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Unit 1: module1: content 1/a - The Development of accounting

The origins of accounting are attributed to Luca Pacioli an Italian Renaissance Mathematician. In
his 1494 text Summa de Arithematica, Geometria, Proportione et Proportionalite Pacioli
described a system to ensure that financial information was recorded efficiently and accurately.
The industrial age and the emergence of large corporations led to the separation of the owners
from the management of businesses and the need to ensure that managers acted in accordance
with owners wishes, coupled with the increasing complexity of business transaction it became
necessary to develop improved approaches for reporting financial information
In the information age with the development of communication technology investors on one side
of the globe were trading and investing with businesses on the other side of the globe
[globalization] - users of accounts needed to be sure that reliance can be placed on the methods
used by a business in calculating its profits and balance sheet values
Prior to 1933 each company’s management largely determined its financial reporting practices -
thus little uniformity in practice existed among firms. In the late 1960’s there was a general
uproar in financial pages of the national press against the failure of the accounting profession to
lay down consistent principles for businesses to follow. It was reported that the methods used by
the different businesses were showing vastly different profits on similar data.
In 1973 the international organization called International Accounting Standards Committee
(IASC) was established. Representatives from the UK, US and other countries sit on the
committee. The IASC issued accounting guidelines called IASs which are intended to be
internationally applicable. The need for the IASC is mainly due to the following:
 Growth in international investment which required similar methods the world over so that
investment decisions are more compatible.
 Growth in multinational firms which have to produce financial statements covering a
large number of countries thereby requiring standardization between countries makes the
accounting work easier, and reduces cost.
 Harmonization of accounting standards as many countries now have their own standard-
setting bodies.
 The need for accounting standards in countries that cannot afford a standard-setting body
of their own.
In order to ensure high-quality financial reporting, accountants present financial statements in
conformity with accounting standards that are issued by standard-setting bodies. Presently, there
are two primary accounting standard-setting bodies - the International Accounting Standards
Board (IASB) and the Financial Accounting Standards Board (FASB). More than 130
countries follow standards referred to as International Financial Reporting Standards (IFRS).
IFRSs are determined by the 1ASB, headquartered in London, with its 15 board members drawn
from around the world.
As markets become more global, it is desirable to increase comparability; to this end the two
standard-setting bodies have made efforts to reduce the differences between IFRS and U.S. GAAP.
As a result of these convergence efforts, it is likely that before long there will be a single set of
high-quality accounting standards that are used by companies around the world.
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Unit 1: module 1: content 1/b - The Nature and scope of financial accounting

The Significance and Limitation of Accounting Information

Limitations of accounting information

1. Accounting transactions are recorded at their original historical monetary cost (historical
cost accounting) – no adjusted is made for inflation.
2. The profit for the period is found by matching the income against the historical cost of
items consumed in generating the revenue
3. Financial statements contain numerous estimates, assumptions and subjective judgments
which are used in the measurement and reporting of business activity e.g. in determining the
provision for bad debt and depreciation. To the extent that the estimates are inaccurate the
financial statements are inaccurate
4. Companies select from various acceptable accounting practices when determining how well
an organization has performed over a period of time. Therefore there is a lack of precision.
E.g. a company may select one method for the valuation of inventory from a number of
acceptable alternatives.
5. Fiscal year end data may not be typical of the financial condition during the year.
Financial statements may therefore not be representative of the balances of the accounts
during the year
6. Diversification within a global environment also limits the usefulness of financial
statements. Many firms are so diversified they cannot be classified by a single industry.
7. Certain events are not conducive to monetary measurement and are not included in
financial statements e.g. the work of good management.

Advantages of historical cost accounting

1. Minimizes subjectivity i.e. records are based on verified by reference to the source
documents.
2. Cheap and simple to operate.
3. The profit concept is well understood. [income less expenses = profit]
4. Within limits historical cost figures provided a basis for comparison with the results of
other companies for the same period.
5. There is no acceptable alternative.
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Disadvantages of historical cost accounting

1. Overstates profit when prices are rising. As inflation pushes prices up the true cost of
using the asset increases yet depreciation is based on historical cost e.g. DSL Ltd purchases
an item of stock for $40 on January 5th 2007. It is sold on August 4th for $130. At the date
of sale the item has a cost of $90. Using HISTORICAL COST the profit would be
calculated as $130 - $40 = $90
This can be overcome by revaluing the asset to current cost and calculating depreciation
based on current cost.

2. It maintains financial capital but does not maintain physical capital e.g. an enterprise
starts of with $1 000 in capital and buys two machines with a life of ten years at a cost of
$500 each. All profits are distributed. At the end of ten years the company has no machines
and $1 000 cash. A new machine costs $800.

3. The balance sheet does not reflect the true value of the enterprise.

 Assets are disclosed at historical cost less depreciation rather than current value.
E.g. property purchased on High street for $100 000 ten years ago will be disclosed
at $100 000 less depreciation while the value may be currently $ 1m.
 Internally generated assets such as brands and goodwill are not disclosed in the
balance sheet.

4. Provides a poor basis for assessing performance – if profit is overstated and assets are
understated then ROCE is doubly distorted and exaggerated.

5. Fails to recognize the losses incurred by holding monetary assets while prices are rising
– purchasing power is decreasing.

6. Financial statements are backward looking and in our rapidly changing environment
provides no indication of what the future will be like and is therefore of limited use for
decision making purposes.
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Current cost accounting – concept

Current cost accounting uses “value to the business” as the measurement basis. Value to the
business is defined as:
a) Net current replacement cost or
b) Recoverable amount. Recoverable amount is the greater of net realisable value of an asset
and, where applicable, the amount recoverable from its further use.

Current cost accounting is based on the deprival method of valuation of assets.

 Inventory and non current assets are valued at deprival value.
 All other assets and all liabilities are monetary in nature and do not need to be adjusted.

Deprival value is the lower of:

Replacement cost Recoverable amount -

The amount it would the higher of NRV and
cost to acquire the economic value [the
items at the time of benefit to be obtained
sale or use from using the asset]

 The current cost accounting income statement therefore reflects the true cost of using
inventory and non current assets in the production of goods and services.
 When an item of inventory is sold the proceeds of the sale is matched against the current
cost of the inventory at the date of the sale to determine the profit

E.g. goods purchased for resale on January 1st 2006 for $250. On 31/03/06 the goods were sold
for$320, when the cost of replacing the goods was $272.

 The current cost accounting balance sheet reflects the current value of inventory and non
current assets i.e. the amount of compensation a company would require if it were deprived
of the asset.
 Depreciation is based on the year end replacement cost of the non current assets

E.g. a company purchased a non current asset on January 1st 2004 for $800. Estimated life was 5
years and residual value nil. A new but identical asset would cost $800 on 31/12/04 and $960 on
31/12/06.
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Unit 1: module 1: content 1/c - The users of accounting information and their needs

Users Needs
Owners/ To make decisions whether to invest in or disinvest in a particular business –
investors they need information concerning the risks and rewards associated with the
business.
Information concerning the financial position and performance to determine
whether managers have acted honestly, efficiently and in the owners best
interest.
Employees Concerns are job security and remuneration - Information concerning the
financial position and performance
Suppliers of Whether the business has enough cash resources to pay for goods and
goods and services supplied – concerned with the liquidity of the firm.
services The ability of the firm to honour and renew long term contracts - financial
position and performance may be required to assess the long term prospects
Lenders Short term lenders will be concerned with liquidity and the ability to make
repayments.
Long term lenders will be concerned with liquidity as well as long term
survival
Customers Information to satisfy them that the business is able to continue supplying
goods or services at the required rate especially where long term contracts
involving detailed negotiations and binding commitments are being undertaken
- financial position and performance
Government Profits for calculating taxation
Information relating to resources of the business and profits for deciding on the
provision of support, curb or to regulate a particular business or industry

Management For decision making, planning and control so as to ensure that resources are
used in the most efficient manner- information on the current and future
financial position of the enterprise.
Competitors For comparison with their own performance to assess their efficiency and
effectiveness
To obtain an insight into possible future strategy
Financial analyst Information to advise investors – financial position and performance
and advisers
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Unit 1: module 1: content 1/d - The accounting Cycle

9. Prepare 1.
a post Analyze
closing transaction
trial on source
balance documents

8. 2.
Journalize
Journalize
and post the
closing transaction
entries s

7. 3.
Prepare Post to
financial ledger
statements accounts

6. Prepare
4.
an
Prepare a
adjusted
trial
trial 5 balance
balance Journalize
and post
adjusting
entries
Adjusting entries are done to:
1. comply with the accruals concept
2. calculate the prepayments and accruals of income and expenses
3. ensure that expenses such as depreciation and provision for doubtful debts are calculated
and correctly accounted for
4. determine the figures to be transferred to the income statement and the figures to be
disclosed in the balance sheet
5. ensure that the correct balances are carried forward in the ledger account