CAPE

ACCOUNTING
UNIT 1

Accounting
Theory
LEARNING OBJECTIVES
1. Explain the purpose of accounting
2. Identify the major financial statements and other
means of financial reporting.
3. Explain how accounting assists in the efficient use of
scarce resources.
Accountancy is the process of communicating financial
information about a business entity to users such as stakeholders
and managers. The communication is generally in the form of
financial statements that show in money terms the economic
resources under the control of management; the art lies in
selecting the information that is relevant to the user. The
principles of accountancy are applied to business entities in three
divisions of practical art: accounting, bookkeeping, and auditing.
Accounting Defined
The American Institute of Certified Public Accountants (AICPA)
defines accountancy as “the art of recording, classifying, and
summarizing, in a significant manner and in terms of money,
transactions and events which are, in part at least, of financial
character, and interpreting the results thereof. ”
ACCOUNTING TERMS
Accounting is a process of identifying and measuring
quantitative financial activities and communicates these
financial reports to the decision-makers.
HISTORY OF ACCOUNTING
Luca Pacioli’s “Summa de Arithmetica, Geometria, Proportioni et
Proportionalità” represents the first known printed treatise on
bookkeeping; and it is widely believed to be the forerunner of
modern bookkeeping practice.
Early accounts served mainly to assist the memory of the
businessperson, and the audience for the account was the
proprietor or record keeper alone. Cruder forms of accounting
were inadequate for the problems created by a business entity
involving multiple investors, so double-entry bookkeeping first
emerged in northern Italy in the 14th century, where trading
ventures began to require more capital than a single individual was
able to invest. The development of joint stock companies created
wider audiences for accounts, as investors without firsthand
knowledge of their operations relied on accounts to provide the
requisite information. This development resulted in a split of
accounting systems for internal (i.e., management accounting) and
external (i.e., financial accounting ) purposes, and subsequently
also in accounting and disclosure regulations, following a growing
need for independent attestation of external accounts by auditors.
 FUNCTIONS OF ACCOUNTING
1. Accounting helps in the maintenance of bookkeeping and record keeping.
2. Accounting helps in the collection and storage of the financial
information, transactions happening within the organization, and financial
activities happening by the organization.
3. It helps in the tracking of several financial information daily or a monthly
basis.
4. It helps in the creation and documentation of financial history from day to
the latest period.
5. It helps in the formulation of comprehensive financial policy for the
business.
6. It is also utilized in the preparation of budgets and financial projections.
7. It helps in the reconciliation of information between two sources of
financial systems.
8. The accounted information can be shared with the external stakeholders
with the intent for business planning and growth.
9. It helps in audit functions and curbs the internal weakness as it makes the
systems accountable.
10. It allows a business or an organization can prepare and work on several
journals to maintain different accounts.
11. A comprehensive accounting system ensures that the accounts of
corporates expenses do not get mixed with the personal accounts of vice
presidents or managers. Such instances are generally referred to as red
flags.
FUNCTIONS OF ACCOUNTING
 See
ACCOUNTING FUNCTIONS
Financial accounting is a branch of accounting that records each
financial information and analyzes it to determine the financial
position of the business. Financial accounting involves the
preparation of various financial statements like income statement,
cash flow statement, balance sheet, etc. using accounting
principles. Although financial accounts are of interest to
management, their principal function is to satisfy the information
needs of persons not involved in the running of the business
(external users).
Management accounting

Tax accounting refers to the methods and policies used for the
preparation of tax returns and other statements needed for tax
compliance and therefore, it provides frameworks and guidelines
for arriving at a taxable profit.
LIMITATIONS OF ACCOUNTING INFORMATION
The limitations of accounting information are as follows:
1. Assumptions, subjective judgements and estimates are required
in the measurement and reporting of business activity.
2. Non-financial events or factors may contribute to the entity’s
success but cannot be measured monetarily; for example, good
working employees or suitable distribution location.
3. Reports are based on historic cost and not the fair market value
(current value).
USERS NEEDS FOR ACCOUNTING INFORMATION
The purpose of financial statements is to provide useful
information about the financial position performance and changes
in financial position of an entity to a wide range of users.
Users need this information for two reasons:
1. to make economic decisions; and
2. to assess the stewardship of management.
MAKING ECONOMIC DECISIONS
The types of economic decisions for which financial statements
are likely to be used include the following:
a) decisions to buy, hold or sell equity investments;
b) assessment of management stewardship and accountability;
c) assessment of the entity's ability to pay employees;
d) assessment of the security of amounts lent to the entity;
e) determination of taxation policies;
f) determination of distributable profits and dividends;
g) inclusion in national income statistics; and
h) regulation of the activities of entities.

