Introduction to Accounting

Accounting
• It is a systematic process of identifying,
recording, measuring, classifying, verifying,
summarizing, interpreting and communicating
financial information.
• It reveals profit or loss for a given period, and
the value and nature of a firm's assets, liabilities
and owners' equity.
• AAA defined accounting as, “ the process of
identifying, measuring and communicating
economic information to permit informed
judgments and decisions by the users of
information.”
Advantages of Accounting
• Accounting helps to maintain the business
records in a systematic manner.
• It helps in the preparation of financial
statements.
• Accounting information is also used to compare
the result of current year with the previous year
to analyze the changes.
• It helps the managers in the decision making
process.
• It provides information to other interested
parties such as shareholders, creditors,
investors, customers, government,
employees, regulatory bodies etc.
• It helps in taxation matter
• Accounting information can be produced as
evidence in the legal matter.
• It helps in valuation of business.
Limitations of Accounting
• The items expressed in monetary terms are
recorded in the accountings where as the items
which are nonmonetary nature not recorded.
• Sometimes accounting data are recorded on the
basis of estimates and which could be
inaccurate.
• Fixed assets are recorded as the original cost.
• Value of money does not remain stable so
accounting value does not show true financial
results.
• Accounting can be manipulated and biased.
USERS OF ACCOUNTING INFORMATION
INTERNAL USERS
• MANAGEMENT
• SHAREHOLDERS
• EMPLOYEES

EXTERNAL USERS
• SUPPLIERS AND CREDITORS
• BANKS AND FINANCIAL INSTITUTIONS
• CUSTOMERS
• GOVERNMENT AND REGULATORY AGENCIES
• SECURITY ANALYSTS AND ADVISORS
• PUBLIC
Branches of Accounting
1. Financial Accounting
2. Cost Accounting
3. Management Accounting
4. Tax Accounting
5. Social Responsibility Accounting
6. Environmental Accounting
7. Inflation Accounting
Characteristics of Accounting
Information
• Understandability
• Relevance (Materiality)
• Reliability
• Neutrality
• Completeness
• Timeliness
• Verifiability
Financial Accounting
Financial Accounting is an
accounting system that focuses on
the preparation of financial
statement of an organization to
provide the financial information
to the interested parties.
It is compulsory to be prepared.
Monetary information only.
It is governed by government, No such regulations exists.
accounting and other statutory
regulations.
Management Accounting
The accounting system which provides
relevant information to the managers to
make policies, plans and strategies for
running the business effectively is
known as Management Accounting.
It is not compulsory
Monetary and non-monetary
information both.
 To assist the management in
To provide financial information planning and decision making
to outsiders. process by providing detailed
information on various matters.

Specified format No specified format

Financial Statements are
The reports are prepared as per
prepared at the end of the
the need and requirements of
accounting period which is
the organization.
usually one year.
Users are both Internal and Users are Only internal
external parties management.
Required to be published and Neither published nor audited by
audited by statutory auditors statutory auditors.
It is based on futuristic data , so
It is based on historical data. forecasts and budgets are
possible.
Qualitative characteristics of
accounting information
• Understandability
• Relevance
• Reliability
• Comparability
Basic Terms in Business
• Assets
▫ Fixed assets
▫ Current assets
▫ investments
• Liabilities
▫ Long term liabilities
▫ Short term liabilities
• Financial position
• Income
• Expenses
• Financial performance
Cash basis Accounting
Under the cash basis of accounting...
• Revenues are reported on the income statement in
the period in which the cash is received from
customers.
• Expenses are reported on the income statement
when the cash is paid out.

The cash method is mostly used by small

businesses and for personal finances. The cash
method accounts for revenue only when the money
is received and for expenses only when the money is
paid out.
Accrual Basis Accounting
• The accrual method accounts for revenue when
it is earned and expenses goods and services
when they are incurred.

• The revenue is recorded even if cash has not

been received or if expenses have been incurred
but no cash has been paid. Accrual accounting is
the most common method used by businesses.
• The accrual basis of accounting provides a better
picture of a company's profits during
an accounting period.

• The reason is that the income statement

prepared under the accrual basis will report all
of the revenues actually earned during the
period and all of the expenses incurred in order
to earn the revenues.
Accounting Concepts
• The business entity concept states that
the transactions associated with a business must
be separately recorded from those of its owners
or other businesses.
• This concept is very important because if
transactions of a business are mixed up with that
of its owners or other businesses, the accounting
information would lose its usability.
• The business entity concept of accounting is
applicable to all types of business organizations
(i.e., sole proprietorship, partnership and
corporation)
• For Example: Mr. John has acquired a floor of a
building having 3 halls for $1,500 per month. He
uses two halls for his business and one for
personal purpose. According to business entity
concept, only $1,000 (the rent of two halls) is a
valid expense of the business.
There are a number of reasons for the
business entity concept, including:
• Each business entity is taxed separately
• It is needed to calculate the financial performance
and financial position of an entity
• It is needed when an organization is liquidated, to
determine the amounts of payouts to the various
owners
• It is needed from a liability perspective, to ascertain
the assets available in the event of a legal judgment
against a business entity
• It is not possible to audit the records of a business if
the records have been combined with those of other
entities and/or individuals
The Going Concern Concept
• The going concern concept or going concern
assumption states that businesses should be treated
as if they will continue to operate indefinitely or at
least long enough to accomplish their objectives.
• In other words, the going concern concept assumes
that businesses will have a long life and not close or
be sold in the immediate future. Companies that are
expected to continue are said to be a going concern.
Companies that are expected to close in the near
future are not a going concern.
Accounting year concept
• Each business chooses a specific time period to
complete a cycle of the accounting process, for
example, monthly, quarterly, or annually—as per a
fiscal or a calendar year.

