Accounting Information Fo Decision Making

MADAWALAMU UNIVERSITY, SCHOOL OF POST GRADUATE STUDIES, Bale-Robe, December 2014
CHAPTER ONE
1. Accounting: Information for Decision Making
1.1. Introduction
A number of developments have taken place in the economy over a period of time. More or less
the complete replacement of venture-type of businesses by the going-concern type businesses,
establishment of concerns on partnership basis and also on limited liability basis besides the
ancient household businesses, promulgation of various Acts governing and regulating the
activities of the business concerns, etc, are some of the developments which have taken place
over the years. These developments led to the emergence of accounting characteristics in the
form of principles, concepts, etc.
Accounting is generally termed as the language of business throughout the world. The language
is the means of communication of ideas or feelings by the use of conventionalized signs,
gestures, marks and articulated vocal sound. In the same way, the accounting language serves as
a means to communicate matters relating to various aspects of business operations. As the
individual business enterprises keep their accounting records separately, the offer to
communicate is essentially from a business enterprise to various individuals, groups and
institutions that are having interest in the operations and results of that enterprise. Now, although
accounting is generally recognized with the business, trade and profession, the business
enterprise is not the only kind of organisation that makes use of accounting. Legal entities
ranging from individual to governments use and prepare accounting to obtain information on the
financial condition and performance of the entity in question. Just as the business enterprises
(like firms, companies, societies and institutions keep their accounts, so can the nations and even
the individual owners of the business and profession entities.
It is necessary to have a good knowledge of accounting-grammar (in the shape of construction of
accounts, conventions, concepts, postulates, principles, standards etc.) to interpret accounting
information for purposes of communication, reporting, decision making or appraisal.
1.2. Definition of Accounting
In the earlier days of business chronicle, the business activities were undertaken by the
individual or group of few individuals with the help of their own capital. Both the ownership and
management, during those days, vested with the same people. They used to invest their own
Financial and Managerial Acct(MBA612): Lecture Note Compiled by Teferi D. Page 1

resources including capital. With the help of this, they used to carry out the business activities by
taking even the entire risk of their own. Consequently, the result of business in the form of profit
or loss accrued to them in totality. They were not liable to report to anybody. As a result,
accounting was primarily concerned with the stewardship and therefore, its function was almost
confined to reporting to the owners as to how their capital being utilized.
But with the coming of giant joint stock companies, and also with the development of economy
vary fast due to the Industrial revolution, a new dimension has been introduced into accounting.
Because, a number of frauds and irregularities started taking place as the persons-in-charge of
accounting were not conversant with the type of accounting problems created by the
development in the industrial economy. Consequently, accounting is expected to perform the
following, besides book-keeping and reporting functions:
To provide the means of guiding and controlling the business activities;
To analyze and interpret the results enabling the management to find out what has
happened, what is happing, what is going to happen in the future and what ought to
happen in the interest of the company;
To look into the future by providing the guidelines for making wise decisions to achieve
the corporate objective, etc.
According to, American Institute of Certified Public Accountants(AICPA), “ Accounting is the
art of recording, classifying and summarising in a significant manner and in terms of money,
transactions and events which are, in part at least, of financial character and interpreting the
results thereof .“
The art of recording involves putting into writing or in print the transactions of financial
character, reasonably soon after occurrence, in the records maintained by the company e.g. cash
book, day books, journals, memoranda books, etc. This part of accounting is essentially
concerned with not only ensuring that all business transactions of financial character are in fact
recorded but also that they are recorded in an orderly manner
The art of summarizing in a significant manner consists of presenting the classified data in a
manner which is useful to the internal and external end-users of accounting statements. At the
end of stipulated periods (usually a month for internal purposes and a year, for external reporting
purposes as required by corporation law), the accounts in the ledger will be balanced as at the
end of that period. The accountant will check (or .try.) the accuracy of the accounts by preparing
a trial balance of all ledger accounts as at the end of that period. This process leads to the

preparation of financial statements like the Balance Sheet, Income Statement (or Profit and Loss
Account as it is often called), Source and Application of funds statement, cost statements,
internal reports to management, etc.
The final function of accounting is the interpretation of the summarized data in such a manner
that the end-user can make meaningful judgments about the financial condition or the
profitability of the business operations or can use the data in preparing future plans and laying
down policies to execute such plans. After the monthly accounting statements for internal
purposes have been prepared, the chief accountant or controller will prepare analytical notes
appraising the performance of the enterprise and its various units or departments (as reflected in
the accounting statements prepared) in relation to the expected performance and highlight areas
of shortfall in performance so that management can take appropriate remedial action for
overcoming such shortfalls.
Similarly, in respect of the annual statutory accounts, the accountant will prepare a note
analyzing the results of operations for the year for the consideration of the Board of Directors.
Thereafter, the directors will include their comments analysing the results reported in their report
annexed to the final-accounts of the year.
There is no single or unanimously accepted definition of accounting. Very often definition
depends on our purpose or intention with the given matter. Accordingly, definition of accounting
is bound to .come closer to our own interpretation of the scope of accounting, and the manner in
which we would like to treat its subject matter. In a rapidly changing socio-economic conditions,
the subject matter of accounting is also changing. Accounting which initially began as the art or
science of record-keeping, is moving towards adoption of a dynamic role which also emphasises
its social goal. This is clearly evident from some of the definitions presented below :
(i) Accounting as a recordkeeping device : The definition of the American Institute of
Certified Public Accountants highlight record-keeping as an essential attribute of
accounting.
(ii) Accounting as an information system: The definition of the American Accounting
Association highlights communication aspect of accounting for decision-making by a
wide variety of users. This user-oriented definition of accounting .refers to the
process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of the information.

To Robert Sterling, accounting stands for a measurement communication process.
According to him, .Accountants ought to measure something and then communicate
the measurement to the people who will make the decisions. Under this interpretation,
the outputs of the accounting system are the inputs to decision theories.
(iii) Accounting as a service activity: A later definition of the Accounting Principles
Board of the AICPA endorses the views of American Accounting Association about
the elements of decision making embedded in accounting : .Accounting is a service
activity. Its function is to provide quantitative information, primarily financial in
nature, about economic entities that is intended to be useful in making reasoned
choices about the alternative course of action..
(iv) Accounting as a dynamic social science : According to Glautier and Underdown,
accounting is a social science. They observe that the history of accounting reflects the
evolutionary pattern of social developments and in this respect, illustrates how much
accounting is a product of its environment and at the same time a force for changing
it. There is, therefore, an evolutionary pattern which reflects changing socio-
economic conditions and changing purpose to which accounting is applied..
The Nature of Accounting
According in its essence is a function that aims to accumulate the communicate information
essential to the understanding of the activities of an entity. It is an obstraction of the real world
economic events. The distinctive nature that makes accounting a unique system is as follows :
(i) Accounting as a process: Accounting is a process which involves gathering,
compacting, interpreting and disseminating economic information in a systematic
way.
(ii) Stewardship function: Accounting is a stewardship function. Its basic goal is to
report on the resources and obligation of the entity to the owners. Through the
medium of financial statements it communicates to the interested parties of the
contributions and relative rights of the economy segments. the shareholders/owners,
creditors and others.
(iii) Concepts and conventions: Since accounting is a process that aims at
communicating economic information, it must rely on a set of previously agreed
concepts, conventions and rules. These rules and conventions are not discovered but
they are contrived and mutually agreed upon.

