Notes By: - Ms. Seema Garg - Assistant Professor, SRCEM, Palwal
STUDY NOTES
Accounting for Managers
MBA/102
Department of Management
SHRI RAM COLLEGE OF ENGINEERING AND MANAGEMENT
Palwal, Haryana
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Account for managers, Lecture notes of Accounting
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STUDY NOTES
Accounting for Managers
MBA/10 2
Department of Management
SHRI RAM COLLEGE OF ENGINEERING AND MANAGEMENT
Palwal, Haryana
UNIT – I
Accounting – An Introduction Introduction Accounting is aptly called the language of business. This designation is applied to accounting because it is the method of communicating business information. The basic function of any language is to serve as a means of communication. Accounting duly serves this function. The task of learning accounting is essentially the same as the task of learning a new language. But the acceleration of change in business organization has contributed to increase the complexities in this language. Like other languages, it is undergoing continuous change in an attempt to discover better means of communications. To enable the accounting language to convey the same meaning to all stakeholders, it should be made standard. To make it a standard language certain accounting principles, concepts and standards have been developed over a period of time. This lesson dwells upon the different dimensions of accounting, accounting concepts, accounting principles and the accounting standards.
Definition of Accounting
Accounting has been defined by the American accounting association committee as: “The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information”. This may be considered as a good definition because of its focus on accounting as an aid to decision making. The American institute of certified and public accountants committee on terminology defined accounting as: “Accounting is the art of recording, classifying and summarizing, in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof”. of all definitions available, this is the most acceptable one because it encompasses all the functions which the modern accounting.
Scope and Functions of Accounting
Individuals engaged in such areas of business as finance, production, marketing, personnel and general management need not be expert accountants but their effectiveness is no doubt increased if they have a good understanding of accounting principles. Everyone engaged in business activity, from the bottom level employee to the chief executive and owner, comes into contact with accounting. The higher the level of authority and responsibility, the greater is the need for an understanding of accounting concepts and terminology. Accounting which is so important to all, discharges the following vital functions:
Keeping Systematic Records:
This is the fundamental function of accounting. The transactions of the business are properly recorded, classified and summarized into final financial statements – income statement and the balance sheet.
Chart Showing Types of Information
Information Non-quantitative Quantitative Information Information Accounting Non- accounting Information Information Operating Financial Management Cost Information Information Information Information The chart clearly presents the different types of information that might be useful to all sorts of individuals interested in the business enterprise. As seen from the chart, accounting supplies the quantitative information. The special feature of accounting as a kind of a quantitative information and as distinguished from other types of quantitative information is that it usually is expressed in monetary terms. In this connection it is worthwhile to recall the definitions of accounting as given by the american institute of certified and public accountants and by the american accounting principles board. The types of accounting information may be classified into four categories: (1) Operating information, (2) Financial accounting information (3) Management accounting information and (4) cost accounting information.
Operating Information:
By operating information, we mean the information which is required to conduct the day-to-day activities. Examples of operating information are: amount of wages paid and payable to employees, information about the stock of finished goods available for sale and each one’s cost and selling price, information about amounts owed to and owing by the business enterprise, information about stock of raw materials, spare parts and accessories and so on. By far, the largest quantity of accounting information provides the raw data (input) for financial accounting, management accounting and cost accounting.
Financial Accounting :
Financial accounting information is intended both for owners and managers and also for the use of individuals and agencies external to the business. This accounting is concerned with the recording of transactions for a business enterprise and the periodic preparation of various reports from such records. The records may be for general purpose or for a special purpose. A detailed account of the function of financial accounting has been given earlier in this lesson.
Management Accounting:
Management accounting employs both historical and estimated data in assisting management in daily operations and in planning for future operations. It deals with specific problems that confront enterprise managers at various organizational levels. The management accountant is frequently concerned with identifying alternative courses of action and then helping to select the best one. For e.g. the accountant may help the finance manager in preparing plans for future financing or may help the sales manager in determining the selling price to be fixed on a new product by providing suitable data. Generally management accounting information is used in three important management functions: (1) control (2) co-ordination and (3) planning. Marginal costing is an important technique of management accounting which provides multi dimensional information that facilitates decision making.
Cost Accounting:
The industrial revolution in england posed a challenge to the development of accounting as a tool of industrial management. This necessitated the development of costing techniques as guides to management action. Cost accounting emphasizes the determination and the control of costs. It is concerned primarily with the cost of manufacturing processes. In addition, one of the principal functions of cost accounting is to assemble and interpret cost data, both actual and prospective, for the use of management in controlling current operations and in planning for the future. All of the activities described above are related to accounting and in all of them the focus is on providing accounting information to enable decisions to be made. Groups Interested In Accounting Information There are several groups of people who are interested in the accounting information relating to the business enterprise. Following are some of them:
Shareholders:
Shareholders as owners are interested in knowing the profitability of the business transactions and the distribution of capital in the form of assets and liabilities. In fact, accounting developed several centuries ago to supply information to those who had invested their funds in business enterprise.