Risk

Choice &

Uncertainty
Financial statements prepared by the Companies are used
by different categories of individuals and corporations in a
sense relevant to them.
USERS OF ACCOUNTING INFORMATION
These users can be broken into two groups
INTERNAL USERS OF ACCOUNTING
Internal users are the primary users of accounting. Following are
the 3 types of internal users and their information needs:
Owners
Owners need to assess how well their business is performing.
Financial statements provide information to owners about the
profitability of the overall business as well as individual products
and geographic segments. Owners are also interested in knowing
how risky their business is. Accounting information helps owners
in assessing the level of stability in business over the years and to
what extent have changes in economic factors affected the bottom
line of the business. Such information helps owners to decide if
they should invest any further in the business or if they should use
their financial resources elsewhere in more promising business
ventures.
INTERNAL USERS OF ACCOUNTING
Managers
Managers need accounting information to plan, monitor and make
business decisions. Managers need to allocate the financial,
human and capital resources towards competing needs of the
business through the budgeting process. Preparing and monitoring
budgets effectively requires reliable accounting data relating to the
various activities, processes, products, services, segments and
departments of the business. Management requires accounting
information to monitor the performance of business by comparison
against past performance, competitor analysis, key performance
indicators and industry benchmarks. Managers rely on accounting
data to form their business decisions such as investment, financing
and pricing decisions. In case of investment decisions for
example, managers would require the return on investment
calculation of a proposed project supported by reliable estimates
of the costs and revenues.
INTERNAL USERS OF ACCOUNTING
Employees
For the employees operating in the finance department, using
accounting information is usually part of their job description. This
includes for example preparing and reviewing various financial
reports such as financial statements. Employees are interested in
knowing how well a company is performing as it could have
implications for their job security and income. Many employees
review accounting information in the annual report just to get a
better understanding of the company’s business.
In recent years, the increase in number of shares and share options
schemes for employees particularly in startups has fostered a
greater level of interest in accounting information by employees.
Moreover, potential employees are also interested to learn about
the financial health of the organization they aspire to join in the
future.
 EXTERNAL USERS OF ACCOUNTING
External users are the secondary users of accounting.
Following are types of external users and their information needs:
Lenders
Lenders use accounting information of borrowers to assess their
credit worthiness, i.e. their ability to pay back any loan. Lenders
offer loans and other credit facilities on terms that are based on the
assessment of financial health of borrowers. Good financial health
is indicated by the borrower’s ability to pay its liabilities on time,
high profitability, substantial securable assets and liquidity. Poor
liquidity, low profitability, lack of assets that can be secured and an
inability to pay liabilities on time demonstrate poor financial health
of borrowers. On a lighter note, borrowers can only get a loan from
lenders if they can prove that they don’t need the money.
EXTERNAL USERS OF ACCOUNTING
Suppliers
Just like lenders, suppliers need accounting information to assess
the credit-worthiness of its customers before offering goods and
services on credit. Some suppliers only have a handful of
customers. These customers could be very large businesses
themselves. Suppliers need accounting information of its key
customers to assess whether their business is in good health which
is necessary for sustainable business growth.
Customers
Most consumers don’t care about the financial information of its
