Chapter 1:

Conceptual Basis of Accounting

Prof. N. Ramachandran

Prof. Ram Kumar Kakani

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Introduction
Accounting

Financial Accounting

Accounting Analysis

Used for Reporting

Providing Information for Planning and Control

Audience: Outside World (Government bodies, Societies, etc)

Audience: Internal (Managers and Investors)

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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Financial Accounting Evolution

Evidence of recording of economic transactions in ancient civilizations
Franciscan Monk Fra Luca Pacioli (14451515) as the father of modern accounting His Summa de Arithmetica, Geometria, Proportioni et Proportionalita, is considered as the first text on accounting

Pacioli structured and organized the initial accounting system based on the benefit and sacrifice principle

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Accountant as a Historian
Accountant can be perceived as a historian who keeps records As historian the accountant has the duty to:
Respect the facts To see the facts are accurate Bring into focus, all known and knowable relevant facts Finally, provide an interpretation of the history proposed

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Financial Accounting Evolution

Product of economic environment Gradually evolved as a profession with the development of economic activity especially Industrial Revolution Scope and nature of accounting is closely associated with the gradual changes in the field of organization and management of organizations In the modern IT era, accounting is getting integrated into software packages and constantly adapting itself

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Foundations of Accounting
Three basic ideas, which gained currency along with the growth in the economic activity, can be considered as the foundation of accounting system

Three Founding Ideas of Accounting

Capital Maintenance

Productive Capital

Profitable Operations
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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Capital Maintenance
The idea is to preserve and maintain resources used for generating wealth Implies the generation of wealth while keeping intact the resource used for such generation Income (during the year) = Capital at the end of the year Capital at the beginning If the above figure is negative, there is capital erosion Continuous capital erosion threatens business survival
Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited." 7

Productive Capital
Productive organization of modern industrial society is founded on the use of capital Wealth is used for generation of further wealth Accumulation and deployment of large-scale productive capital involves the problem of maintenance and preservation of such resources Consider the Oil Wells owned by the Oil Companies Would that be productive capital if it does not result in any revenue during a particular period? Throws up the important information function of the valuation of such resources.
Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited." 8

Profitable Operations
When productive capital is to be used on a large scale for economic activities, the idea of profit becomes the motive force This induces one to go in for future consumption in preference to present consumption Resources can be deployed for large number of alternative uses. There is an important criterion for making decisions in the exercise of choice This coupled with the idea of maintenance of capital makes the problem of measurement of profit crucial to accounting.
Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited." 9

Development of Accounting
Early medieval commerce was agency book-keeping for a specified venture Development of Joint Stock Companies Operating individuals were not the owners Investment Banking keeping records for inspection

Large scale manufacturing and service organizations creation of artificial juridical entities based on common stock of capital collected from large number of investors
Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited." 10

 Development of Accounting
Recording and summarizing of business related events and transactions for the purpose of financial reporting Two basic principles Form of the account the basic information formats Equilibrium of the complete set of accounts forms the foundation of the accounting system

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Accounting as a Measurement & Valuation System

Basic orientation of financial accounting is income determination
Oriented towards an entity- a business unit Tries to prescribe a series of concepts, standards, postulates and principles

Accounting theory as a doctrine is explanatory in nature and the underlying reasoning and justifications are related to practice
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Definition of accounting
Multiple definitions exist According to American Institute of Certified Public Accountants (AICPA)

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.

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Valuation in Accounting
Duality of Values Valuation in Accounting
Valuation could trace values through the entire Causal network of Networking transformations, among Values which forms the basis of all economic activity

Benefit and Sacrifice aspect of every economic transaction

Transformation of Values

Exchange of a utility differential to a monetary differential

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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Illustration Valuation of a Machine

Keshubhai, a cotton yarn manufacturer, purchased a machine paying cash Rs. 70,000. At which value do you record this transaction? Historical Cost

Current (Replacement) Cost

Net Realizable Value Present Value Due to its many advantages, historical cost is the most used in the field of accounting
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Four Types of Business Entities

