and not merely their legal form. The substance of
transactions or other events is not always consistent with that which is apparent from
their legal or contrived form. For example, an enterprise may dispose of an asset to
another party in such a way that the documentation purports to pass legal ownership to
that party; nevertheless, agreements may exist that ensure that the enterprise continues to
enjoy the future economic benefits embodied in the asset. In such circumstances, the
reporting of a sale would not represent faithfully the transaction entered into (if indeed
there was a transaction).

Neutrality
To be reliable, the information contained in financial statements must be neutral, i.e. free
from bias. Financial statements are not neutral if, by the selection or presentation of
information, they influence the making of a decision or judgment in order to achieve a
predetermined result or outcome.

Prudence
Prudence is the inclusion of a degree of caution in the exercise of the judgements needed
in making the estimates required under conditions of uncertainty, such that assets or
income are not overstated and liabilities or expenses are not understated. However, the
exercise of prudence does not allow, for example, the creation of hidden reserves or
excessive provisions, the deliberate understatement of assets or income, or the deliberate
overstatement of liabilities or expenses, because the financial statements then would not
be neutral and, therefore, not have the quality of reliability.
Completeness
To be reliable, the information in financial statements must be complete within the
bounds of materiality and cost. An omission can cause information to be false or
misleading and thus unreliable and deficient in terms of its relevance.

Comparability
To be comparable, financial statements must have the following characteristics:
Consistency
Users must be able to compare the financial statements of an enterprise through
time in order to identify trends in its financial position and performance. Users
must also be able to compare the financial statements of different enterprises in
order to evaluate their relative financial position, performance and changes in
financial position. Hence, the measurement and display of the financial effect of
like transactions and other events must be carried out in a consistent way
throughout an enterprise and over time for that enterprise and in a consistent way
for different enterprises.
Disclosure
The users must be informed of the accounting policies employed in the
preparation of the financial statements, any changes in those policies and the
effects of such changes. Users need to be able to identify differences between the
accounting policies for like transactions and other events used by the same
enterprise from period to period and by different enterprises. Compliance with
International Accounting Standards, including the disclosure of the accounting
policies used by the enterprise, helps to achieve comparability.
Uniformity
The need for comparability should not be confused with mere uniformity and
should not be allowed to become an impediment to the introduction of improved
accounting standards. It is not appropriate for an enterprise to continue
accounting in the same manner for a transaction or other event if the policy
adopted is not in keeping with the qualitative characteristics of relevance and
reliability. It is also inappropriate for an enterprise to leave its accounting
policies unchanged when more relevant and reliable alternatives exist.
Because users wish to compare the financial position, performance and changes
in financial position of an enterprise over time, it is important that the financial
statements should show corresponding information for the preceding periods.
IAS 1(effective from July 1, 98) defines overall considerations for financial
statements as; Fair presentation, Accounting policies, Going concern, Accrual
basis of accounting, Consistency of presentation, Materiality and aggregation,
Offsetting Comparative information.

Qualitative Characteristics of Financial Statements

Qualitative characteristics are the attributes that make the information provided in
financial statements useful to users. The principal qualitative characteristics are
understandability, relevance, reliability and comparability which have been explained
above.

CONSTRAINTS ON RELEVANT& RELIABLE INFORMATION

The following are some of the constraints in providing relevant and reliable information:

Timeliness
If there is undue delay in the reporting of information, it may lose its relevance.
Management may need to balance the relative merits of timely reporting and the
provision of reliable information. To provide information on a timely basis, it may often
be necessary to report before all aspects of a transaction or other event are known, thus
impairing reliability. Conversely, if reporting is delayed until all aspects are known, the
information may be highly reliable, but of little use to users who have had to make
decisions in the interim. In achieving a balance between relevance and reliability, the
overriding consideration is how best to satisfy the economic decision making needs of
users.

Balance between Benefit and Cost

The balance between benefit and cost is a pervasive constraint rather than a qualitative
characteristic. The benefits derived from information should exceed the cost of providing
it. The evaluation of benefits and costs is, however, substantially a judgmental process.
Furthermore, the costs do not necessarily fall on those users who enjoy the benefits.
Users other than those for whom the information is prepared may also enjoy benefits, for
example, the provision of further information to lenders may reduce the borrowing costs
of an enterprise. For these reasons, it is difficult to apply a cost-benefit test in any
particular case. Nevertheless, standard-setters in particular, as well as the preparers and
users of financial statements should be aware of this constraint.