suppliers. Industrial consumers however need accounting
information about its suppliers in order to assess whether they
have the required resources that are necessary for a steady supply
of goods or services in the future. Continuity in supply of quality
inputs is essential for any business.
EXTERNAL USERS OF ACCOUNTING
Government
Government ensures that a company's disclosure of accounting
information is in accordance with the regulations that are in place
to protect the interest of various stakeholders who rely on such
information in forming their decisions. Government defines and
monitors accounting thresholds such as sales revenue and net
profit to determine the size of each business for the purpose of
ensuring that it complies with the relevant employee, consumer
and safety regulations.
Auditors
External auditors examine the financial statements and the
underlying accounting record of businesses in order to form an
audit opinion. Investors and other stakeholders rely on the
independent opinion of external auditors on the accuracy of
financial statements.
Public
General public may also be interested in accounting information of
a company. These could include journalists, analysts, academics,
activists and individuals with an interest in economic
developments
EXTERNAL USERS OF ACCOUNTING
Tax Authorities
Tax authorities determine whether a business declared the correct
amount of tax in its tax returns. Occasionally, tax authorities
conduct audits of the tax returns filed by businesses in order to
verify the information with the underlying accounting records.
Tax authorities also cross reference accounting information of
suppliers and consumers in order to identify potential tax evaders.
Investors
Investors need to know how well their investment is performing.
Investors primarily rely on the financial statements published by
companies to assess the profitability, valuation and risk of their
investment. Investors use accounting information to determine
i. Whether an investment is a good fit for their portfolio
ii. Whether they should hold, increase or decrease their
investment.
EXTERNAL USERS OF ACCOUNTING
Investment Analysts
Investment analysts keep a close eye on the financial statements of
the company. They have good industry knowledge and updated
about how the company is performing. Based on their analysis
from the financial statements, the investment analysts decide
whether to recommend the stock of the Company to their clients or
not.
Competitors
Competitors would like to know the financial status of the
competing company. They would like to maintain a competitive
edge on their competitors and hence, would like to know the
financial health of the other company. Further, they could decide to
change their strategy looking at the statements.
Rating Agency
A credit rating agency reviews the financial statement of the
company to give credit rating to the debt instruments of the
company. The issuing company has to provide all information to
the credit rating agency to get a rating of the securities it is issuing
to raise funds. The investors of these securities can make an
informed decision once a rating agency has provided a rating,
which is based on the financials of the company.
USERS OF ACCOUNTING INFORMATION
THE QUALITATIVE CHARACTERISTICS OF FINANCIAL
STATEMENTS
All of the above user groups, both internal and external to
the organisation, require the information provided to be
useful. In this context, information should:
(a) enable its recipient to make effective decisions;
(b) be adequate for taking effective action to control the
organisation or provide valuable details relating to its
environment;
(c) be compatible with the responsibilities and needs of its
recipient;
(d) be produced at optimum cost;
(e) be easily understood by its recipient;
(f ) be timely;
(g) be sufficiently accurate and precise for the purpose of
its provision.
 QUALITATIVE CHARACTERISTICS OF FINANCIAL
STATEMENTS
The IASB’s Framework also suggests that financial
statements should have certain qualitative characteristics,
including relevance, reliability, completeness,
comparability, understandability and timeliness.
Fundamental (Primary)
Qualitative Characteristics