Sole Proprietorship Partnership S R Batliboi & Company; Delhi Traders Partners Minimum: 2 No. of Shareholders Management Control Liability Legal Registration Flexibility One Person Maximum: 20 Partners Unlimited Voluntary Limited Liability Partnership Ai Jai Kai LLP; RP Associates LLP Partners Minimum: 2 Maximum: No Limit Designated Partners Limited Compulsory Company Garware Marine Limited; Amsar Private Limited Shareholders Minimum: 7 Maximum: No Limit Board of Directors Limited Compulsory Comparatively Less

Examples
Owner

M/s Prabhudas & Sons;Anil Pan Shop Sole Proprietor

Proprietor Unlimited No Provision Maximum

Depends on Partners Partners bring in the funds

Depends on Partners Partners bring in the funds

Source of Equity Funds

Proprietor brings in the funds

Shareholders brings in the funds

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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Basic Framework of Accounting

Concept refers to an idea, a general notion, thought or assumption. Standards are something established for use as a rule, intended to act as a basis of comparison and reference in measuring, quantity, and or quality and assigning value Postulates are assumptions; they are taken to be true or real

Principles refer to a law, the method or a rule of conduct.

Concepts Standards Postulates Principles
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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Generally Accepted Accounting Principles - GAAP

Combination of authoritative standards (set by policy boards) and the accepted ways of doing accounting Differs from country to country based on the accounting principles and standards adopted in that country Rules that business entities are expected to follow while preparing their financial statements

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Accounting Standards-setting Organization in Selected Countries

Country Australia Canada Policy Setting Board Australian Accounting Standards Board (AASB) sets GAAP Canadian Accounting Standards Board (CASB) of the Canada Institute of Chartered Accountants (CICA) sets GAAP in Canada Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAI) is the body entrusted with the work of preparing the standards.

India

U.K. U.S.A.

Accounting Standards Board (ASB) is comprised of nine members drawn from different user groups.
Financial Accounting Standards Board (FASB) is the body solely in charge of issuing standards.
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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Interpreting GAAP and Accounting Standards GAAP Accounting practices holding sway in a country. Country specific Accounting Standards Authoritative standards (set by policy boards) International standards exist

Indian GAAP is to be followed in the pecking order of: 1. 2. 3. 4. 5. Accounting Standards laid down by ICAI Statements issued by the ICAI. Guidance notes issued by the ICAI. Expert Advisory opinions issued by the ICAI Technical guides and monographs issued by the ICAI.
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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Conceptual Basis
Concepts are essential ideas that permit the identification and classification of phenomena or other ideas

A concept must state all that the given class includes and all that it excludes
Formed primarily by observation and established through agreement

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Basic concepts of accounting accepted as principles

Property Rights the right of accounting entities to possess and alienate property value Business Entity the entity is separate and distinct from the owners and the entity is liable to the owner Hence, in a limited liability company, the enterprise is liable to the owner (shareholder) based on the proportion of the capital investment (share capital) made by the latter
Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited." 22

Concepts
Going Concern entities have a life of infinite duration, unless facts are known that indicate otherwise the basis of valuation of resources is influenced more by their future utility to the business entity than by their current market valuation Money Measurement Representation in a common denominator and amenable to summarization by addition & subtraction

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Accounting Concepts
Matching Determining the profits after charging the expenses of a period with the revenues earned in the same period Realization Determines the point of time when revenue and hence returns (or profits) can be recognized objectively, unbiased, and with certainty Consistency Once a choice is made for the treatment of a transaction, the same is consistently followed
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Concepts
Diversity among Independent Entities There are wide variations in the organization and operations of entities requirements and demands are different Conservatism Anticipate no gains, but provide for all possible losses and if in doubt, write it off Results in an understatement of profits and values Close nexus with idea of capital maintenance

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Concepts
Dependability of Data
Accounting entities ensure the standard of internal controls to ensure that the data used as the basis of accounting records are controlled to ensure their quality

Materiality
Necessitated by practicability and feasibility

Timeliness
The idea of accounting periods is used so as to ensure regularity and timeliness of reporting
Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited." 26

Accounting Policies
Specific accounting principles and the methods of applying these principles for the preparation and presentation of financial statements of an enterprise based upon the accounting concepts followed by the enterprise Areas of applicability Valuation of Inventories, Fixed Assets, Investments Role of ICAI Guidance Notes

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Objectives of Accounting
Income determination For rational economic decision-making Financial reporting Summarized as all those things of value owned by the entity and all the claims against these possessions Disclosure All the relevant & pertinent information is supplied to the information users

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Purposes Of Accounting Information

Purposes of Accounting Information

Score Keeping

Attention Directing

Problem Solving

Reporting on the financial health

Signaling the user about the need to take a decision

Provision of such information that would enable to find solutions

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Accounting & Management Control

Control means the process of keeping the organization in course
This involves measurement through the control system The controller (accountant) and managers obtain information, which enables them to diagnose the situation

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Illustration on using Accounting Information

A firm sells three products P1, P2, P3. Profit of the firm is declining
Year 1 Year 2

Sales
Less: cost of goods sold Gross margin Less: Depreciation Other operating expenses Profit

Rs 1,000
400 600 200 100 Rs 300

Rs 1,000
500 500 200 100 Rs 200
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Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

Illustration
The Problem: Decrease in profits during the period - as a result of overall increase in the cost of goods sold Now, which product is losing money?
Year 1 P1 Sales Less: COGS 300 150 P2 300 150 P3 400 100 P1 400 200 Year 2 P2 400 200 P3 200 100

Gross margin

150

150

300

200

200

100

Sales of P3 have decreased. Cost of sales to sales of P3 has doubled

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited." 32

Accounting Information users

Stakeholders are the ones who have an interest in what happens as a result of the entities activities Stakeholders classified as Internal users viz., managers External users viz., creditors, equity investors, government, and society

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Class Discussion
Stakeholder Government Unions & staff Area of interest Tax liabilities of the firm Potential for pay awards and bonus deals

Public/Society Lenders Shareholders Customers

Ethical & environmental activities of the firm Whether the firm is has a long-term future Profitability and share performance Ability of the firm to carry on providing a service or producing a product

Note: These should not be regarded as the 'only' answers

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BHEL and its Stakeholders

Stakeholder Would be interested due to

Government & its agencies

Top Managers, Workers, Unions Public

Income tax & other tax liabilities

Potential for pay hikes, bonus, and incentives Ethical and environmental activities

Long-term Lenders, Present & Potential Shareholders

Fund managers & Analysts Customer Supplier & Other Creditors

Whether the firm has a long-term future

Profitability & share performance Ability to take a bigger order, etc Whether to offer the firm credit and if so, terms

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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IASB and Need for IFRS

During the last couple of decades, efforts to make accounting information more useful have increased Leading to the creation of IASB i.e., International Accounting Standards Board a body consisting of members from many countries. The IASB proposed a convergence concept with a hope that similar economic transactions should result in similar accounting approach (across different jurisdictions) Leading to a series of standards, known as, the International Financial Reporting Standards (IFRS)

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Branches of Accounting
Accounting

Government Accounting

Enterprise Accounting

Social Accounting

Financial Accounting

Management Accounting

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Enterprise Accounting
Specifically addresses issues of measurement and valuation in the context of business enterprises Has evolved into two disciplines Financial Accounting Providing financial information relating to the entity to outsiders Management/Cost Accounting Reporting the activities of the entity to managers so as to enable them to plan and control the activities of the entity vis--vis other competing entities

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Organizational Structure vis--vis Role of Accounting

CEO EXTERNAL AUDIT

CFO

Finance Officer Clerk 1

Accounts Officer 1 Clerk 2 INTERNAL AUDIT

Accounts Officer 2 Clerk 3

Financial Accounting for Management, 3/e by Ramachandran & Kakani Copyright 2011, by Tata McGraw Hill Education Private Limited."

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Thank You

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