SESSION: 1

Topic 1: Introduction to Financial Accounting

1.1.1
Learning objectives

• Know various forms of organization

• Appreciate the role of accounting in the capital market ecosystem

1.1.2
 Forms of Business Organization

Low High
Separation of ownership and management
1.1.3
 Corporate form of organization

• Most large businesses are organized

as publicly held corporations (or
companies)
• Why?

- Capital gives scale to the business

- Tradeable units of ownership (Shares)
become a currency
- Diversifies risk of investment

1.1.4
 Distinguishing features of corporations

• Advantages
• Separate legal existence
• Continuous life
• Limited liability of stockholders
• Transferable ownership rights
• Ability to acquire capital

• Disadvantages
• Agency conflicts – companies are owned by shareholders but run by managers
• Government regulations
• Additional taxes

1.1.5
 Shares and their special place in corporate ownership

In the absence of restrictive provisions, each

share carries the following rights:

• To share proportionately in profits and

losses.

• To share proportionately in management

(the right to vote for directors).

• To share proportionately in assets upon

liquidation.

• To share proportionately in any new

issues of shares of the same class

1.1.6
 Role of information (and Accounting)

 Financial reporting is a mechanism to alleviate the information asymmetry

problem in contracting
 It builds trust and accountability
 Owners risk their capital and expect operating managers to deliver
performance
 Questions: are resources being used in the best manner? Are managers
working hard to benefit the owners?
 Accounting underlies financial reporting
 A set of rules for recording transactions and their economic effects
 Aggregating the effects of like transactions
 Presenting the aggregated effects in a pre defined format for the reader to
make inferences

1.1.7
8

Role of accounting based performance reports

Adverse Moral Hazard

Selection “hidden
“uncertain actions of
manager type” managers”

Owners Managers
Information
Asymmetry

Periodic accounting reports from managers to the owners solve

this problem
1.1.8
Role of financial accounting in capital market ecosystem

Capital
Regulators – MCA, SEBI, RBI
Intermediaries – Stock exchanges, Banks, Insurance companies, Institutional
investors, Investment banks, Brokerage houses

Investors Companies

Information
Regulators –MCA (Ministry of Corporate Affairs), NFRA (National Financial
Reporting Authority)
Intermediaries – Auditors, analysts, financial media

1.1.9 Adapted from Fig 1.1 of Palepu, Healy, and Bernard, Business Analysis and Valuation, 2E (Cengage Learning)
 What happened here ?

[Source: Yahoo finance: https://in.finance.yahoo.com/q/bc?s=SATYAM.BO&t=my&l=on&z=l&q=l&c=]

1.1.10
 Why are accounting rules needed and who makes these rules ?

• Financial reporting concepts and principles tell us when and how to measure, record and
classify business transactions and aggregate them into financial reports.

• By following these principles, financial reporting systems provide information that is

consistent over time and across different businesses, and accounting becomes a language
that is widely understood.

• This eventually help investors examine the company's financial statements to judge
whether the funds they have invested have been used wisely or not.

• Accounting regulators
• India – Indian Accounting Standards (Ind AS) issued by the Ministry of Corporate
Affairs (MCA)as recommended by National Financial Reporting Authority (NFRA)
• USA - US GAAP issued by Financial Accounting Standards Board (FASB). The
US Congress deleted the authority to the Security Exchange Commission (SEC),
which in turn delegated to FASB.
• EU and several countries of the World (100+) - International Financial Reporting
Standards (IFRS) issued by International Accounting Standards Board
1.1.11
Who is responsible for preparing financial statements?

• Management prepares financial statements (CEO and CFO have to sign them)

• In U.S. frequency of financial reports include-

• Annual reports (10-K) – to be filed annually
• Quarterly reports (10-Q) – to be filed every quarter
• Current reports on any material events (8-K) – as and when important events
happen

• The Audit Committee of the Board of Directors provides oversight of management’s

process

• Auditors are hired by the Board to “express an opinion” about whether the statements
are prepared in conformity with appropriate standards (GAAP / Ind-AS / IFRS)

• The MCA (or SEC in the U.S.) and other regulators take action against the firm if any
accounting standard violations or other rules are found

• Information intermediaries (stock analysts, institutional investors, the media) may

question firms with suspect accounting
1.1.12
Fundamental accounting concepts and principles

Accrual accounting -
 This method focuses on the economic characteristics of transactions rather than their
cash flows. Application of this method leads to the creation of balance sheet and income
statement.

 Formally, accrual accounting occurs through the process of -

1. Revenue recognition: A firm can recognize revenue when:

 It has earned the revenue by doing what it’s agreed to do (i.e. when the
company has performed the service or transferred control of the goods)
 The amount of revenue recognized is the consideration the company expects
to receive
 US GAAP and IFRS have recently come up with more detailed guidelines

2. Matching expenses to revenues:

 Product costs, i.e. those that can be directly associated with revenues, are
recognized as expenses in the period when the firm recognizes the revenue
 Period costs, i.e. those that are not directly associated with revenues, are
recognized as expenses in the time period benefitted
1.1.13
Entity concept – a business entity is separate from its owners and other businesses

Money measurement concept - financial accounting deals only with things that can be
represented in monetary terms.

Going concern concept - an entity is expected to remain in operation for the indefinite
future. Alternative is that the entity is about to go out of business. If this was the case, all its
resources should be valued at their current worth to potential buyers.

Consistency concept - an entity should use the same accounting methods and procedures
from period to period unless it has a sound reason to change methods. If an entity does make
a procedural accounting change, its management and auditors are required to note the
change in their discussion of the entity's accounts.

Materiality concept - an entity need only apply proper accounting to items that are material,
i.e., significant to potential users of the financial statements. This concept allows the
accountant to be practical in choosing the appropriate degree of precision in the accounts.

1.1.14
Historic cost concept - requires that transactions be recorded in terms of their actual cost (or
price paid) at the time the transaction occurred.

• It allows the accountant to ignore opinions and hearsay about the monetary value of items,
and to report amounts based on actual transactions. The reliance on the historical cost
concept may sometimes yield more reliable financial information.
• Reliability refers to the objectivity and verifiability of the information

• But, the use of the historical cost concept also means that some amounts on an entity's
balance sheet are based on historical values, determined at the time of purchase, which
could predate the current balance sheet date by years. Consequently, it is unlikely that the
asset amounts on the balance sheet reflect the value that the assets would fetch if they
were sold today (Fair value). In this sense, the financial statements may be 'less relevant'
for end-users.
• Relevance refers to the timeliness and usefulness of the information to its users.

• When relevance and reliability have to be traded off, financial reporting practices often
tend to favor reliability.
1.1.15
Dual aspect concept - formalizes the idea that there are two sides to every accounting
transaction. Recording both sides of each transaction is known as double-entry bookkeeping.

Assets = Liabilities + Stockholders’ equity

Resources Claims on resources by non- Claims on resources by owners

owners (outsiders)

• Must always balance! (Double-entry bookkeeping)

• Changes over a period between two balance sheets are summarized in the income
statement, statement of shareholders’ equity, and statement of cash flows

1.1.16
Coming up
• Next session – Preparing financial statements- part 1 (async session)

1.1.17