• An accounting period is the span of time covered by

a set of financial statements. This period defines the
time range over which business transactions are
accumulated into financial statements, and is
needed by investors so that they can compare the
results of successive time periods.
Matching concept
• This principle dictates that for every entry of
revenue recorded in a given accounting period, an
equal expense entry has to be recorded for
correctly calculating profit or loss in a given
period.
• The matching concept is an accounting practice
whereby firms recognize revenues and their
related expenses in the same accounting period.
Firms report "revenues," that is, along with the
"expenses" that brought them. The purpose of
the matching concept is to avoid misstating
earnings for a period.
Historical Cost concept
• The historical cost concept (also known
as cost principle of accounting) states that the
assets and liabilities of a business should be
presented in accounting records at
their historical cost.
• The fixed assets of a business are recorded on
the basis of their original cost in the first year of
accounting. Subsequently, these assets are
recorded minus depreciation. No rise or fall in
market price is taken into account. The concept
applies majorly to fixed assets.
Money measurement concept
• Only business transactions that can be expressed
in terms of money are recorded in accounting,
though records of other types of transactions may
be kept separately.
• The money measurement concept states that a
business should only record an accounting
transaction if it can be expressed in terms of
money. This means that the focus of accounting
transactions is on quantitative information, rather
than on qualitative information.
 Accounting Conventions
• Convention of conservatism:
• In accounting, the convention of
conservatism, is a policy of anticipating possible
future losses but not future gains. This policy
tends to understate rather than overstate net
assets and net income.
• When given a choice between several outcomes
where the probabilities of occurrence are equally
likely, you should recognize that transaction
resulting in the lower amount of profit, or at least
the deferral of a profit.
• In accounting, it states that when choosing
between two solutions, the one that will be least
likely to overstate assets and income should be
selected. Essentially, "expected losses are losses
but expected gains are not gains”.
• The conservatism principle is the foundation for
the lower of cost or market rule, which states
that you should record inventory at the lower of
either its acquisition cost or its current market
value.
Consistency
• The consistency principle states that, once you
adopt an accounting principle or method, continue
to follow it consistently in future accounting
periods.
• Auditors are especially concerned that their clients
follow the consistency principle, so that the results
reported from period to period are comparable.
• It implies that a business must refrain from
changing its accounting policy unless on
reasonable grounds. If for any valid reasons the
accounting policy is changed, a business must
disclose the nature of change, the reasons for the
change and its effects on the items of financial
statements.
• Consistency concept is important because of the
need for comparability, that is, it enables
investors and other users of financial
statements to easily and correctly compare the
financial statements of a company.
• Company B is a retailer dealing in shoes. It
used first-in-first-out method of inventory
valuation in respect of shoes at Branch X
and weighted average inventory valuation
method in respect of similar shoes at Branch Y.
Here, the auditors must investigate whether
there are any valid reasons for the different
treatment of similar inventory located at
different locations.
The materiality concept
• The materiality concept, also called the
materiality constraint, states that financial
information is material to the financial
statements if it would change the opinion or view
of a reasonable person.
• Some financial information might be material to
one company but might be immaterial to
another. This is somewhat obvious when you
think about a small company verses a large
company.
• The main question that the materiality concept
addresses is does the financial information make
a difference to financial statement users.
• Professionals are often left up to their experience
and good judgment to understand what is
material and what isn’t.
• A large company has a building in the hurricane zone.
The company building is destroyed and after a lengthy
battle with the insurance company, the company
reports an extra ordinary loss of $10,000. The
company has net income of $10,000,000. The
materiality concept states that this loss is immaterial
because the average financial statement user would
not be concerned with something that is only .1% of
net income.
• Assume the same example above except the company
is a smaller company with only $50,000 of net
income. Now the loss is 20% of net income. This is a
substantial loss for the company. Investors and
creditors would be concerned about a loss this big. To
the smaller company, this $10,000 would be
considered material.
 Full disclosure
• The purpose of the full disclosure principle is to share
relevant and material financial information with the
outside world. Since outsiders don’t know the details of
a company’s business deals, contracts, and loans, it’s
difficult to form an opinion of the entity.
• Relevant information to outsiders is anything that
could change an external user’s decision about the
company. This can include transactions that have
already occurred as well as future events contingent on
third parties. Any type of information that could sway
the judgment of an outsider should be included in the
financial statements in an effort to be transparent.
Several examples of full disclosure are:
• The nature and justification of a change
in accounting principle
• The nature of a non-monetary transaction
• The nature of a relationship with a related
party with which the business has significant
transaction volume
• The amount of material losses caused by the lower
of cost or market rule
• The facts and circumstances causing goodwill
impairment