Management:
With the advent of Joint Stock Company form of organization the gap between ownership and management widened. In most cases the shareholders act merely as renders of capital and the management of
Social Responsibility Accounting:
This branch is the newest field of accounting and is the most difficult to describe concisely. It owes its birth to increasing social awareness which has been particularly noticeable over the last three decades or so. Social responsibility accounting is so called because it not only measures the economic effects of business decisions but also their social effects, which have previously been considered to be immeasurable. Social responsibilities of business can no longer remain as a passive chapter in the text books of commerce but are increasingly coming under greater scrutiny. Social workers and people’s welfare organizations are drawing the attention of all concerned towards the social effects of business decisions. The management is being held responsible not only for the efficient conduct of business as reflected by increased profitability but also for what it contributes to social well-being and progress.
Inflation Accounting:
Inflation has now become a world-wide phenomenon. The consequences of inflation are dire in case of developing and underdeveloped countries. At this juncture when financial statements or reports are based on historical costs, they would fail to reflect the effect of changes in purchasing power or the financial position and profitability of the firm. Thus, the utility of the accounting records, not taking care of price level changes is seriously lost. This imposes a demand on the accountants for adjusting financial accounting for inflation to know the real financial position and profitability of a concern. Thus emerged a future branch of accounting called inflation accounting or accounting for price level changes. It is a system of accounting which regularly records all items in financial statements at their current values.
Human Resources Accounting:
Human resources accounting is yet another new field of accounting which seeks to report and emphasize the importance of human resources in a company’s earning process and total assets. It is based on the general agreement that the only real long lasting asset which an organization possesses is the quality and caliber of the people working in it. This system of accounting is concerned with, “the process of identifying and measuring data about human resources and communicating this information to interested parties”.
Nature and Meaning Of Accounting Principles
The rules and conventions of accounting are commonly referred to as principles. The american institute of certified public accountants has defined the accounting principle as, “a general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice”. It may be noted that the definition describes the accounting principle as a general law or rule that is to be used as a guide to action. The canadian institute of chartered accountants has defined accounting principles as, “the body of doctrines commonly associated with the theory and procedure of accounting, serving as explanation of current practicesand as a guide for the selection of conventions or procedures where alternatives exist ”. This definition also makes it clear that accounting principles serve as a guide to action.
Accounting principles are judged on their general acceptability to the makers and users of financial statements and reports. They present a generally accepted and uniform view of the accounting profession in relation to good accounting practice and procedures. Hence the name generally accepted accounting principles.
Accounting Concepts
The important accounting concepts are discussed hereunder:
Business Entity Concept:
It is generally accepted that the moment a business enterprise is started it attains a separate entity as distinct from the persons who own it. In recording the transactions of a business, the important question is: How do these transactions affect the business enterprise? The question as to how these transactions affect the proprietors is quite irrelevant. This concept is extremely useful in keeping business affairs strictly free from the effect of private affairs of the proprietors. In the absence of this concept the private affairs and business affairs are mingled together in such a way that the true profit or loss of the business enterprise cannot be ascertained nor its financial position. To quote an example, if a proprietor has taken rs.5000/- from the business for paying house tax for his residence, the amount should be deducted from the capital contributed by him. Instead if it is added to the other business expenses then the profit will be reduced by rs.5000/- and also his capital more by the same amount. This affects the results of the business and also its financial position. Not only this, since the profit is lowered, the consequential tax payment also will be less which is against the provisions of the income-tax act.
Going Concern Concept:
This concept assumes that the business enterprise will continue to operate for a fairly long period in the future. The significance of this concept is that the accountant while valuing the assets of the enterprise does not take into account their current resale values as there is no immediate expectation of selling it. Moreover, depreciation on fixed assets is charged on the basis of their expected life rather than on their market values. When there is conclusive evidence that the business enterprise has a limited life, the accounting procedures should be appropriate to the expected terminal date of the enterprise. In such cases, the financial statements could clearly disclose the limited life of the enterprise and should be prepared from the ‘quitting concern’ point of view rather than from a ‘going concern’ point of view.