Relevance Representational
faithfulness

Enhancing Qualitative Characteristics

Understandability Timeliness

Verifiability Comparability
RELEVANCE
Relevance refers to how helpful the information is for
financial decision-making processes. For accounting
information to be relevant, it must possess:
a) Confirmatory value – Provides information about
past events
b) Predictive value – Provides predictive power
regarding possible future events
Therefore, accounting information is relevant if it can
provide helpful information about past events and help in
predicting future events or in taking action to deal with
possible future events. For example, a company
experiencing a strong quarter and presenting these
improved results to creditors is relevant to the creditors’
decision-making process to extend or enlarge credit
available to the company.
REPRESENTATIONAL FAITHFULNESS
Representational faithfulness, also known as reliability, is the
extent to which information accurately reflects a company’s
resources, obligatory claims, transactions, etc. To help, think of
a pictorial depiction of something in real life – how accurately
does the picture represent what you see in real life? For
accounting information to possess representational
faithfulness, it must be:
a) Complete – Financial statements should not exclude any
transaction.
b) Neutral – The degree to which information is free from
bias. Note that there are subjectivity and estimation
involved in financial statements, therefore information
cannot be truly “neutral.” However, if a company polled
1,000 accountants and took the average of their answers,
that would be considered neutral and free from bias.
c) Free from error – The degree to which information is free
from errors.
d) it reflects the substance of transactions i.e. represents
faithfully what has taken place;
e) it is free from material error;
f) prudence (caution) has been applied where there is any
uncertainty.
RELIABILITY
Accounting information is very reliable for this auditor,
audit the account from time to time. the information is
free from any error and manipulation and can be used by
the users.
Example of Reliability: Auditor verifies all transactions
with the help of invoices, cash memos, etc so the
information can be used to raise the fund form investors.
UNDERSTANDABILITY
The information in the accounting Statement must be
prepared in such a way so the user can understand the
information easily. The data must be presented so that
even a layman can understand the information.
VERIFIABILITY
Verifiability helps assure users that information
faithfully represents the economic events it purports to
represent.
Verifiability means that different knowledgeable and
independent observers could reach consensus (not
necessarily complete agreement) that a particular
depiction is a faithful representation.
COMPARABILITY
Comparability means that the accounting information can
be compared with inter-firm comparison(other firms) or
within the intra-firm comparison(our own firm) of a
certain period of time.
Accounting information of an enterprise is useful when it
is comparable with similar information for the same
enterprise in other periods of time and similar information
regarding other enterprises at the same time. Thus, the
information should be presented in a consistent manner
over time and consistent between entities to evolve users
to make significant comparisons.
The comparison helps in analyzing, interpreting, and
decision-making.
Example of Comparability: Compare our firm yearly
progress with the competitor’s firm. or Compare current
year profit with the last year profit.
COMPLETENESS:
Completeness means that all material information that is
necessary to investors, creditors or other users for
assessing the financial position and operating results of
the organization has been disclosed in the financial
statements.
TIMELINESS
The more quickly the information is communicated or
provided to the users, the more likely it is to influence
their decisions. Hence, accounting information should be
made available at appropriate time without delays for
prompt decision-making.
Generally, the older the information is, the less useful it
is. However, older financial information may
still be useful for identifying and assessing trends (for
example, growth in profits over a number of
years).
NEUTRALITY
Neutrality: Accounting information is neutral in the
sense that it should be free from bias and it should not
favor one group over another. Neutrality is significant
especially for the external users of accounting
information.
Circle the correct answer
1. The fundamental qualitative characteristic of
faithful Representation has the components of
a. Predictive value and confirmatory value.
b. Comparability, consistency, and confirmatory value.
c. Understandability, predictive value, and reliability.
d. Completeness, neutrality, and freedom from error.
2. 4. The area of accounting aimed at serving the
decision making needs of internal users is:
a. Financial accounting. c. Managerial accounting.
b. External auditing. d. Bookkeeping.
3 The primary objective of financial accounting is
to:
a. Serve the decision-making needs of internal users.
b. Provide accounting information that serves external
users.
c. Monitor and control company activities.
d. Provide information on both the costs and benefits of
looking after products and services.
4. Accounting is an information and measurement
system that does all of the following except:
a. Identifies business activities.
b. Records business activities.
c. Communicates business activities.
d Eliminates the need for interpreting financial data.
5. According to Statements of Financial Accounting
Concepts, neutrality is an ingredient of
Faithful representation Relevance
a. Yes Yes
b. Yes No
c. No Yes
d. No No
6. External users of accounting information include
all of the following except:
a. Shareholders. c. Customers.
b. Purchasing managers. d. Government regulators.
7. The enhancing qualitative characteristics of
financial reporting are
a. Relevance, reliability, and faithful representation.
b. Cost-benefit and materiality.
c. Comparability, verifiability, timeliness, and
understandability.
d. Completeness, neutrality, and freedom from error.
8. What is the main aim of accounting?
a. to produce a trial balance
b. to record every financial transaction individually
c. to maintain ledger accounts for every asset and liability
d. to provide financial information to users of such
information