(iv) Accounting as a means to an end: Although accounting system is characterised by
a host of rules, procedures and conventions, they are not the end by themselves. The
ultimate end of accounting is to provide external information-communication system
by gathering, compacting, interpreting and disseminating economic data which gives
a financial representation of the relative economic rights and interests of the economy
segments, in order to facilitate judgment formulation and action taking by its users.
(v) Accounting as an art : Accounting is more of an art than a science, its logical
foundation is not deeply embedded in scientific or natural law. It is essentially and
fundamentally utilitarian in nature, therefore, its methodologies are primarily based
on expediency and upon actual day to day needs of the business community.
Functions of Accounting
Accounting being an indispensible part of business system, it is important to delineate precisely
its functions. But unfortunately the accountants are not unanimous about the exact functions of
accounting, neither is there any authoritative pronouncement that can remove disagreement about
the probable functions of accounting.
D.R. Scott observed that accounting has three major functions to do. These are recordkeeping
function, the control function and the protection of equities function. Maurice Moonitz, however,
defines accounting in terms of five basic functions of accounting. According to him, .The
function of accounting is
1) to measure the resources held by specific entities;
2) to reflect the claims against and the interests in those entities;
3) to measure the changes in those resources, claims and interests;
4) to assign the changes to specifiable periods of time; and
5) to express the foregoing in terms of money as a common denominator..
A.C. Litteton on the other hand, identifies six areas of .accounting actions.. These are:
a) homogenizing diverse events;
b) converting events into entries;
c) classifying entries into accounts;
d) reclassifying account data into fiscal periods;
e) summarizing and reporting periodic data; and
f) reviewing accounting data and processes.

Elsewhere, Littleton states that .accounting has one function.to furnish dependable, relevant
information about business enterprise..
Although diverse opinions have been expressed above about the functions of accounting, the
most common perceptions about the functions of accounting are as follows :
(i) Recording function: According is essentially a recordkeeping function of the past,
present and future economic events of the business. The recording function involves
techniques of information gathering and processing.
ii) Summarising function: The next important function of accounting is summarizing
diverse economic data into homogeneous group or unit called account. It is most
important function of accounting since just like our language system, accounting
communicates economic information to its users through these accounts.
(iii) Accounting as a medium of communication between the firm and the external
parties: Accounting is not an end in itself, but it exists to serve a purpose. The
purpose is to supply reliable and dependable information about the economic
chronicles of the business for the purpose of decision making by the interested
parties.
(iv) Income determination: .Net income determination under the historical cost method
lies at the heart of the whole accounting methodology, .says Campfield. Income is
the basic measure that provides information about the periodic progress of business.
It also provides the basic rationale for being in business.
(v) Preparation of balance sheet: Balance sheet is very often stated as a statement of
financial condition or position that purports to show the economic resources,
obligations and owner‟s equities of the business at periodic interval of time. Some
views however, consider it as a mere statement of balances of the unallocated costs
that has not been assigned to the income statement. Despite difference of opinions
about the exact nature of balance sheet, accountants have found its preparation
extremely useful.
(vi) Control function: Accounting is a special type of calculative service that comes
handy to the management for the purpose of exercising control over many functional
areas of business.
(vi) Compliance with legal requirements: In modern days accounting is not merely an act
of prudence to exercise control, but its necessity arises from the need of compliance

with many legal requirements. For example, the Companies Act of countries in the
globe makes it obligatory for every company to prepare a statement of profit and loss
and balance sheet at the end of each accounting period.
Objectives of Accounting
Although the terms, definition, function and objective are very often used interchangeably there
is presumably a distinction among them. As stated earlier, definition describes what a thing is,
while function describes what it does and objective, describes what it intends to do.
Thus, when we speak of objective, we rationalize the thinking process to formulate a set of
attainable goals, with reference to the circumstances, feasibility and constraints. Deciding about
the objectives of accounting, therefore, requires perceptions about the environment in which
accounting system works. .The environment of accounting has a direct bearing on the objectives
of accounting and on the logical derivation of principles and rules..
The accounting environment generally comprises the firm (i.e., the entity which prepares
financial statements), different groups of external users and the existing legal and economic
environment. The feasibility and constraints imposed by the accounting environment provides
the boundary of accounting objectives.
The basic objective of accounting is to render stewardship services to the owners. This purpose
has become all the more important with the diffusion of ownership in corporate business that
separated ownership from management. In consequence, stewardship function has become
predominant over record-keeping. The managers of the business as steward are responsible for
protecting the interests of the owners as well as the assets of the business. The basic objectives of
accounting in such cases are:
i. To measure the resources held by the entity,
ii. Protection of equities, i.e., to measure the claim against those resources by the
owners and out-siders, and
iii. To measure the results and financial condition of business.
Notwithstanding this, accounting may pursue many other goals that may arise from the specific
information needs of the owners/managers for the purpose of management control and meeting
legal requirements. Since the middle of the present century, however, a shift of emphasis of
accounting objectives have begun. Increasing legal control and wide-spread public interests in
corporate business have broadened the scope and objective of accounting. This in clearly
manifested in the APB statement No.4 which entails an elaborate list of objectives of accounting.

The APB‟s list of objectives marks a substantial departure from the trend of the contemporary
accounting literature which had never given significant attention to why accounting was done.
APB.s objectives of accounting may be broken into two distinct aspects-the general objectives
and the qualitative objectives.
The general objectives of accounting according to the APB are :
1. To provide quantitative financial information about a business enterprise that is useful to
the users, particularly the owners and creditors, in making economic decisions.
2. To provide reliable financial information about economic resources and obligations of a
business enterprise.
3. To provide reliable information about changes is not resources of an enterprise that
result from its profit directed activities.
4. To provide other needed information that assists in estimating the earning potential of
the enterprise.
5. To provide other needed information about changes in economic resources and
obligation.
6. To disclose, to the extent possible, other information related to the financial statements
that is relevant to the user.s needs.
The qualitative objectives of accounting, according to the APB are :
(i) relevance, (ii) understandability, (iii) verifiability, (iv) neutrality, (v) timeliness, (vi)
comparability, and (vii) completeness.
1.3. Branches of Accounting

In this age of specialization, many branches of knowledge have emerged as distinct disciplines
with clear cut objectives of its own. The same is true about accounting. Each branch of
accounting emerged owing to the developments in the corporate world necessitating a specially
designed accounting system to serve one or more group(s) of stakeholders. According to the
purpose and level of objectives, thus the general branch of accounting may be classified into the
following : Financial accounting, cost accounting, management accounting, social accounting,
etc.
A. Financial Accounting: is the oldest and the forerunner of the other branches of
accounting. It is a branch of accounting which aims at the supply of information to the
interested parties or decision makers who are external to the organizations including the
owners and the employees. The internal parties (management) can also use these bits of

information. However, financial accounting is primarily concerned with the recording of
day-to-day transactions – both financial and operational – and also the preparation of
financial statements(viz., Profit and Loss account, and Balance Sheet) which form a
prominent and compulsory part of external reports(i.e. Annual Reports). In Eric Kohler‟s
Dictionary the term has been defined as ”the accounting for revenues, expenses, assets
and liabilities that is commonly carried on in the general office of a business.” Financial
Accounting is often limited to the accounting concerned with published financial reports
in contrast to internal aspects of accounting such as cost accounting.. The emphasis of
financial accounting is on the historical records of by-gone transactions in accordance
with Generally Accepted Accounting Principles (GAAPS)s with a view to fulfilling
stewardship obligation by the management to the owners, creditors and other interested
parties.
B. Cost Accounting: Although financial accounting is the forerunner of cost accounting,
the concurrent development of cost accounting with financial accounting can be traced as
early as the 15th century. There is evidence of the use of cost accounting by the
merchants of Venice as a means of accounting control since the latter half of the 14th
century. It is, however, after the Industrial Revolution which created factory system that
systematic cost accounting has emerged in England. The emphasis of cost accounting is
on cost ascertainment, cost analysis and cost control and in contrast to financial
accounting, it is prospective looking. Cost accounting embodies the analysis and
synthesis of cost in such a manner that it is possible to disclose the total cost of
production of a commodity or a service, vis-a-vis the analysis of the cost elements in
terms of material, labour and overhead costs.
According to the Chartered Institute of Management Accountants (CIMA), Cost
accounting is the process of accounting for cost from the point at which expenditure is
incurred or committed to the establishment of its ultimate relationship with the cost
centers and cost units. In its widest usage, it embraces the preparation of statistical
data, the application of cost control methods and the ascertainment of the profitability
of activities carried out or planned.
C. Management accounting: The development of management accounting as a specialized
branch of accounting is rather new and probably cannot be traced back earlier than the
present century. Its importance lies in supplying both quantitative and qualitative

information to the internal management of an organisation for the purpose of day to day
decisions. Due to its importance in today‟s complex business organisations, it has been
described as the accounting eye that provides a way of making visible the internal
functioning of an organisation. The National Accounting Association(NAA) in the USA
however, has defined management accounting as the .process of identification,
measurement, accumulation, analysis, preparation, interpretation and communication of
financial information used by management to plan, evaluate and control within
organisation and to assure appropriate use of and accountability for its resources.
Management accounting deals with the internal reporting and primarily with the
furnishing of required and relevant data to the managerial personnel for the purpose of
planning, controlling, and decision making. The type of accounting information required
by the management differs from one type of decision to another, and also from one level
of management to another. It is not necessarily confined to the financial accounting
information but it is much more than this depending upon the type, importance,
complexity, etc., of the problem.
D. Social accounting: Accounting has long been recognized as a social function, but the
development of social accounting techniques is the newest of the accounting innovation
whose history does not date back beyond four decades from now. Social accounting has
been defined by Seidler and Seidler as .... . ...The modification and application by
accountants, of the skills, techniques and discipline of conventional.... accounting to the
analysis and solution of problems of a social nature. This concept views social
accounting as essentially an extension of the principles, practices and particularly the
skills, of conventional accounting and accountants. David Linowes, who is one of the
pioneers in the field of social accounting, defines it in a broader sense as the .application
of accounting in the field of social sciences. These include sociology, political science
and economics. The subject matter of social accounting, according to this definition,
transcends beyond the traditional profit parameters of conventional accounting and
intends to examine the exchanges between the business and its social environment. It
intends to cover such wide areas as the national income accounting, evaluation of social
programmes, the role of accounting in economic development, the development of social
indicators, human resources accounting, social audit and social cost measurement.

1.4. Financial Accounting Vs Cost Accounting

Both the Financial Accounting and Cost Accounting are concerned with the provision of
financial information to different parties who have direct and indirect stake and interest in the
activities of an organization. Therefore, both are concerned with the systematic accounting for
various transactions and presenting of information derived from them to the interested parties.
Further, both use the same set of transactions and both follow the Double-Entry Principle.
Besides, both express the transactions in monetary terms. In spite of these similarities, a number
of differences can be found between them. Some of the differences are summarized below:
S.No Dimension Financial accounting Cost accounting
1 Scope Financial Accounting extends to cover Cost Accounting considers
both operating and the non-operating only operating activities for
activities. That means, it considers both the purpose of preparing
the operating and the non-operating cost books of accounts and
transactions for the purpose of preparing for submitting cost reports
the final accounts (viz., income statement to the interested parties
and Balance Sheet). (viz., internal parties i.e
management).
2 Party to be It primarily aims at furnishing the It aims at providing
served information for use mainly by the parties information for use by the
who external to the company like, internal parties for taking
shareholders, debenture holders, necessary decisions. This
employees, customers, financial information and other cost
institutions, governments and their reports are not normally
agencies etc. But this information and applied to the external
the reports may also be used by the parties
parties who are internal to the company
viz., management.
3 Purpose It reports primarily aim at providing Cost reports are meant only
information to the external parties for for use by the people who
taking decisions by them. are internal to the
company(management) for

proper planning, control,
decision-making, etc.
4 Flexibility Financial Accounts are governed by Cost Accounts are prepared
Generally Accepted Accounting in a more flexible manner
Principles (GAAPs) and not restricted by
GAAPS
Financial Accounting Vs Management Accounting

Basically, Accounting is an information system. Depending up on the party which the accounting
aims to serve, it may be divided into Financial Accounting and Management Accounting. Both
focus on providing information for making economic decisions. However, a number of
differences exist between them. Some of these differences are summarized as follows:
S.No Dimension Financial accounting Management Accounting