Money Measurement Concept:
Accounting records only those transactions which can be expressed in monetary terms. This feature is well emphasized in the two definitions on accounting as given by the American institute of certified public accountants and the American accounting principles board. The importance of this concept is that money provides a common denomination by means of which heterogeneous facts about a business enterprise can be expressed and measured in a much better way. For e.g. When it is stated that a business owns rs.1,00,000 cash, 500 tons of raw material, 10 machinery items, 3000 square meters of land and building etc., these amounts cannot be added
Liabilities + Capital = Assets It is customary to place ‘liabilities’ before ‘capital’ because creditors have priority in the repayment of their claims as compared to that of owners. Sometimes greater emphasis is given to the residual claim of the owners by transferring liabilities to the other side of the equation as: Capital = Assets – Liabilities All business transactions, however simple or complex they are, result in a change in the three basic elements of the equation. This is well explained with the help of the following series of examples:
Accounting Period Concept:
In accordance with the going concern concept it is usually assumed that the life of a business is indefinitely long. But owners and other interested parties cannot wait until the business has been wound up for obtaining information about its results and financial position. For e.g. If for ten years no accounts have been prepared and if the business has been consistently incurring losses, there may not be any capital at all at the end of the tenth year which will be known only at that time. This would result in the compulsory winding up of the business. But, if at frequent intervals information are made available as to how things are going, then corrective measures may be suggested and remedial action may be taken. That is why, pacioli wrote as early as in 1494: ‘frequent accounting makes for only friendship’. This need leads to the accounting period concept. According to this concept accounting measures activities for a specified interval of time called the accounting period. For the purpose of reporting to various interested parties one year is the usual accounting period. Though pacioli wrote that books should be closed each year especially in a partnership, it applies to all types of business organizations.
Accounting Conventions
Convention Of Conservatism: It is a world of uncertainty. So it is always better to pursue the policy of playing safe. This is the principle behind the convention of conservatism. According to this convention the accountant must be very careful while recognizing increases in an enterprise’s profits rather than recognizing decreases in profits. For this the accountants have to follow the rule, anticipate no profit, provide for all possible losses, while recording business transactions. It is on account of this convention that the inventory is valued at cost or market price whichever is less, i.e. When the market price of the inventories has fallen below its cost price it is shown at market price i.e. The possible loss is provided and when it is above the cost price it is shown at cost price i.e. The anticipated profit is not recorded. It is for the same reason that provision for bad and doubtful debts, provision for fluctuation in investments, etc., are created. This concept affects principally the current assets. Convention Of Full Disclosure: The emergence of joint stock company form of business organization resulted in the divorce between ownership and management. This necessitated the full disclosure of accounting information about the enterprise to the owners and various other interested parties. Thus the convention of full disclosure became important. By this convention it is implied that accounts must be honestly prepared and all material information must be adequately disclosed therein. But it does not mean that all information that someone desires are to be disclosed in the financial statements. Convention of Consistency: According to this concept it is essential that accounting procedures, practices and method should remain unchanged from one accounting period to another. This enables comparison of performance in one accounting period with that in the past. For e.g. If material issues are priced on the basis of fifo method the same basis should be followed year after year. Convention Of Materiality: The implication of this convention is that accountant should attach importance to material details and ignore insignificant ones. In the absence of this distinction, accounting will unnecessarily be overburdened with minute details. The question as to what is a material detail and what is not is left to the discretion of the individual accountant. Further, an item should be regarded as material if there is reason to believe that What are 'International Financial Reporting Standards - IFRS' International Financial Reporting Standards (IFRS) are a set of international accounting standards stating how particular types of transactions and other events should be reported in financial statements. IFRS are issued by the International Accounting Standards Board, and they specify exactly how accountants must maintain and report their accounts. IFRS were established in order to have a common accounting language, so business and accounts can be understood from company to company and country to country.
Standard IFRS Requirements IFRS cover a wide range of accounting activities. There are certain aspects of business practice for which IFRS set mandatory rules.
- Statement of Financial Position: This is also known as a balance sheet. IFRS influence the ways in which the components of a balance sheet are reported.
- Statement of Comprehensive Income: This can take the form of one statement, or it can be separated into a profit and loss statement and a statement of other income, including property and equipment.
- Statement of Changes in Equity: Also known as a statement of retained earnings, this documents the company's change in earnings or profit for the given financial period.