Balance between Qualitative Characteristics

In practice, a balancing, or trade-off, between qualitative characteristics is often
necessary. Generally, the aim is to achieve an appropriate balance among these
characteristics to meet the objectives of financial statements. The relative importance of
the characteristics in different cases is a matter of professional judgment.

MAJOR FIELDS OF ACCOUNTING

There are three major fields of accounting: financial accounting, management accounting
and tax accounting.

Financial Accounting
This can be regarded as the main field of accounting. The other two are its offshoots.
Financial accounting is used by every business irrespective of its level and nature of
operation, i.e. service, trading or manufacturing. The main purpose is to provide
information to decision makers. The only source of information for investors and lenders
is the financial statements that are the outcome of financial accounting system. The
financial statements include balance sheet, profit and loss statement and cash flow
statement. These statements provide information regarding the financial position, past
performance, and future capability of the firm to generate cash and meet its obligations.

Management Accounting
Whereas the financial accounting provides general-purpose information to all concerned,
the management accounting is meant specifically to assist the management in its
operational and strategic planning. This objective is achieved through preparation of
periodic reports about products, activities, departments and individuals. Cost accounting
and responsibility accounting are the two significant parts of management accounting.
The most important role of management accounting is to set targets in the form of
budgets or standards, measure the actual performance and then make a comparison of the
two. This performance evaluation process results in the preparation of reports that
indicate the deviation from the targets known as variances. The variances are planning
and control indicators that help the management to make efficient operational decisions.
Internal audit is another important role of management accounting. The system provides
credibility to the reports produced and used within the organization.

Tax Accounting
The financial statements are prepared according to the generally accepted accounting
principles (GAAP), in case of Pakistan, IAS. IAS allow flexibility in the accounting
treatment of different items some of them may not be acceptable to tax authorities. The
taxable profit is to be calculated according to the tax laws based on information provided
by the financial statements. The preparation of tax returns has therefore become a
specialized field. Every enterprise would like to minimize its tax burden. This requires
tax planning. Tax planning requires a thorough knowledge of tax laws along with the
understanding of accounting principles. The planning process involves anticipating the
tax effects of different business transactions and then structuring them to minimize this
effect.

ACCOUNTING AS A CAREER
Accountants have always been in demand. Supply of good accountants is generally short
of its demand. The demand has considerably increased due to industrialization and boost
in global economies. The accountant is a person needed by all types of businesses.
Accounting jobs are one of the best paid in the world. Pakistan is no exception.

Point to Think
The objective of providing an overview of the development of accounting
theory is to make this clear that there is a great deal of scope for the Muslims
to take part in the exercise of developing accounting theory to meet the
requirements of a just accounting system. A widely propagated view that
accounting has well-defined and settled principles at the international level
and that it would be erratic to make any effort to change them according to
the Muslims' needs is a misconception. The accounting is in its developing
stage and each development needs to be analyzed in the light of tenants of
Shari'ah before being adopted as GAAP by the Muslim ummah.
Questions for Class Discussion
1. What is the function of accounting?
2. What type of information does the accounting produce?
3. Who are the users of accounting information?
4. Why investors and lenders are interested in the financial statements? Explain with examples.
5. What are the main fields of accounting?
6. What is the main purpose of International Accounting Standards Committee?
7. Explain briefly the development of IAS.
8. What should be the main characteristics of financial statements?
9. Why is the study of accounting necessary for a manager?
10. How can the accounting information affect the economic activity in a country?

Self-Study Questions
Test your understanding of the chapter by marking the best answer for each of the following
questions:
1. Accounting is a function of a country's:
a) Economic system
b) Political system
c) Social system
d) All of the above
2. Modern accounting has its roots in:
a) The twentieth century
b) The fourteenth century
c) The nineteenth century
d) The fourth century
3. Accounting may be applied to:
a) Schools
b) Retailers
c) Manufactures
d) All of the above
4. Financial reporting is primarily concerned with providing information to:
a) Management
b) Stockholders only
c) The SEC only
d) All outside interested parties
5. The Accounting process involves:
a) DATA Recording
b) DATA Classification
c) Summarizing
d) All of the above