1 Utility Financial Accounting and its reports are Management Accounting
useful to external parties such as and its reports are useful to
shareholders, debenture holders, the internal parties viz,
creditors, financial institutions, management for
governments and their agencies, formulating plans, policies,
customers, etc and to take various
decisions
2 Party to be It aims at furnishing the information to It aims at providing
served external parties but this information may information for use for
also be utilized by the internal parties internal parties
3 Flexibility Financial Accounts are governed by Not governed by GAAPs
Generally Accepted Accounting
Principles (GAAPs)
4 Time Period It usually covers one year There is no rigidity as to
the time period
5 Objective The primary objective of Financial Management Accounting
Accounting is to record the day-to-day aims at assisting the
transactions of the business with a view managerial personnel in

to ascertain the profit earned, or loss their decision making
incurred, by the company during an process by redesigning
accounting period and also to prepare the accounting information
assets-liabilities statement suitability.
1.5. Users of Accounting Information

(1) External Users
In order to understand the communication process, we might ask ourselves who are the people
interested in the operations of a business enterprise. There are several entities outside the
business (or in other words, external to it), which are interested in its operations because of their
business dealings with the enterprise. There are individuals or organizations who have economic
transactions with the business, e.g. suppliers of goods and services on credit, banks or financial
institutions lending money either for a short or a long period, buyers of goods and services
produced by the enterprise on the basis of stipulated targets, contractors who have undertaken to
build plants and buildings and other facilities for the business. They are all interested in varying
degrees in the operations of the businesses with which they deal in order to determine whether
the enterprise is credit worthy and the terms under which credit can be extended, i.e. the amount
of goods or services that can be sold on credit (or the loans that can be advanced), the period of
such credit and the likelihood that the debt arising out of the transactions would be repaid in
time.
The external group is by no means limited to such individuals or organizations who have
economic transactions with the business. Regulatory agencies, i.e. government departments or
other agencies who are charged with the responsibility for regulating general business activity or
particular types of business are also naturally interested in the operations of the business. Some
of the government departments having general interest, in the Ethiopian context, are the Ministry
of Trade, National Bank of Ethiopia, Ethiopian Revenue and Custom Authority, Ministry of
Industry, etc. The interest of the regulatory agencies is essentially to ensure that the enterprise :
i. complies with the requirements of the law relating to financial transactions, e.g. it pays
the required amount of tax, does not overtrade on its capital, pays dividends to its
shareholders out of the profits, provides depreciation according to prescribed norms, etc;
ii. discloses its capital, retained earnings, profits, sales and costs to the public at large so as
to submit its activities to public scrutiny;

iii. provides data relating to its borrowings (and the assets charged or mortgaged for raising
such loans) so that future lenders are provided with the required information regarding
the present level of borrowings and the state of the security provided by the assets, etc.
Obviously, the balance sheet and the income statement prepared in consonance with the
requirements of the disclosure provided in the law would be of great help to the regulatory
agencies in these matters.
The third category of external users consists of those who have neither any economic
transactions nor are concerned with regulation of business activities but are interested in the
operations of the business on behalf of constituents which they represent, i.e., as representatives
of external interests. In this category can be included labour unions, stock brokers, chambers of
commerce, trade associations export agencies, etc., These bodies would like to ensure that their
members or clients. interests are safeguarded in terms of the required degree of financial viability
of the enterprise with which they deal or that the revenue costs and profits of the enterprises are
disclosed fairly so as to enable their members or clients to determine accurately, in financial
terms, the quantum of economic transactions, for instance, bonus to be paid to the members of a
trade union or dividends to be paid to investors.
In other circumstances, a person or a body might be interested in the results of the operations of a
business for determination of claims or resolution of disputes, e.g. a court deciding upon the
ownership of shares as between two claimants or judging the merits of a claim against a business
in liquidation, an arbitrator settling a dispute between a business organization and the suppliers
of goods and services to that business or a tax tribunal assessing a claim of a business enterprise
for income tax relief.
Lastly, the external group would include, on the one hand, the auditor of the business who is
required by law to certify the accounts and, on the other, the prospective shareholders who wish
to subscribe for shares of a business enterprise or want to buy an already-issued share from
another shareholder. Other persons who would be interested in the business, even though they
may not be directly concerned, are the business economists analysing the business enterprise‟s
success or the financial press providing information to their reader regarding the operations of
the business world.

2) Internal Users
It is not difficult to conclude that the internal people who would be most interested are the
owners of the business. The owners are proprietors in proprietory concerns and the partners in
partnership businesses, while in the case of a company (or corporation, as it is sometimes called)
the legal owners of the company are the shareholders. Shares may be held by individuals or
companies or corporations or even the government. Clearly, the owners would like to know :
a. whether the enterprise made any profit during the period reported and if so, what the
dividend prospects are ;
b. whether the financial condition of the enterprise is sound as reflected in its capital to
retained earnings ratio, current assets to current liabilities ratio, funds flow statement,
etc.;
c. whether these operations are profitable in terms of return on funds invested or return on
assets, profits per rupee of sales, gross margin per unit of sales, etc.;
d. whether the growth of its sales are in line with the expectations of the shareholders;
e. whether its costs are in line with the volume of sales and norms of costs in similar
enterprise elsewhere.
There might be individual shareholders who are interested in greater financial details relating to
the operations of a company, but the average shareholder would expect to find answers to the
questions set out above in the balance sheet and the income statement prepared by the enterprise
for purposes of external reporting. However, the owners are not the only persons within the
company (or the internal group) who are interested in the various aspects of the operations of a
business. With the separation of management and ownership, managers at various levels
beginning from shop floor superintendent to the Chairman and Chief Executive, are also
interested in the business. Some of their needs for accounting information relate to:
a. setting up targets for future periods, usually the next financial year;
b. measuring the performance of the various units of the business as also the enterprise as a
whole;
c. evaluating the performance in relation to the targets set up;
d. highlighting the areas of shortfalls from planned performance; and
e. taking remedial action for overcoming such shortfalls.
Most of this information would be financial in nature and would essentially be prepared from the
accounting records. However, it would require special knowledge and skill to assemble the data

and to present them in meaningful terms for resolution of the managerial problems outlined
above.
The last category of persons belonging to the internal group who are interested in ascertaining
the financial condition of the companies for the resolution of their problems are the employees of
the business.
The external end-users would essentially be interested in the determination of financial position
and profitability, while the managers of the enterprise (or internal end-users) would emphasise
the development of data for performance appraisal, decision making and planning. Accordingly,
the more important uses of accounting relate to development of information for providing
answers to questions like:
i. How good or bad is the financial condition of the business, generally?
ii. Have the operations of the business as a whole resulted in a profit (or surplus) or a
loss (or deficit)?
iii. How well have the different functions or departments performed and how successful
have been the results of individual activities or products?
iv. What are the likely results of new decisions to be made or old decisions which are to
be modified?
v. In the light of the past results of operations, how should the business enterprise plan
its future activities to achieve expected results ?
Scope of Accounting
Accounting is a highly organised and integrated discipline, the usefulness of which have been
found in diverse areas of socio-economic activities. Although, accounting basically started as a
device for recording economic events by the business enterprise in the pursuit of its profit
motive, the scope and method of the discipline lend itself to wide social application. The basic
orientation of the discipline being information communication it can be applied to the
measurement and communication of data revealing past, present and prospective socio-economic
activities to improve control methods and decision-making at levels of socio-economic activities.
Thus, accounting as the measurement and communication of social data is ubiquitous, always
playing a constructive role. The tools and techniques of the discipline can be used in a diverse
field of human activities that require some sort of evaluation. It can be used to deal with any
organisational unit, whether business, Governments, nations or individuals and it can be
concerned equally with the measurement of the flow of socio-economic activities, whether or not

expressed in financial terms. It is thus possible to apply the techniques of accounting to the basic
areas of social interests such as national income accounting, human resource accounting, to
identify and measure data about human resources for the purpose of communication of
information to the interested parties, and socio-economic accounting that may encompass
community involvement of the business, physical resources and environmental contributions and
product and service contribution.
1.6. Uses of Accounting Information
Accounting information is used by different parties for different purposes. It is used by both the
internal and external parties. The important uses of accounting information are: for managerial
decision, managerial planning, Managerial control, evaluation of performance, and provide
assistance to external parties in making their decisions.
A. Managerial Decisions: management is expected to make various decisions – both short-
run long-run decisions, both tactical and strategic decisions, etc. However, what are
common with all these decisions are their future implications. The decisions taken today
followed by their implementation will influence the future performance of the
organization, and the future performance depends upon the quality of the decisions taken
today and the way in which they are implemented. Any laps at the stage of taking
decisions will have adverse impact on the future performance of the organization.
Decisions pertaining to the revisions of prices of goods and services, new product
pricing, make or buy decision, product diversification, etc are some of the decisions that a
managerial personnel have to take. Since they influence the future results of the
organization, it is necessary for the management to take the decision after evaluating the
pros and cons of different alternatives. To evaluate the different alternatives and to take a
final decision, management needs relevant accounting information. Hence, the
accounting information is useful for taking various decisions by the managerial personnel
of business organizations.
B. Managerial Planning: Another important aspect of management is the planning for the
future in the form of defining the goals for the future organizational performance, and
deciding about the tasks and optional use of available resources to accomplish those
goals. It may noticed at this stage that every planning has a purposes or a set of purposes
in the form of achieving goals or targets by allocating and utilizing available resources
and time optionally. Further, the allocation and utilization of resources require proper

planning. To accomplish the goals by utilizing the available resources, the management
needs relevant accounting information. Hence, the accounting information enables the
management to plan for the future systematically.
C. Managerial Control: Control complements the Planning. Normally, it involves four
steps viz., (a) establishment of performance standards based on the objectives of
organization, (b) measurement and reporting of actual performance, (c) comparison of
actual results with the standards set to find out the difference between the two, and (d)
taking appropriate corrective and/or preventive measures to ensure that no adverse
variance takes place in future. It may be noticed here that the performance standards are
influenced by the planning function. Though it is a challenging task, it is necessary to set
real standards for each of the important tasks. Whenever the actual performance is lower
than the standard set, it necessary to analyze the reasons for the same and to take
appropriate corrective action to ensure that this type of variation does not recur in future.
In each of the four steps, the management needs relevant accounting information. That
means, accounting information is immense help to the management in achieving the
planned and desired result.
D. Evaluation of Performance: it is necessary to evaluate the performance of the
organization both on continuous basis and on periodical basis. This is necessary to find
out the financial soundness of the organization, to find out whether a business activity
/product resulted in profit or loss, to assess the efficiency of different department of the
organization, to ascertain whether each of the products is earning profit, the firm is
competitors in the industry, etc. for all these exercises, the management needs accounting
information. This shows the importance of accounting information in evaluating the
performance of the organization and its divisions.
E. Assistance to External Parties: Accounting information is also useful to all categories
of external parties such as shareholders, debenture holders, financial advicors,
governments, tax offices, employees, and the trade unions, etc of business organization.
1.7. Fundamental Accounting Concepts and Principles

Basic concepts
Transactions are recorded in accounts, following certain fundamentals, concepts and
conventions, which are called as Generally Accepted Accounting Principles. Accounting

principles may be defined as those rules of action or conduct, which are adopted by the
accountants, universally, while recording the transactions.
The chief objective behind the accounting principles is that the accounting statements should be
both reliable and informative. This objective can be achieved when there is certain common
agreement and compliance about the accounting principles. Every profession has developed its
own jargon and vocabulary. Like all other professions, accounting has also developed its own
concepts and conventions. These concepts and conventions have been evolved after centuries of
experimentation and their use have, now, become accepted principles.
“Accounting” is based on a number of rules or conventions, which have evolved over time.
These principles are known as Generally Accepted Accounting Principles (GAAPs). Generally
Accepted Accounting Principles (GAAP) may be defined as those rules of action or conduct,
which are derived from experience and practice, and when they prove useful, they are accepted
as principles of accounting. They are, however, not rigid. They are subject to change. They have
evolved in order to deal with practical problems experienced by a preparer and a user rather than
to reflect some theoretical ideal.
Generally Accepted Accounting Principles (GAAP) is a term used to describe, broadly, the body
of principles that governs the accounting for financial transactions underlying the preparation of
a set of financial statements. However, it should be mentioned, at the outset, that an application
of many concepts does involve subjective judgment about the selection of methods available for
choice, on the part of a person who is preparing the accounts. Depreciation can be provided on
fixed assets, either on the basis of straight-line method or written down method. Both the
methods are recognised. Same financial data, if different methods are applied, shows different
financial results. This means that two different persons using the same source data could produce
two entirely different sets of financial statements, with different operational results and financial
position. There is no difference of opinion whether depreciation on fixed assets is to be provided
or not. Here, the subjective judgment relates to selection of method of depreciation and not
providing for depreciation on the fixed assets.
According to the American Institute of Certified Public Accountants (AICPA), the principles,
which have substantial authoritative support, become a part of the generally accepted accounting
principles.
To achieve basic objectives and implement fundamental qualities GAAP has basic assumptions,
principles, and constraints.

I. Assumptions
A. Business Entity: assumes that the business is separate from its owners or other
businesses. Revenue and expense should be kept separate from personal expenses. Hence,
the business transactions are recorded in separate books of account and the business
transactions are not combined with personal transactions of the owner(s). Of course, all
transactions of the company are carried out by the personnel who act or transact on behalf
of the company and in the name of the company.
B. Going Concern: assumes that the business will be in operation indefinitely. This
validates the methods of asset capitalization, depreciation, and amortization. Only when
liquidation is certain this assumption is not applicable. The business will continue to exist
in the unforeseeable future. An accounting entity is viewed as continuing in operation in
the absence of evidence to the contrary. Because of the relative permanence of
enterprises, financial accounting is formulated assuming that the business will continue to
operate for an indefinitely long period in the future. The going concern assumption leads
to the corollary that individual financial statements are part of a continuous, interrelated
series of statements. This further implies that data communicated are tentative and that
current statements should disclose adjustments to past-year statements revealed by more
recent developments.
C. Monetary Unit measurement assumption: assumes a stable currency is going to be the
unit of record. A unit of exchange and measurement is necessary to account for the
transactions of business enterprises in a uniform manner. The common denominator
chosen in accounting is the monetary unit. Money is the common denominator in terms
of which the exchangeability of goods and services, including labour, natural resources,
and capital, are measured. Money measurement assumption holds that accounting is a
measurement and communication process of the activities of the firm that are measurable
in monetary terms. Obviously, financial statements should indicate the money used.
II. Concepts
A. The Accounting Period Concept According to the „Going Concern Concept‟, every
business would exist for a longer duration. That longer duration is divided into
appropriate segments or periods for studying the results shown by the business for
each period. After each period, it is necessary to „stop‟ and „see back‟ how things
have been going. So, it is necessary to maintain accounts with reference to a specific

period. The specific period is normally one year. This time interval is called
„accounting period’. At the end of each accounting year, Profit and Loss Account and
Balance Sheet are prepared. Profit and Loss Accounts shows the financial results,
while Balance Sheet shows the financial position. When making comparison, the
accounting period should be similar. In other words, results of one year cannot be
compared with the results of another period where the period has been only six
months. Suitable adjustments are to be made before comparison of results of different
periods for proper evaluation and conclusion
B. The Objectivity Concept: Objectivity connotes reliability and trustworthiness. It
states that the company financial statements provided by the accountants should be
based on objective evidence. A principle is objective to the extent when the
accounting information is not influenced by personal bias or judgment of those who
provide it. This implies that accounting information is prepared and reported in a
“neutral” way. In other words, it is not biased towards a particular user group or
vested interest. It also implies verifiability, which means that there is some way of
ascertaining the correctness of the information reported.
C. The Dual-Aspect Concept: This is the basic concept of accounting. As per this
concept, for every debit, there is a corresponding credit. In other words, when a
transaction is recorded, debit amount has to be equal to the credit amount. This is also
known as „Double Entry Principle‟. No transaction is complete without double aspect.
When a new business is started with a capital of birr, the position is expressed as
under:
Capital (Equities) = Cash (Assets)
The term „Assets‟ denote the resources owned by the business, while the term „Equities‟ denote
the various claims of the parties against those assets.
Equities are of two types. They are owner‟s equity and outsider‟s equity. Owner‟s equity (or
capital) is the claim of owners against the assets of the business. Outsider‟s equity (or liabilities)
is the claim of the outsiders such as creditors, loan providers and debenture-holders against the
assets of the company. Someone, either owner or outsider, has a claim against the assets of the
business. So, the total value of the assets is equal to the total value of capital and liabilities.
Equities = Assets
Capital + Liabilities = Assets

III. Principles
A. Historical cost principle requires companies to account and report based on acquisition
costs rather than fair market value for most assets and liabilities. This principle provides
information that is reliable (removing opportunity to provide subjective and potentially
biased market values), but not very relevant. Thus there is a trend to use fair values. Most
debts and securities are now reported at market values.
B. Revenue Recognition Principle holds that companies may not record revenue until (1) it
is realized or realizable and (2) when it is earned. The flow of cash does not have any
bearing on the recognition of revenue. This is the essence of accrual basis accounting.
Conversely, however, losses must be recognized when their occurrence becomes
probable, whether or not it has actually occurred. This comports with the constraint of
conservatism, yet brings it into conflict with the constraint of consistency, in that
reflecting revenues/gains is inconsistent with the way in which losses are reflected.
C. Matching Principle. Expenses have to be matched with revenues as long as it is
reasonable to do so. Expenses are recognized not when the work is performed, or when a
product is produced, but when the work or the product actually makes its contribution to
revenue. Only if no connection with revenue can be established, cost may be charged as
expenses to the current period (e.g. office salaries and other administrative expenses).
This principle allows greater evaluation of actual profitability and performance (shows
how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good
examples of application of this principle.
D. Full Disclosure Principle. Amount and kinds of information disclosed should be decided
based on trade-off analysis as a larger amount of information costs more to prepare and
use. Information disclosed should be enough to make a judgment while keeping costs
reasonable. Information is presented in the main body of financial statements, in the notes
or as supplementary information
IV. Constraints
A. Materiality: refers to the relative importance of an item or event. This convention
emphasizes that all material facts should be recorded in accounting. Materiality is defined
in the International Accounting Standards Board‟s “Framework for the Preparation and
Presentation of Financial Statements” in the following terms: “Information is material, if

its omission or misstatement could influence the economic decision 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”. Those who make accounting decisions continually confront the need to
make judgments regarding materiality. Is this item large enough for users of the
information to be influenced by it? The accountant should regard an item material, if he
has reason to believe that the knowledge of it would influence the decision. In other
words, if the knowledge of information would have a bearing on the decision, then that
information is material and is to be provided. The significance of an item should be
considered when it is reported. An item is considered significant when it would affect the
decision of a reasonable individual.
B. Consistency: It means that the company uses the same accounting principles and
methods from period to period. It is presumed, unless otherwise stated, Accounting
Practices are unchanged, year after year. If the accounting practices are changed, the fact
is to be mentioned and its impact is to be quantified. If closing stock is valued at cost or
market price, whichever is lower, the same principle is to be applied, every year.
Similarly, if the fixed assets are depreciated according to the diminishing balance
method, the same method is to be consistently followed. Following diminishing balance
method for one year and straight-line method for the next year would distort the results. It
does not mean ignoring change for betterment.
The important point is departure for better techniques are allowed, but the effect of
change has to be arrived at and specified. Otherwise, comparison would give misleading
results. So, if the valuation of closing stock is changed from the earlier stated one (cost or
market price, whichever is lower) to the valuation based on the market price alone, then
in the year of change, the change has to be stated and, equally, the impact of change, in
terms of profits, is to be quantified in „Notes to Accounts‟. Once a firm has chosen a
particular method of accounting, it should adhere to that method in the future, so as to
allow for the most meaningful comparisons on a year-by-year basis. However,
consistency does not mean inflexibility. When there are compelling reasons for a change,
that change should be reported. If adoption of a change results in inflating or deflating the

profit figures and financial position, compared to the previous year, a suitable note about
the impact of change on operational results and financial position has to be given in the
„Notes to the Accounts‟ of the financial statements. Where accounting policies are
changed, companies are required to disclose this fact and explain the impact of any
change.
C. Conservatism: when choosing between two solutions, the one which has the less
favorable outcome is the solution which should be chosen (see convention of
conservatism). „Playing safe‟ is the main idea underlying this convention. In the initial
stages of accounting, not actual profits, but, even anticipated profits have been recorded.
This concept emphasizes that profit should never be overstated or anticipated. Concept of
conservatism is otherwise known as „Prudence‟. Basically, the concept says that
whenever there are two equally acceptable methods, the one, which is more conservative,
will be accepted. When a judgment is based on general estimates, if there is a dilemma as
to which is correct, the most conservative estimate will be accepted. When there is a
probability of getting profit or loss, profit will be ignored, but loss will be taken into
account. If an optimistic view of profits is taken, then dividends may be paid out of
profits that have not been earned.
D. Cost Constraint- The cost benefit principle or cost benefit relationship states that the
cost of providing financial information in the financial statements must not outweigh the
benefit of that information to the users. In other words, financial information is not free.
Companies spend millions of dollars every year gathering and organizing financial
information to assemble into financial statements. The benefits of reporting financial
information should justify and be greater than the costs imposed on supplying it.
1.8. Accounting Systems: Cash Vs. Accrual system of Accounting

A basis of accounting can be defined as the time various financial transactions are recorded. The
cash basis of accounting and the accrual basis of accounting are the two primary methods of
tracking income and expenses in accounting. Both can be used in a range of situations from the
accounts of a whole country, a large corporation, a small business or an individual. In many
cases regulatory bodies may require individuals, businesses or corporations use one method or
the other. When this is not the case, the choice of which to use is an important decision as both
have advantages and disadvantages.

The accrual method records income items when they are earned and records deductions when
expenses are incurred. For a business invoicing for an item sold, or work done, the corresponding
amount will appear in the books even though no payment has yet been received – and debts
owed by the business show as they are incurred, even though they may not be paid until much
later.
The following chart provides a comparison of the cash and accrual methods of accounting,
highlighting some benefits and challenges with each method:
Some Comparative Basis of Accounting
Criteria Cash Basis Accrual Basis
Accounting method in which income is Accounting method in which
recorded as cash is received and income is recorded when
Definition expenses are recorded when cash is paid earned and expenses are
recorded when incurred,
regardless of cash flow
Compliance with GAAP

Does not meet GAAP requirements Meets GAAP requirements
Generally, an easier method for smaller Provides more information
entities; for entities that conduct business regarding income and
primarily in cash, this method sometimes expenses of an entity;
provides adequate information to monitor accounting for outstanding
Advantages financial condition commitments and prepaid
cash receipts, this method
allows for more accurate
measurement of net
income/(loss)
May offer a misleading financial picture if an Generally, more complicated
organization has unpaid expenses, outstanding and expensive method; this
Challenges receivables and/or cash receipts that are method still necessitates a
unavailable for immediate use process to monitor an entity‟s
cash position and cash flow

Adjusting cash basis records to approximate accrual basis records
Cash Basis Adjustments to Cash Basis Equals Accrual Basis
– Beginning inventories
+ Ending inventories
Cash receipts
–Beginning accounts receivable = Gross revenue
+ Ending accounts receivable
– Beginning accounts payable
+ Ending accounts payable
– Beginning accrued expenses
+ Ending accrued expenses
Cash + Beginning prepaid expenses
disbursements – Ending prepaid expenses
+ Beginning unused supplies (fuel, chemicals, etc.) = Operating expenses
– Ending unused supplies
+ Beginning investment in growing crops
– Ending investment in growing crops
Depreciation
expense No adjustment made (see Note 1) Depreciation expense
Cash net Accrual adjusted net
income (after- income (after-tax)
tax)
NOTE 1: Because depreciation is a noncash expense, technically it would not be reflected on a
cash basis income statement.
Accrual Vs Deferrals
Accrual (accumulation of something) refers to accounts on a balance sheet that represent
liabilities and non-cash-based assets used in accrual-based accounting. These types of accounts
include, among others, accounts payable, accounts receivable, goodwill, deferred tax liability and
future interest expense.
For example, a company delivers a product to a customer who will pay for it 30 days later in the
next fiscal year, which starts a week after the delivery. The company recognizes the proceeds as

revenue in its current income statement still for the fiscal year of the delivery, even though it will
get paid in cash during the following accounting period. The proceeds are also an accrued
income (asset) on the balance sheet for the delivery fiscal year, but not for the next fiscal year
when cash is received.
Similarly, a salesperson, who sold the product, earned a commission at the moment of sale (or
delivery). The company will recognize the commission as an expense in its current income
statement, even though the salesperson will actually get paid at the end of the following week in
the next accounting period. The commission is also an accrued expense (liability) on the balance
sheet for the delivery period, but not for the next period when the commission (cash) is paid out
to the salesperson.
Accrued Expenses and Accrued Revenues
The term accrual also often used as an abbreviation for the terms accrued expense and accrued
revenue that share the common name word, but they have the opposite economic/accounting
characteristics.
i. Accrued Revenue (or accrued assets) is an asset, such as unpaid proceeds from a
delivery of goods or services, when such income is earned and a related revenue item
is recognized, while cash is to be received in a later period, when the amount is
deducted from accrued revenues.
ii. Accrued Expense (or accrued liability) is a liability whose timing or amount is
uncertain by virtue of the fact that an invoice has not yet been received. The
uncertainty of the accrued expense is not significant enough to qualify it as a
provision. An example of an accrued expense is a pending obligation to pay for goods
or services received from a counterpart, while cash is to be paid out in a latter
accounting period when the amount is deducted from accrued expenses.
Deferral
A Deferral, in accrual accounting, is any account where the asset or liability is not realized until
a future date (accounting period), e.g. annuities, charges, taxes, income, etc. The deferred item
may be carried, dependent on type of deferral, as either an asset or liability. Deferrals are the
consequence of the revenue recognition principle which dictates that revenues be recognized in
the period in which they occur, and the matching principle which dictates expenses to be
recognized in the period in which they are incurred. Deferrals are the result of cash flows
occurring before they are allowed to be recognized under accrual accounting. As a result,

adjusting entries are required to reconcile a flow of cash (or rarely other non-cash items) with
events that have not occurred yet as either liabilities or assets. Because of the similarity between
deferrals and their corresponding accruals, they are commonly conflated.
a. Deferred Expense: is an asset representing cash paid out to a counterpart for goods or
services to be received in a later accounting period. Cash has left the company, but the
event has not actually occurred yet. Prepaid expenses are the most common type. For
instance, a company may purchase a year of insurance. After six months, only half of the
insurance will have been 'used' with another six months of the insurance still owed to the
company. Thus, the company records half of the payment as an outflow (an expense) and
the other half as a receivable from the insurance company (an asset).
b. Deferred Revenue: is a liability, such as cash received from a counterpart for goods or
services that are to be delivered in a later accounting period. When such income item is
earned, the related revenue item is recognized, and the deferred revenue is reduced. It
shares characteristics with accrued expense with the difference that a liability to be
covered later is an obligation to pay for goods or services received from a counterpart,
while cash for them is to be paid out in a later period when its amount is deducted from
accrued expenses. Revenue has come into the company, but the event has still not
occurred - it is unearned revenue. A magazine company, for instance, may receive money
for a one year subscription. However, the company has not spent the resources in
producing and delivering those magazines and thus accountants record this revenue as a
liability equal to the amount of cash received. The magazine company, while now having
more cash on hand, also now owes a year of magazines. The amount of each magazine
that gets delivered is then taken out of liabilities and recorded as revenue during the
economic period in which it actually happens, not just when the company gets paid for it.
1.9. Basic Financial Statements
Financial Statements represent a formal record of the financial activities of an entity. These are
written reports that quantify the financial strength, performance and liquidity of a company.
Financial Statements reflect the financial effects of business transactions and events on the
entity.Every business concern wants to know the various financial aspects for effective decision
making. The preparation of financial statement is required in order to achieve the objectives of
the firm as a whole. The term financial statement refers to an organized collection of data on the

basis of accounting principles and conventions to disclose its financial information. The
following are the four basic financial statements:
1. Income Statements (or Profit and Loss Account)
2. Balance Sheet
3. Statement of Retained Earnings
4. Statement of Cash Flow
The meaning and importance of the financial statements are presented as follows:
(1) Income Statements: The term 'Income Statements' is also known as Profit and Loss
Account. It reports the company's financial performance in terms of net profit or loss over
a specified period. Income Statement is composed of the following two elements:
Income: What the business has earned over a period (e.g. sales revenue, dividend
income, rent income, etc.)
Expense: The cost incurred by the business over a period (e.g. salaries and wages,
depreciation, rental charges, etc.)
Net profit or loss is arrived by deducting expenses from income.
(2) Balance Sheet: Balance Sheet may be defined as "a statement of financial position
of any economic unit disclosing as at a given moment of time its assets, at cost,
depreciated cost, or other indicated value, its liabilities and its ownership equities." In
other words, it is a statement which indicates the financial position or soundness of a
business concern at a specific period of time. Balance Sheet may also be described as a
statement of source and application of funds because it represents the source where the
funds for the business were obtained and how the funds were utilized in the business. It
is comprised of the following three elements:
Assets: Something a business owns or controls (e.g. cash, inventory, plant and
machinery, etc)
Liabilities: Something a business owes to someone (e.g. creditors, bank loans,
etc)
Equity: What the business owes to its owners. This represents the amount of
capital that remains in the business after its assets are used to pay off its
outstanding liabilities. Equity therefore represents the difference between
the assets and liabilities.

(3) Statement of Retained Earnings: This statement is considered to be as the
connecting link between the Profit and Loss Account and Balance Sheet. The
accumulated excess of earning over losses and dividend is treated as Retained Earnings.
The balance of retained earnings shown on the Profit and Loss Accounts and it is
transferred to liability side of the balance sheet. Statement of Retained Earnings also
known as the Statement of Changes in Equity, details the movement in owners' equity
over a period. The movement in owners' equity is derived from the following
components:
o Net Profit or loss during the period as reported in the income statement
o Share capital issued or repaid during the period
o Dividend payments
o Gains or losses recognized directly in equity (e.g. revaluation surpluses)
o Effects of a change in accounting policy or correction of accounting error
(4) Statement Cash Flow Statement: is prepared to understand the changes in the
firm's cash position. That means, it is prepared to project the manner in which the cash
received has been utilized during the accounting year. It considers only the cash
transactions both cash receipts and cash payments made during an accounting period. It
presents the movement in cash and bank balances over a period. The movement in cash
flows is classified into the following segments:
Operating Activities: Represents the cash flow from primary activities of a
business.
Investing Activities: Represents cash flow from the purchase and sale of assets
other than inventories (e.g. purchase of a factory plant)
Financing Activities: Represents cash flow generated or spent on raising and
repaying share capital and debt together with the payments
of interest and dividends.
Nature of Financial Statements
Financial Statements are prepared on the basis of business transactions recorded in the
books of Original Entry or Subsidiary Books, Ledger, and Trial Balance. According to
the American Institute of Certified Public Accountants, "Financial Statement reflects a
combination of recorded facts, accounting conventions and personal judgments and
conventions applied which affect them materially." It is therefore, nature and accuracy of

the data included in the financial statements which are influenced by the following
factors: (1) Recorded Facts, (2) Generally Accepted Accounting Principles, (3) Personal
Judgments, and (4) Accounting Conventions.
Objectives of Financial Statements
The following are, among others, the important objectives of financial statements:
1) To provide adequate information about the source of finance and obligations of
the finance firm.
2) To provide reliable information about the financial performance and financial
soundness of the concern.
3) To provide sufficient information about results of operations of business over a
period of time.
4) To provide useful information about the financial conditions of the business and
movement of resources in and out of business.
5) To provide necessary information to enable the users to evaluate the earning
performance of resources or managerial performance in forecasting the earning
potentials of business.

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MADAWALAMU UNIVERSITY, SCHOOL OF POST GRADUATE STUDIES, Bale-Robe, December 2014

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1.3. Branches of Accounting

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1.4. Financial Accounting Vs Cost Accounting

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Financial Accounting Vs Management Accounting

S.No Dimension Financial accounting Management Accounting

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1.5. Users of Accounting Information

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1.7. Fundamental Accounting Concepts and Principles

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1.8. Accounting Systems: Cash Vs. Accrual system of Accounting

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Compliance with GAAP

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Cash Basis Adjustments to Cash Basis Equals Accrual Basis

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