- Statement of Cash Flow: This report summarizes the company's financial transactions in the given period, separating cash flow into Operations, Investing, and Financing. History of IFRS IFRS originated in the European Union, with the intention of making business affairs and accounts accessible across the continent. The idea quickly spread globally, as a common language allowed greater communication worldwide. Although only a portion of the world uses IFRS, participating countries are spread all over the world, rather than being confined to one geographic region. The United States has not yet adopted IFRS, as many view the American GAAP. as the "gold standard"; however, as IFRS become more of a global norm, this is subject to change if the SEC decides that IFRS are fit for American investment practices. Currently, about 120 countries use IFRS in some way, and 90 of those require them and fully conform to IFRS regulations. IFRS are maintained by the IFRS Foundation. The mission of the IFRS Foundation is to "bring transparency, accountability and efficiency to financial markets around the world." Not only does the IFRS Foundation supply and monitor these standards, but it also provides suggestions and advice to those who deviate from the practice guidelines. FACTORS RESPONSIBLE FOR USES OF IFRS The below are the primary drivers encouraging the use of IFRS globally.
- Globalisation of trade & capital markets
- Rapid development of Information Technology and its impact on operations
- Fast & simplified process of moving funds between countries
- Increased investors interest in foreign investments
Definition and Explanation of Final Accounts: Every businessman goes into a business with the idea of making profit, which is the reward of this effort. He tries his best to get more and more profit at the smallest economic cost. The role of accounting is to accumulate accounting data in such a manner that the amount of profit made or loss sustained during a particular period ascertained. The "final accounts" enable us to check on the conduct of the business, and to discover whether it is being run profitably. They are the means of conveying to the owner/owners, management, creditors, and interested outsiders a concise picture of profitability and financial position of the business. The preparation of the final accounts is not the first stage of an accounting cycle but they are the final products of the accounting cycle, that is why, they are called final accounts. These accounts summaries all the accounting information recorded in the original books of entry and the ledger consisted of hundreds of thousands of pages. The final accounts or a financial statement consists of:
- Trading and profit and loss account or income statement, which is prepared to know the profit earned or loss suffered by the business during a specific period.
- Balance sheet, which is prepared to know the financial position of the business on a particular date. Definition and Explanation: The account which is prepared to determine the gross profit or gross loss of a business concern is called trading account. It should be noted that the result of the business determined through trading account is not true result. The true result is the net profit or the net loss which is determined through profit and loss account. The trading accounting has the following features:
- It is the first stage of final accounts of a trading concern.
- It is prepared on the last day of an accounting period.
- Only direct revenue and direct expenses are considered in it.
- Direct expenses are recorded on its debit side and direct revenue on its credit side.
- All items of direct expenses and direct revenue concerning current year are taken into account but no item relating to past or next year is considered in it.
- If its credit side exceeds it represents gross profit and if debit side exceeds it shows gross loss. Purpose of Preparing Trading Account:
The profit or loss determined by a trading account is the gross result of the business but not the net result. If so, then a question arises - what is the use of preparing a trading account? This account is necessary because of the following advantages.
- Gross profit of a business is very important data, since all business expenses are met out of it. So the amount of gross profit should be adequate to meet the indirect expenses of a business concern.
- The amount of net sales can be determined through this account. Gross sales can be ascertained from sales account in the ledger, but net sales cannot be so obtained. The true sales of a business is net sales - not gross sales. Net sales are determined by deducting sales returns from gross sales in trading account.
- The success or failure of a business can be ascertained by comparing net sales of the current year with that of the last year. It should be noted that an increase in the amount of net sales of the current year over the last year may not be regarded as a sign of success, since sales may increase because of rise in price level.
- Percentage of gross profit on net sales (gross profit ratio) can be easily determined from trading account. This percentage is very important yardstick for measuring the success or failure of a business. Compared to last year, if the rate increases, it indicates success; on the other hand if the rate decreases, it is an indication of failure.
- Percentage of different items of buying expenses (direct expenses) on gross profit can be easily determined and by comparing the percentage of the current year with that of the previous year the variations can be ascertained. An analysis of variances will disclose their cause which will help in controlling the amount of expenses.
- Inventory or stock turnover ratio can be determined from trading account. The success or failure of a business can be measured by this rate. Higher rate indicates a favorable sign i.e. goods are sold soon after their purchase. On the other hand, low rate signifies deterioration, i.e. goods are sold long after their purchase. Method of Preparation of Trading Account: Trial balance is a list of all ledger accounts balances, so all the necessary information for preparation of a trading account is available from the trial balance. As gross profit or gross loss of a particular period is determined through trading account. So it's heading will be as follows: XYZ co. Trading Account for the year ended 31.12. (if accounting period ends on 31.12.2005) From the trial balance, the balance of opening stock account, purchases account, returns inwards account and of all direct expenses are transferred on the debit side of the trading account, and the balance of the sales account, returns outwards account, and closing stock account are transferred on the credit side of the trading account. If the credit side of the trading account exceeds the debit side, the result is "gross profit", and if debit side exceeds the credit side, the result is "gross loss". The format of a trading account is shown below: