12 Chapter 1 Accounting, Markets, and Governance

Understanding Business Organizations

Learning Objective Peter Drucker, the great management philosopher, said: "With respect to the definition
Understand the of business purpose and business mission, there is only one focus, one starting point .
• • working of business It is the customer. The customer delivers the business." Business organizations bring
organizations. together materials, technology, people, and money in order to satisfy their customers'
needs and thereby seek to earn a profit.
Business organizations provide products and services. They convert inputs into
outputs by applying processes. The conventional view is that a product has form
and substance and the seller transfers it physically to the buyer. Soaps, pens, cars,
computers, and medicines are examples of products that we use in our everyday life.
Merchandising (or trading) organizations such as Pantaloons, Wal-Mart, and
Amazon.com buy and sell products; they do not make them. These organizations
connect producers with consumers. Manufacturing organizations make products
that vary greatly in complexity: Amul makes butter and cheese; Sony's equipment have
intricate electronics; Boeing aircraft requires complex engineering.
Services are work done by one person that benefits another. Unlike products,
services do not have form or substance. The recipient of a service can experience
it personally but cannot transfer it to another person. Repairing cars, hairstyling,
writing computer programs, performing cardiac surgery, providing legal advice,
managing hotels, and transporting passengers are familiar examples of services.
Service organizations such as the State Bank of India, Goldman Sachs, and Lakme
Beauty Salon provide professional or personal services. Increasingly, the line between
products and services is disappearing. Is the iPod, the iPad, or the Sony PlayStation a
product or service? These would seem to be more of a service packaged as a product.
A significant portion of the cost of a car - commonly considered a product - is the
cost of embedded software that controls fuel mix, brakes and air conditioning.

HANDHOLD 1.1 Business organizations provide goods and services ranging from toothpaste to fly-by-wire aircraft.
Business Organizations Consider the following examples to get a sense of how business organizations affect our lives.
Amazon Internet retail
Amul Dairy products
Apollo Hospitals Health care
Apple Computers Computing, communication, and entertainment
Boeing Civilian and military aircraft
Cipla Medicines
Deloitte Accounting, auditing, and business advice
Facebook Internet social networking
Google Internet search and advertising
HDFC Bank Banking and financial services
Hindustan Unilever Toothpaste, soaps, and detergents
Infosys Software products and services
Larsen & Toubro Designing and building roads and flyovers
Mahindra & Mahindra Automobiles
ONGC Exploring and extracting petroleum
Zynga Online games

Business organizations perform complex operations. Yet, in essence they are cash
generating-cum-dispensing machines: they receive cash from customers for providing
goods and services and pay suppliers for materials, equipment, labour, electricity and
transportation. To illustrate this idea, let us think of a biotechnology firm - Nzyme
Company - thit produces fermentation agents for food and beverages. It hires buildings
and equipment and employs scientists and other professionals. The company receives
cash from its customers in three ways: (a) for sales made in the past collected in the
 Understanding Business Organizations 13

current period, (b) for sales made in the current period; and (c) for sales to be made
in the future for which it receives advance payments from its customers. The company
pays its scientists and other employees salaries and other benefits and its suppliers for
materials, office and factory space, electricity, and laboratory equipment and supplies.
It pays income tax and other taxes to the government. It distributes a part of the
surplus cash to its owners in the form of dividends. Figure 1.1 presents the activities
of this business. As you can imagine, business operations are far more involved. We
will add more details as we proceed.

Cash Receipts Cash Payments

Employees
Salaries, Benefits

Customers Lenders
Current Sales Principal, Interest

Figure 1.1
THE BUSINESS
ORGANIZATION AS A CASH
MACHINE

Businessorganizations
are cash generating-cum-

.. dispensing machines, often

with leads and lags in
receiving and paying cash.

Describe the business of the following organizations:

TEST YOUR
(a) Ikea
UNDERSTANDING 1.1
Business Organizations
(b) WhatsApp Inc.
(c) eBay
(d) Nike
(e) LVMH
(n Samsung
(g) Hitachi
(h) Vodafone
14 Chapter 1 Accounting, Markets, and Governance

FINANCIAL VIEW
Is Business Simple?
Business is in some ways quite simple; it has clearly defined aims. The aim is to make money. So you have a
measure against which to judge all the subsidiary actions which add up to the overall result.
These words are from The Power of Yes, a play by Sir David Hare, the well-known British dramatist. The play
was running to full house in 2010 in London's National Theatre. It was described variously as "banker bashing",
"an exhilarating lecture on the banking crisis", and "asks questions to which we all want to know the answers".
How right is Sir David's comment?
Anyone who has either run a business or observed one closely would know that business is far from simple.
Even a small business - something seemingly as straightforward as selling vegetables from a pushcart - requires
complex operations such as selecting suppliers, identifying customers, skilfully bargaining with both, forecasting
demand, ensuring quality in purchases, managing a couple of assistants, collecting cash from some customers even
while attending to other customers, paying suppliers, dealing with competition, managing the municipal authorities
and the police, and coping with a crippling cash crisis all the time.
Again, the idea that business is just about making money is naive. Recall Peter Drucker's words: The customer
delivers the business. While profit is necessary to reward risk and pay for innovation, it is not an end in itself. If a
business pursues profit mindlessly by sacrificing quality and safety, it will disappear soon. Also, similar to many other
human endeavours, business works on shared interest, rather than self-interest. Patients keep their illnesses under
control by taking drugs, and pharmaceutical firms benefit from selling drugs. Both benefit. Many profitable business
enterprises create jobs, pay taxes, and support the wider community. Loss-making firms are a burden on society.
Business enterprises sustain themselves by building and nurturing trust. Investors, customers, suppliers and
employees will not accept a firm that has breached their trust, and the business has to fold up. A firm that sells
unsafe drugs, toys or cars will look on helplessly as its sales drop, stock prices crash, employees leave, and
product liability claims pile up. Selling snake oil is not a sustainable business.
If anything, the financial crisis, the subject of The Power of Yes, underscores the position that business is
neither 'simple' nor is its only aim 'to make money'. If it were that clear-cut, Bear Stearns and Lehman Brothers
would not have evaporated.
Interestingly, in 2010 National Theatre's website listed among its 'Partners', 'Sponsors' and 'Platinum Members'
firms such as Travelex, Accenture, Bank of America, Merrill Lynch, Morgan Stanley, Philips, American Express,
British American Tobacco, GlaxoSmithKline, and Goldman Sachs. Theatre needs the support of business, even
to bash it, it appears.
Do a small experiment to find out whether business is simple: Try to sell something, anything, to someone
you don't know.

(What is Accounting )
~----------
Learning Objective Accounting is one of the fastest-growing professions and ranks among the most popular
Define accounting
fields of study in colleges, universities, and business schools. It offers interesting,
• and explain its role
challenging, and rewarding careers. Business enterprises, government agencies,
in making economic
.fI« charities, and individuals need information to make sound decisions. The accounting
and business
decisions.
system provides relevant and reliable financial information to interested parties.
Accounting is often called the language of business. The function of a language
-is to facilitate communication among individuals in a society. Accounting is the
common language used to communicate financial information in the world of business.
Clearly, individuals who aspire to be professional accountants should be experts in
accounting. Many others, such as investors, managers, employees, civil servants, police
investigators, lawyers, judges, and regulators, have to constantly deal with business
organizations. All of them should have good knowledge of accounting terms, principles
and techniques.
Here are some typical responses of MBA students on why they think they need
to study accounting (besides the predictable one, "Accounting is in the curriculum, so
I have no choice."):
• "Since a company's financial statements affect stock prices, a manager should know
accounting."
• "Accounting will help me in understanding what the accountant is trying to say."
• "The accsamtant is good at numbers and, as a manager, I have to be good at
interpreting the numbers."
• "I want to be an investment banker. Accounting information will help me to value
firms."
 What is Accounting 15

• "I would like to learn about indicators that would help me evaluate the financial
health of a business."
• "A manager has to analyze financial reports and make critical business decisions
based on them."
• "Start-up entrepreneurs should know financial accounting, so that they can manage
the accounting and finance function of their business."
• "With a consulting career in mind, I am interested in finding out how to use the
financial statements to evaluate the performance of business enterprises."
• "The law requires the chief executive officer (CEO), along with the chief financial
officer (CFO), to certify the financial statements. At the least, the CEO should know
the meaning of the various items appearing in the statements."
Managers have a responsibility to provide truthful, relevant and timely information.
The MBA Oath initiated by the students of Harvard Business School has this to say
on reporting:
I will report the performance and risks of my enterprise accurately and honestly.

After what happened in the technology bubble of the 1990s and the global
financial crisis in 2008, managers need to reassure everyone that their enterprises'
financial reports are trustworthy. For this, they should have a sound understanding
of financial statements.
Accounting provides "information that is useful in making business and economic
decisions - for making reasoned choices among alternative uses of scarce resources
in the conduct of business and economic activities."! It is a principal means of
communicating financial information to owners, lenders, managers, and any others
who have an interest in an enterprise. Accounting is not an end in itself. Indeed, this
book presents accounting as an information development and communication function
that supports economic decision-making.

The Accounting Information System

An oft-quoted publication of the American Accounting Association states, "essentially,
accounting is an information system.,,2 A system converts inputs into outputs using
processes. The accounting system processes business transactions to provide information
to various interested parties. There are external and internal users of the information
thus produced. The external users are those who are outside the firm and include
investors and lenders. Managing directors, marketing managers, production managers,
materials managers, human resource managers, and financial controllers are examples
of the internal users of accounting information. Figure 1.2 depicts the accounting
information system .
• .<0

Accounting Information and Economic Decisions

Accounting information is useful in making a number of decisions that affect the income
or wealth of individuals and organizations. Accounting reports are designed to meet
the common information needs of most decision-makers. Examples of decisions that
are based on accounting information include the followingr'

1 Statement of Financial Accounting Concepts No.1, Objectives of Financial Reporting by

Business Enterprises, Financial Accounting Standards Board, 1978.
2 A Statement of Basic Accounting Theory (Sarasota, Florida: American Accounting Association,
1966), p. 64. Professors John A. Christensen and Joel S. Demski provide an analytical study of
accounting as an information system in Accounting Theory: An Information Content Perspective,
New York: 1rwinlMcGraw-Hill,-t003.
3 The Conceptual Framework for Financial Reporting, International Accounting Standards Board,
September 2010.
16 Chapter 1 Accounting, Markets, and Governance

Figure 1.2
THE ACCOUNTING
INFORMATION SYSTEM
The accounting
information system
produces financial
statements and
reports for investors,
lenders, managers, and
others by processing
transactions and events
applying accounting
principles and standards
and legal requirements.

(a) Decide when to buy, hold or sell an equity investment.

(b) Assess the stewardship or accountability of management.
(c) Assess the ability of the enterprise to pay and provide other benefits to its
employees.
(d) Assess the security for amounts lent to the enterprise.
(e) Determine taxation policies.
(f) Determine distributable profits and dividends.
(g) Prepare and use national income statistics.
s; (h) Regulate the activities of enterprises.
The information given in a language can be useful only to persons who understand
that language. For example, if a restaurant's menu is in Italian, a customer should
-'know enough Italian to be able to make sense of the items and their ingredients. In
the same way, a decision-maker who intends to use accounting information should have
a fair understanding of business and economic activities and be willing to study the
information with reasonable diligence. Decision-makers should know the intricacies of
accounting; it is an indispensable part of their toolkit.

Cu~_se_r_s_o_f__ A_C_c_o_u_n_t_in_g
__ l_n_fo
__rm__ a_t'_lo_n )
Learning Objective Investors and lenders are the most obvious users of accounting information. Other users
Identify the major include analysts, advisers, managers, employees, trade unions, suppliers, customers,
• • users of accounting governments, regulatory agencies, and the public. Business enterprises and managers
information.
increasingly emphasize the interests of co-workers, customers and the society in which
they operate and the need to create sustainable economic, social, and environmental
prosperity wOI'<fdwide.It is further evidence of the broader constituency for financial
reporting.
 Users of Accounting Information 17

Investors
Investors are the major recipients of the financial statements of business enterprises.
They may be retail investors with small shareholdings or large mutual funds, hedge
funds or private equity firms. As chief providers of risk capital, investors are keen
to understand both the profit from their investments and the associated risk, i.e. the
likelihood of loss or low profit.
Accounting information enables investors to identify promising investment
opportunities. Investors need information to decide which investments to buy, retain,
or sell, as well as the timing of the purchases or sales of those investments. They also
require information to monitor management performance and to assess the ability of
the enterprise to pay dividends. In recent years, investors have started questioning
executive compensation in light of the performance reported in the financial statements.
For example, in 2012, the shareholders of WPP, an advertising company, rebuked their
top management for asking for outsize pay when the company's performance was not
considered outstanding.
While present investors have a legal right to receive periodic financial reports,
potential investors too are interested in financial information. Private equity funds
are on the lookout for investing in ailing businesses that they can restructure and
sell at a substantial profit. Hedge funds use accounting and other information to earn
high profits. Activist investors seek to force managers to act in the interests of
shareholders.

Lenders
Lenders such as banks and debentureholders want to know about the financial stability
of a business that approaches them for funds. They are interested in information that
would enable them to determine whether their borrowers will be able to repay the
loans and pay the related interest on time.
Banks use credit evaluation benchmarks based on information derived from financial
statements when deciding on the amount of the loan, interest rate, repayment period,
and security. They also use the information for monitoring the financial condition of
borrowers. Thus, many lenders stipulate dos and don'ts, or covenants, for borrowers
that often require the use of accounting information. For example, a loan agreement
may impose an upper limit on a borrower's total debt from all sources or compel the
borrower to keep a minimum level of cash. If a borrower fails to comply with the
stipulations, the lender may raise the interest rate, ask for additional security, and
even demand repayment of the loan.

Many students take education loans. Deciding on student loan applications can be tricky. The education DECISION-MAKING
loan market is highly competitive and students have many banks to choose from. What Information does
The bank officer needs relevant information in order to decide on a loan request. She must decide the Bank Manager
quickly whether to accept or reject a loan application. If she asks for a lot of information or lays down Need for Deciding on
difficult dos and don'ts, she will displease customers who may go to another bank. On the contrary, if Loans?
she accepts loan requests based on insufficient information or lays down lax conditions, she will face
a higher risk of customers defaulting on loan repayment. Unfortunately for the officer, the bank expects
her to both increase the amount of student loan business and minimize the risk of loan default. So, she
must ask the student for minimum relevant information, stipulate reasonable conditions, and process the
loan application expeditiously.
Imagine that you are a bank officer dealing with student loan requests. Your challenge is to come up
with a suitable list of information items, documents and covenants.

Analysts and Advisers

..If
Investors and creditors seek the assistance of information specialists in assessing
prospective returns. Equity analysts, bond analysts, stockbrokers, and credit rating
18 Chapter 1 Accounting, Markets, and Governance

agencies offer a wide array of information services. These information specialists serve
the needs of investors by providing them with skilled analyses and interpretation of
financial reports. Equity analysts collect information about firms also through other
means such as face-to-face meetings and conference calls with company executives
and field visits. Sell-side analysts work for brokerages, banks and research firms who
use their reports to recommend to their clients whether to buy, sell or hold certain
investments. In contrast, buy-side analysts are employed in mutual funds and other
investment firms ad produce research reports for in-house use by their employers.
Proxy advisory firms recommend to shareholders whether they should support or
oppose resolutions proposed by the board of directors.

Managers
Managers both produce financial information for use by others and use it in many
of their decisions. They need information for planning and controlling operations,
for making special decisions, and for formulating major plans and policies. Some of
this information is available from the accounting system which they use to evaluate
potential investment projects. Since managers are responsible for reporting enterprise
performance to owners and others, they monitor the key financial indicators that
appear in the financial reports. Besides, they compare their firm's performance with
that of their competitors. Sometimes, the managers of a business may be interested in
acquiring other firms. Increasingly, managers receive a commission or bonus related to
profit or other accounting measures, and they have a natural interest in understanding
how those numbers are computed.

FINANCIAL VIEW Some companies appear to be responding to shareholder and employee outrage over excessive executive
Pay and Performance remuneration. They try to justify pay increase by underscoring the performance of the managers. For example,
a news report on Polaris Software had the following to say on the significant increase in top management
remuneration:
A good financial performance by Polaris Software Labs has led to higher salaries and perks for its Chairman
and Chief Executive Officer, Mr. Arun Jain, for 2008--09. In 2008-09, Mr. Jain took home ~11.8 million as salary,
perquisites and allowances, including ~5.30 million as bonus, which is calculated on performance criteria. This
was possible with the company reporting a consolidated net profit of ~1,300 million on revenues of ~13,770 million
during the year, according to the 2008-09 annual report. In comparison, in 2007-08, Mr. Jain's salary declined
to ~8.53 million, including a bonus of ~2 million. This was due to a decline in the net profit to ~730 million (from
~1,010 million) on revenues of ~10,990 million (from ~10,320 million). Mr. Arup Gupta, Chief Operating Officer,
Polaris, took home ~10.8 million in 2008-09. This includes n08 million as performance-driven pay.
Explaining a 38 per cent increase in the CEO's remuneration was all the more important in the context of
the widespread trend of freeze on hiring and increment and even lay-off of some employees in the information
technology industry in India in 2008 and 2009 .
.,.
Source: T.E. Raja Simhan, Polaris CEO takes home higher pay, Business Line, June 29, 2009.

Further, when faced with a hostile takeover attempt, managers communicate

additional firm-related financial information with a view to boosting the firm's stock
price. As you can imagine, managerial motives in financial reporting can vary depending
on the context of the business, and can conflict with those of investors and other users
of financial statements.

Employees and Trade Unions

Employees are keen to know about their employer's general operations, stability and
profitability. Current employees have a natural interest in the financial condition of
the enterprise because their jobs and salaries depend on the financial performance
of the firm.-iA noteworthy instance is the strong support from the Railway employee
 Users of Accounting Information 19

unions to the 2012 Railway Budget proposal to raise passenger fares to restore the
financial performance of the Indian Railways." Potential employees may use financial
information in order to gauge the enterprise's prospects. Past employees, who depend
on their former employer for their post-retirement benefits, such as pensions and
health care, have a continuing interest in the enterprise's performance and prospects.
Trade unions use financial reports for negotiating enhancements in wages, bonus and
other benefits.

Suppliers and Trade Financiers

Suppliers regard the enterprise as an outlet for their products or services. They use
financial information to assess the likelihood of the enterprise continuing to buy
from them, especially if it is a major customer. Suppliers plan their production and
capacity expansion on the basis of the expected demand from their customers. Trade
financiers provide short.-term financial support. Both suppliers and trade financiers
want information that enables them to determine whether the enterprise will pay
them on the dot. While lenders take a long-term view, suppliers and trade financiers
usually focus on the enterprise's near-term financial condition.

Customers
Present, prospective and past customers use information about the financial affairs of
an enterprise in deciding whether and how much business to do with it. Customers
would like to be certain that they can count on their suppliers for future purchases
and after-sales support. This is"particularly important for products and services that
are proprietary. For example, car owners depend on the manufacturer for warranty
repairs and continued supply of spare parts. The users of a computer software look to
the software firm for periodic upgrade of the product. When an airline keeps incurring
losses, customers become anxious about higher ticket prices, flight cancellations,
mileage points accumulated under frequent flyer programmes and even aircraft safety.
When Sat yam Computer Services was hit by an accounting scandal, some of its
important clients were concerned and began to review their contracts and look at
other suppliers. Insurance policyholders need confidence that their insurer will have
the financial resources to pay their claims. In all these cases, the supplier's financial
reports can be useful to the customers. At the same time, when suppliers make large
profits; customers may suspect that they are being overcharged. For example, if your
mobile phone company makes huge profits, you would like the company to cut call
charges. Sometimes companies have to respond to customers' perceptions of profiteering
by behaving in..•
morally acceptable ways. In 2012 Starbucks, the coffee shop, offered to
pay the UK government $16 million more in income tax than what was legally payable
because its customers were furious about how little tax the firm paid in their country.

Government and Regulatory Authorities

The three levels of government in India - Central, state and local - allocate resources
and are concerned with the activities of enterprises. They require information in
order to regulate the business practices of enterprises, determine taxation policies,
investigate crime, and provide a basis for national income and similar statistics.
The Ministry of Corporate Affairs (MCA) is among those in the Government of
India that take a keen interest in the financial affairs of business enterprises. The
Serious Fraud Investigation Office (SFIO) attached to the MCA investigates corporate
.It
"Railmen threaten agitation against any rollback of fare hike, The Hindu, March 18, 2012.
20 Chapter 1 Accounting, Markets, and Governance

fraud. The Ministry of Finance is concerned with tax administration and the working
of the economy. A number of regulatory agencies are government or quasi-government
bodies, such as the Securities and Exchange Board of India (SEBI), the Reserve Bank of
India (RBI), the Insurance Regulatory and Development Authority (IRDA), the Telecom
Regulatory Authority of India (TRAI), and the Competition Commission of India (CCl).
These agencies use financial reports in order to identify abuses and violations and to
protect the interests of investors and consumers. SEBI stipulates extensive disclosures
in the financial statements and offer documents. IRDA requires life and non-life
insurance companies to provide public disclosures of accounting practices, valuation
of investments, and pension and post-retirement obligations, so that policyholders and
investors can understand the financial health of their insurer. Others such as stock
exchanges have a legitimate interest in financial reports of publicly held enterprises
to ensure efficient operation of capital markets.

IN PRACTICE The principal mandate of the Competition Commission of India (CCI) is "to prevent practices
Profiting from having adverse effect on competition, to promote and sustain competition in markets, to protect the
Cartelization interests of consumers and to ensure freedom of trade carried on by other participants in markets, in

•• India."
In June 2012, the CCI fined 11 cement manufacturers a total of ~63 billion for collusive price-fixing

.'@); and thereby earning abnormal profits. The fine was one-half of the net profits of the manufacturers
in 2009-10 and 2010-11, the periods for which the inquiry was conducted. The CCI used profitability
measures such as return on capital employed (RaCE) and operating profit margin (OPM). The cement
manufacturers have appealed against the CCI's order.
Source: CCI website and various newspaper reports.

The Public
The activities of business enterprises affect the members of the public in a variety of
ways. For example, businesses employ people from the local community and patronize
local suppliers; so the prosperity of the local community depends on their success.
It is said that, whenever the software industry slows down, business in upmarket
restaurants and pubs in Bangalore falls. Financial statements assist the public by
providing information about the trends and recent developments in the prosperity
of the enterprise and the range of its activities. Political parties, public affairs
groups, consumer groups, newspapers and magazines, television channels, anti-
globalization and anti-business activists, and environment protection groups have a
general interest in the affairs of business enterprises. The nature and extent of their
interest often vary considerably. They use the information in the financial statements
." to put forward their point of view. For example, when there was a blowout in the
Deep Horizon well in the Gulf of Mexico in 2010, the profits of BP and other large
oil companies came under public scrutiny. Extractive industries such as oil, gas and
mining are frequent targets of attack on the basis of their profits that activist groups
argue are ill-gotten. Of course, investment banks are always under attack for a variety
of reasons.
Exhibit 1.1 summarizes the major users of accounting information and some typical
questions for which they look for answers in accounting reports. Whether someone
is a legitimate user of accounting information differs from one country to another.
For example, in the US and the UK, financial statements are meant primarily for
shareholders and lenders. But countries in Continental Europe, such as Germany,
France and Sweden, explicitly recognize employees and trade unions as having a stake
in financial reports.
-;,
Users of Accounting Information 21

Investors, lenders and many others use accounting information to make important economic decisions. EXHIBIT 1.1
Users of Accounting
Users Examples Queries/Concerns Information
Investors, analysts, Retail investors • Should I buy, hold or sell the company's shares?
advisers Mutual funds, private equity funds, • Will the investment yield good dividends regularly?
hedge funds • Is the enterprise in which I have invested, or
Equity analysts and bond analysts thinking of investing, performing well?
Credit rating agencies • Are there governance problems in the company?
Investment banks • Are the shares a good medium- to long-term
Shareholder activists investment?
Proxy advisory firms
Lenders Banks • Can my borrower pay the principal and interest on
Bank depositors time?
Debentureholders • What should be the security and interest rate for
Leasing companies a loan? .
Managers Chief executive officers • How is my business performing relative to my
Chief finance officers competitors?
Marketing managers • Which projects should I invest in?
Production managers • Do the financial reports communicate my firm's
Profit centre heads true value?
• Will it be profitable for me to buyout my
business?
Employees, trade unions Factory and office workers • How much increase in wages and bonus can my
Trade unions employer afford?
Trade union federations • Can my employer continue to be in business?
• Can my employer honour its future obligations for
pension, health and other post-retirement benefits?
Suppliers, trade Suppliers of materials, services and • Will my customer be a major source of business?
financiers utilities • Can my customer pay for its purchases on time?
Short-term financiers • Can my borrower repay on time?
Customers Present, past and prospective • Is my supplier a reliable and competitive source?
customers • Can I count on my supplier to provide spare parts
for equipment?
• Does my supplier have the financial resources to
honour its warranty obligations?
Governmint, regulatory Income tax officers • Is a business evading income tax, excise duty,
authorities Excise and service tax officers service tax, sales tax or other government levies?
Commercial tax officers • Should the government subsidize an industry,
Ministry of Finance increase taxes, or give it protection from dumping?
Ministry of Corporate Affairs • Does a bank follow prudent financial norms?
Securities and Exchange Board of • Does a business make required disclosures of its
India financial affairs?
Reserve Bank of India • Does a business make abnormal profits by stifling
Competition Commission of India competition in its industry?
Stock exchanges • Does an insurance company follow prudential
Insurance Regulatory and norms?
Development Authority
The public Local community • Does a business exploit local suppliers, small
Political parties businesses or labour?
Public affairs groups • Does a business earn profits by compromising on
Consumer groups product safety or damaging the environment?
Environmental activists • Is a business abusing its monopoly by
.It overcharging its customers?
22 Chapter 1 Accounting, Markets, and Governance

TEST YOUR Excerpts from the earnings release of Infosys for the quarter ended September 30, 2013 appear
below:
UNDERSTANDING 1.2
Analyst Questions Financial Highlights:
Consolidated results under International Financial Reporting Standards (IFRS) for the quarter ended
September 30, 2013.
Revenues were ~129.65 billion for the quarter ended September 30, 2013; Quarter on
quarter (QoQ) growth was 15.1%; Year on year (YoY) growth was 31.5%
Net profit was ~240.70 billion for the quarter ended September 30, 2013; QoQ growth
was 1.4%; YoY growth 1.6%
was
Earnings per share (EPS) was ~42.12 for the quarter ended September 30, 2013; QaQ
growth was 1.4%; YoY growth was 1.6%
EPS for the quarter is ~45.96 per share, excluding the provision of ~2.19 billion for visa
related matters. EPS for the quarter is ~42.12 per share, including the provision of ~2.19
billion for visa related matters. The difference is n.84 per share.
liquid assets including cash and cash equivalents, available-for-sale financial assets, and
government bonds were ~269.07 billion as on September 30, 2013 versus ~240.78 billion
as on June 30, 2013
Other highlights:
Infosys and its subsidiaries added 68 clients during the quarter
Gross addition of 12,168 employees (net addition of 2,964) for the quarter by Infosys and
its subsidiaries
160,227 employees as on September 30, 2013 for Infosys and its subsidiaries
Decjored an interim dividend of ~20 per share. The record date for the payment of dividend
is October 18, 2013
As an analyst following the technology sector, what questions would you have for Infosys?

(Financial and Management Accounting )

-. -----=--------=-------~

Learning Objective The accounting system provides information to persons inside and outside the
Distinguish enterprise. Financial accounting is the preparation and communication of financial
• .' between financial information for use primarily by those outside the enterprise. Its chief purpose is
and management to provide information about the performance of the enterprise's management to its
accounting. owners. Management accounting is the preparation and communication of financial
iA
and other information to the management, which helps it carry out its responsibilities
in planning and controlling operations. Management accounting information is more

.. detailed and timely than what is available to external users .

(Accounting Measurement Assumptions )

-. -----=---------~

.
The purpose of accounting is to measure and communicate an enterprise's economic
Learning Objective
Discuss the activities. Numerous events affect a business. Examples include receiving cash from
. customers, paying income tax, using office supplies, and buying equipment on credit.
• assumptions
underlying Business transactions are events that result in the transfer or exchange of value
accounting between two or more parties, e.g. buying goods, collecting cash, and repaying a loan.
measurement and Transactions may involve monetary exchanges, such as buying a computer for cash, or
explain their non-monetary exchanges such as swapping a building for a piece of land. Also, there
significance.
may be one-way transfers, e.g. donations and thefts. Certain external events do not
involve a transfer or exchange, for example, a flood or an earthquake. Accounting also
records internal events such as consumption of materials and use of equipment, which
take place within the enterprise.
Accounting measures events only if they affect the financial position of the
enterprise. As a result, important events affecting a business, such as the launching
42 Chapter 1 Accounting, Markets, and Governance

(Financial Statements )
~. ---------~
Learning Objective Financial statements provide information about an enterprise's financial performance
Describe the five and financial position. Financial statements present the financial effects of transactions
•
• • major financial and other events by grouping them into broad classes, or elements. Revenues and
statements and
expenses are the elements related to the measurement of performance; assets, liabilities,
explain how they
and equity are the elements related to the measurement of financial position. A
are interrelated.
complete set of financial statements normally consists of the statement of profit and
loss, statement of retained earnings, balance sheet, cash flow statement, statement of
changes in equity, and explanatory notes. Financial statements are a central feature
of accounting because they are the principal means of communicating accounting
information to those outside an enterprise. Business enterprises publish five major
financial statements:
1. The statement of profit and loss reports the financial performance of an
enterprise during a period.
2. The statement of retained earnings explains what the enterprise did with its
earnings, i.e. how much it distributed and how much it retained.
3. The balance sheet shows the financial position of the enterprise at a point in
time.
4. The cash flow statement summarizes the cash inflows and outflows of the
enterprise resulting from its operating, investing, and financing activities
during a period.
5. The statement of changes in equity explains how equity changed as a result of
net profit, dividends, return of capital and other transactions.
Exhibit 1.4 shows Softomation's financial statements.
We now briefly analyze these statements.

Statement of Profit and Loss

The statement of profit and loss (or profit and loss account or income statement)
summarizes the activities of an enterprise in a period by disclosing the revenues
earned and the expenses incurred. By measuring the net profit earned by a business,
it indicates its degree of operating success. From Exhibit 1.4, we note that in March
20XX Softomation earned a revenue of ~20,OOOfrom services, and incurred expenses
totalling ~5,200, consisting of salaries expense of ~4,OOOand rent expense of ~1,200.
Thus, it reported a net profit of~14,800 for the period. You might have noticed that the
statement of profit and loss is a summary of the revenues and expenses that appear
..• in the 'Equity' column in Exhibit 1.3. We note that Softomation's revenues are from
its business activities.
What do you think of Softomation's performance?

EXHIBIT 1.4 There is no specific format for the financial statements of proprietorship and partnership enterprises.

Financial Statements
SOFTOMATION
Statement of Profit and Loss
For the month ended March 31, 20XX

Revenues
Revenue from services . ~20,OOO
Expenses
Salaries expense .
Rent expense .

Net profit .
 Financial Statements 43

SOFTOMATION
Statement of Retained Earnings
For the month ended March 31, 20XX

Beginning balance . ~ 0
Add Net profit . 14,800
Available for distribution . 14,800
Deduct Drawings . 3,500
Ending balance . 11,300

. SOFTOMATION
Balance Sheet, March 31, 20XX

Assets
Cash. . . ~ 3,300
Trade receivables . . 8,000
Supplies ~ . 6,000
Equipment . 58,000
85,300
Liabilities
Trade payables . ~24,000
Equity
Capital, Suresh . 50,000
Retained earnings............................... . . 11,300
61,300
85,300

. SOFTOMATION
Cash Flow Statement
For the month ended March 31, 20XX .

Cash flows from operating activities

Cash received from customers . ~ 12,000
Cash paid to suppliers and employees . (7,200)
Net cash provided by operating activities ~ 4,800
Cash flows from investing activities
Purchase of equipment. . (58,000)
Net cash used in investing activities . (58,000)
Cash flows from financing activities
Capital in:;ested by Suresh . 50,000
Capital withdrawn by Suresh . (3,500)
Loan from Manish . 20,000
Net cash provided by financing activities 66,500
Net increase in cash ." . 13,300
Beginning balance . a
Ending balance . 13,300

SOFTOMATION
Statement of Changes in Equity
For the month ended March 31, 20XX
Capital Retained Earnings Total
Beginning balance . ~ 0 ~ a ~ a
Capital introduced . 50,000 50,000
Net profit . 14,800 14,800
Withdrawn . (3,500) (3,500)
Ending balance . 50,000 11,300 61,300

Statement of Retained Earnings .It

The statement of retained earnings explains what Softomation did with its net
profit. This statement is a bridge between the statement of profit and loss and the
44 Chapter 1 Accounting, Markets, and Governance

equity section of the balance sheet. A business may distribute its earnings to the
owners, retain the earnings, or distribute a portion of the earnings and retain the
rest. Suresh withdrew ~3,500 of Softomation's March earnings of n4,800 and retained
~11,300. The payout, the ratio of distribution to net profit, is over 23 per cent. Since
distribution of profit is not an expense, it appears in the statement of retained earnings,
and not in the statement of profit and loss. It is a ''below the line" item. The retention
indicates the extent of the owner's ploughing back the earnings into the business. As
a result of the retention, Suresh's stake in Softomation has gone up, and this should
be reassuring to the firm's present and potential creditors.
Do you think Suresh was right in withdrawing a part of Softomation's profit?

Balance Sheet
The balance sheet presents an enterprise's assets, liabilities and equity at a point in
time. It summarizes the resources, and the claims to those resources by owners and
creditors, of the enterprise on a certain date. As shown in Exhibit 1.4, at the end of
March 20XX, Softomation has assets totalling ~85,300 equal to the total of liabilities
of ~24,OOOand equity of ~61,300.
Do you think Softomation is a financially sound business?

TEST YOUR
A report in the Indian Express (June 24, 2009) under the headline "Citibank India net up 20 per cent"
UNDERSTANDING 1.6
stated that its "total revenues were up 24 per cent at ~104.23 billion amid inflows by way of higher
Accounting Terms in
interest income, trading income and fees" and "the balance sheet of the bank grew 26 per cent from
News Report
~838.51 billion ~o ~1,052.64 billion." Are these statements consistent with the headline?

Cash Flow Statement

The cash flow statement describes the investments in assets made during the
period and how those investments are financed and how much the owners took from
the business. It reports the cash effects of not only the enterprise's operations but
also its investing (i.e. buying assets) and financing (i.e. cash received from or paid
to owners and lenders) activities. The cash flow statement in Exhibit 1.4 describes
how Softomation managed to end the month with a cash balance of n3,300. Current
operations resulted in net cash increase of ~4,800. Investment in equipment resulted
in cash outflow of ~58,000. Owner's investment, net of withdrawal, and loan provided
net cash of ~66,500.
What does the statement tell us about Softomation's cash flow?

.• Statement of Changes in Equity

The statement of changes in equity (or statement of shareholders' equity)
describes the changes in the components of equity, such as share capital and retained
earnings. Changes in share capital result from introduction or withdrawal of capital
by the owners. Changes in retained earnings result from net profit and distributions
to the owners.
What can we learn from the changes in Softomation's equity?
At this stage, our aim is to get a glimpse of financial statements. You will study
the principles and procedures followed in the preparation, analysis and interpretation
of financial statements in later chapters. You will find it greatly useful to keep referring
to company annual reports as you progress through the book. Appendix A has the 2013
financial statements of Hindustan Unilever.
 What do Accountants Do? 45

How are the Financial Statements Interrelated?

The statement of profit and loss, statement of retained earnings, balance sheet, cash
flow statement, and the statement of changes in equity are related to each other. Take,
for example, the transaction on March 1: Suresh began business with cash, ~50,000.
This transaction affects cash and equity, both balance sheet items. Since it results
in cash inflow, it appears also in the cash flow statement. Look at the transaction
on March 21: Paid creditor for supplies, ~2,000. It reduces liabilities and cash, both
balance sheet items. Since it results in cash outflow, it is also an item in the cash flow
statement. The effect of some transactions may be confined to one of the statements.
Consider the transaction on March 4: Bought supplies on credit, ~6,000. It affects the
balance sheet because supplies is an asset and the credit purchase creates a liability
for a payable. When Softomation pays the supplier on March 21, cash decreases,
affecting the balance sheet (cash and payables) and the cash flow statement - operating
cash outflow. The owner's withdrawal of ~3,500 on March 31 affects the statement of
retained earnings - drawings, the cash flow statement - financing cash outflow, and
the statement of changes in equity.
TEST YOUR
Rita Company provides services for f13,OOO to a customer and immediately receives an amount of
UNDERSTANDING 1.7
f4,OOO. How will this transaction affect the company's statement of profit and loss, balance sheet,
Effect of Transaction on
and cash flow statement?
Financial Statements

Preview of Financial Statement Analysis

Softomation earned a net profit of n4,800 on revenue of ~20,000 and assets of ~85,300.
The company's profit margin, the ratio of profit to revenue, is 74 per cent. The
company's return on assets, the ratio of net profit to assets, is 17.35 per cent. The
company's asset turnover, the ratio of revenue to assets, is 0.24. The margin looks
impressive considering that this is the first month of the business. The return on assets
also looks good. The asset turnover is quite low for a service enterprise but then it is
too early to expect full utilization of assets. Hopefully, the sales will pick up and the
asset turnover will improve over time. The large payout of profits is unusual at the
early stages of a business. A significant portion of the assets is of a long-term nature
and needs to be financed by long-term capital. Receivables are 80 per cent of sales and
it could be a matter of concern if the trend continues. Current operations produced net
cash ef ~4,800 as against a profit of ~14,800. That could mean the profits are mostly
stuck in receivables.

(~VV_h_a_t__d_o_A__Cc_o_u_n_t_a_n_t_s_D_O_? )
Many think that the work of accountants is bookkeeping - the process of recording learning Objective
transactions. However, bookkeeping forms only a small part of accounting and is Describe the
possibly the simplest. Accounting, on the other hand, includes the design of efficient •• career
opportunities for
information systems, budgeting, cost analysis, tax planning, auditing, and the analysis accountants.
and interpretation of information. Accountants play an important role in society and
offer a wide range of services to business as well as the government. For the purposes
of our discussion, the area of accounting may be divided into the following broad
fields:
• Public accounting;
• Private accounting;
• Government accounting; and
• Not-for-profit accounting.
46 Chapter 1 Accounting, Markets, and Governance

Public Accounting
Accounting firms engaged in public accounting provide a variety of accounting
services to the public for a fee. They vary in size from large national or international
accounting firms employing thousands of persons to numerous one-person practices.
CAs are, similar to doctors and lawyers, licensed to practise their profession to
ensure that the public gets services of an acceptable standard. To become a CA, it is
necessary to pass a rigorous and comprehensive examination conducted by the rCAl
and undergo at least three years of practical training in accounting, auditing, tax and
other related areas. On successful completion of the examination and training, the
individual can apply for a certificate of practice which is the licence to practise as a
CA. CAs can practise individually or in partnership with other CAs.

SURVEY The auditors of the 500 companies that comprise the CNX S&P Index in 2013 were as follows:
Who Audits India's Top
Accounting firm Number of audits
Companies?
Deloitte 75
i"~ IL
Icmi ,4 PricewaterhouseCoopers 41
J""""" Ernst & Young 54
I»'
I' KPMG 29
10{ 0
1!2 Others 454
653
Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers are the Big Four accounting firms that
audit large companies all over the world. They operate in India through members that are Indian
accounting ~rms. '
Note: Information about auditors was available for 457 companies out of 500. If a company has joint auditors
(i.e. two or more audit firms), it is counted for each accounting firm. So the total of audits is more than 457.
Source: Prowess database.

Accounting firms provide a wide variety of services. The principal services offered
include (a) auditing, (b) forensic accounting and risk management, (c) tax services,
(d) advisory services, (d) bankruptcy, and (e) small business services. These are
described below.
Auditing (or assurance) It involves the examination of financial statements and
generally forms an important part of the work of a CA. Companies must have their
financial statements audited by an outside CA. The major duties of a company's
auditor are examining and verifying the company's financial statements; appraising
the company's procedures for collecting, recording, and reporting financial information;
testing the controls by which the company protects its financial systems from frauds
and errors; and publishing an opinion as to whether the company's financial statements
give a "true and fair view" of its financial affairs.
Auditing enhances the credibility of financial reports prepared by an enterprise.
By ensuring that the financial statements are correct and complete, auditing increases
their reliability and usefulness for making economic decisions by investors, creditors,
analysts, and others. Credible financial reports are essential for society to have trust
in public companies. The following comment in The Wall Street Journal sums up the
importance of auditing:

Accountants, more specifically, auditors, are charged with making sure corporations properly report
their financial condition. They are, when everything is working right, the truth police, a check on
a corporation's darker thouqhts.V

17Tracy Byrnes, Besmirched auditors remam vital to the investment world, The Wall Street
Journal, April 12, 2002.
 What do Accountants Do? 47

Auditors must be both technically competent in their work and independent of

the enterprise whose financial statements they audit. A rigorous system of training
and examination certifies that auditors possess the requisite technical skills. But
it is not always easy for auditors to be independent of the enterprise that engages
and pays them. At a minimum, auditors should scrupulously avoid transactions and
client relationships that could compromise their ability to express an independent
professional opinion on its financial statements.
Forensic accounting and risk management Growing financial fraud has led
to the emergence of forensic accounting, a field that specializes in uncovering fraud
in organizations. More often than not, there is likely to be some kind of employee
involvement in fraud. Forensic accountants spend a lot of time interviewing suspects
and witnesses. These days a lot of information handling is automated. So forensic
accountants require high-level computer skills. The very nature of the work of forensic
accountants makes their world mysterious. Even so, there have been occasional reports
of the work done by them, such as tracking down assets held in Swiss banks and
investigating ghost payroll. Risk management, an allied field, aims at identifying
potential weakness and failures in financial systems in order to design robust controls.
With the rise of white-collar crime, such as tax evasion, money laundering and bribery,
the demand for forensic accountants and risk management specialists is growing.
Tax services Business enterprises have to consider the tax consequences of
alternative courses of action. Tax services include not only the preparation of tax
returns and compliance with tax laws but also planning business activities with a
view to minimizing taxes. It is often possible to effect considerable savings in tax
expense by appropriately arranging one's business affairs. While evasion of taxes is
definitely unlawful, it is perfectly legitimate for everyone to reduce their tax expense.
To be successful in tax practice, an accountant should be up-to-date with changes in
tax statutes, rules, notifications and circulars, and court decisions.
Advisory services An important part of the revenues of large accounting firms
comes from advisory services, an omnibus term for a wide variety of consulting
activities. These services go beyond the traditional boundaries of accounting and
auditing. Examples of consulting assignments include rethinking business strategy,
designing organizations, recruiting personnel, reviewing costs, designing information
systems, improving inventory control, helping companies go public, and advising on
restructuring. Specialists such as actuaries, computer consultants, MBAs, engineers,
and economists are employed in consulting. Although auditing continues to be the
mainstay for most accounting practices, its relative importance is declining as the
demand for advisory services grows. Large accounting firms are now "professional
services firms". Nearly one-fourth of the amounts the companies in the CNX S&P 500
companies paid their auditors in 2013 was for non-audit services.

In many countries, accounting firms cannot provide non-audit services which are considered to impair DEBATE
auditor independence. The Companies Act 2013 prohibits the company's auditor from providing the Should Auditors
following services: bookkeeping, internal audit, design and implementation of financial information be Prohibited from
systems, actuarial services, investment advisory services, investment banking services, outsourced Providing Non-audit
financial services, management services and any other kind of services prescribed by the government. Services?
The ICAI stipulates that the fees for non-audit services shall not exceed the statutory audit fee for a
client. Significantly, there is no prohibition on auditors from providing tax advice to their audit clients.
One view is that since clients benefit from the auditors' knowledge of their business, auditors should
be allowed to provide non-audit services. A counter-view is that when auditors provide non-audit
services to their clients, they tend to compromise their independence as auditors.
What do you think? ~
48 Chapter 1 Accounting, Markets, and Governance

Bankruptcy Bankruptcy is the inability of a business to pay all of its obligations.

When a business files for bankruptcy, its assets are sold and the amounts due to its
creditors are paid out of those sale proceeds. Bankruptcy administrators do not have
the glamour of investment bankers. But when the music stops and an investment bank
is wound up, its bankruptcy administrators stand to gain. For example, fees paid to
lawyers and accountants for unwinding Lehman Brothers in the US and Europe were
estimated to surpass $2 billion.l" The operation involved settling derivative contracts,
selling off the bank's subsidiaries and real estate, and dealing with litigation by and
against the bank.
Small business services Many accounting firms provide a variety of services for
small businesses. Setting up an accounting system, compiling financial statements,
preparing budgets and forecasts, and assisting the client in obtaining a bank loan are
examples of small business services.

Private Accounting
An accountant is said to be in private accounting when she is employed by a
business enterprise. Private accountants are employed by organizations in such diverse
businesses as steel making, manganese mining, banking, airlines, software, real estate,
and hotels. Typical designations of these accountants are financial vice-president,
financial controller, works accountant, and management accountant. In recent years,
individuals with backgrounds in finance and accounting have become chief executives
in a number of companies. Among the areas in which private accountants specialize
are management accounting, internal auditing, and information systems.
Management accounting Accountants in management accounting provide
information to management for making business decisions and formulating long-term
policies. Management accounting information has use in several areas including cost
control, product costing, capital investment appraisal, profitability analysis, corporate
planning, budgeting, pricing policies, and cash flow and liquidity management. Members
of the Institute of Cost Accountants of India, known as cost accountants, specialize
in management accounting. A large number of CAs employed in business enterprises
too perform management accounting functions.
Internal auditing In addition to the audit by outside accounting firms, most large
corporations have their own internal audit departments. Internal auditors are
concerned with reviewing internal controls, assessing compliance with established
policies, ascertaining the extent to which company's assets are safeguarded, and
.,. recommending improvements to operations. External auditors are primarily concerned
with the fairness of the financial statements of a business. The Companies Act 2013
requires companies to appoint an internal auditor, who shall be a CA or a cost
accountant.
Information systems A rapidly growing field for accountants is the design
and development of information systems for processing accounting data. Since
large corporations make extensive use of technology for processing transactions, a
good working knowledge of computer hardware and software is indispensable for
specialization in this field. Information system auditors examine the adequacy of
security in computerized accounting systems.

18Jennifer Hughes, Tellis Demos and Nicole Bullock, Lehman unwinding fees to pass $2 billion,
Financial Times, September 14, 2010.
What do Accountants Do? 49

Some see the chartered accountancy qualification and an MBA as competitors. Both attempt to DEBATE
provide a business education. CAs and MBAs ask: Which of them is better? Who will Make a Better
MBA is a degree; CA is a professional certification. Students in the best MBA programmes discuss CFO: CA or MBA?
business problems in the classroom, which is away from the real world. But to become a CA, you
have to do real work in the offices of a CA firm and its clients, under the guidance of experienced
seniors, which helps the student acquire some fairly tricky skills. Anyone who asks an MBA class to
analyze a set of financial statements and work with creditor-days calculations or break-even analysis
might think that a finance director who has only an MBA can function only in a business where
financial statements don't matter. An MBA equips you to ask some of the right questions; a CA
enables you to provide the answers. Boards looking for a CFO generally do not want someone who
is "just an accountant." CFOs must be able to look beyond accounting if they want to add value.
An MBA syllabus covers many areas besides accounting.
What do you think?
Adapted from: Rupert Merson, Business school rival doesn't quite add up, Financial Times, March
29, 2007.

Government Accounting
Government departments and agencies receive and pay huge sums of money. We
are familiar with government organizations such as the Indian Railways, India Post,
the Income Tax Department, the Police, and the Defence Services. Unlike business
enterprises, the sole objective of government is not to make a profit from its operations.
Still, it is essential that the sums due to the government are collected when due, and
payments are properly authorized and result in expected benefits. The government
should be cost effective in its operations, so that taxes and other levies can be kept low.
Sources of government revenues include income tax, excise and customs duties,
value added tax, and various types of fees and cesses. Examples of payments made by
government include salaries and allowances of personnel in civil and defence services,
pensions of retired government employees, costs of goods and services procured for
projects, and benefits under various welfare programmes for the poor. Efficient and
proper handling of revenues and expenses requires extensive systems for checking
and recording documents and preparation of financial reports for internal use and for
Parliament. Government accounting systems are mostly run by members of central
services such as the Indian Audit and Accounts Service, the Indian Civil Accounts
Service,the Indian Railway Accounts Service, and the Indian Defence Accounts Service.
The Controller-General
•.. of Accounts is the head of the Central government's accounting
function and is part of the Ministry of Finance.
The Comptroller and Auditor-General of India (CAG), an independent authority
under the Constitution of India, audits the transactions and accounts of government
and public secto;' undertakings. The CAG communicates its major observations and
recommendations to Parliament. The CAG's audit reports are discussed in committees
of Parliament, such as the Public Accounts Committee (PAC) and the Committee on
Public Undertakings. In this way, Parliament is able to exercise control over the
government's financial management. The CAG is more concerned with the propriety
and efficiency of the actions of officers of the government, unlike company auditors who
are mainly concerned with the fair presentation of information in financial statements
in compliance with accounting standards.
In recent times, the CAG's reports on defence purchases and award of mobile
telephone licences have attracted a lot of attention. Proper accounting and independent
auditing are instrumental in ensuring government's accountability. The CAG
occasionally audits non-government companies at the request of the government. In
2014, the Delhi government asked the CAG to conduct a special audit of electricity
distribution companies in DelHf in response to complaints that they were profiteering
at the expense of consumers. In 2010, the Department of Telecommunication asked
the CAG to audit the records of some telecommunication companies when there were
doubts whether the companies under-reported to avoid paying the government's share
50 Chapter 1 Accounting, Markets, and Governance

of licence fee and spectrum charges. In 2009, the Ministry of Petroleum asked the CAG
to audit the expenditure that Reliance Industries incurred in developing the Krishna-
Godavari basin gas field D6 because of allegations of inflating gas field costs.

Not-for-Profit Accounting
Religious and charitable institutions are established for providing certain types of
services to the public. Unlike business enterprises, these organizations are not profit-
oriented. Donations and endowments made by philanthropic individuals are the major
sources of revenues for non-business organizations. These organizations need financial
reports for assuring present and potential donors that the funds are utilized efficiently,
effectively and properly for the stated purposes.

(~A_c_c_o_u_n_t_in_g
__ a_s__a_n_A __ca_d_e_m__ i_c_D_i_s_c_ip_l_in_e )
learning Objective Accounting is not only a profession but also a field of intellectual enquiry, similar
Appreciate to medicine, law, architecture and engineering. Accounting academics publish their
• accounting as an research in scholarly journals such as The Accounting Review, the Journal of Accounting
•
academic and Economics, and the Journal of Accounting Research. Accounting researchers apply
discipline.
economic and behavioural theories to financial reporting and disclosure, and other
areas of accounting.
Examples of problems that researchers have examined include:
(a) How does accounting influence stock prices?
(b) How do firms benefit from improving their disclosure?
(c) Under what conditions is accrual accounting more informative than cash
accounting?
(d) Why do accountants take note of losses quicker than gains?
(e) What are the major factors in selecting accounting methods and disclosure
levels?
(f) Is it possible to predict future profits from past profits?
(g) Does disclosure affect managerial behaviour?
(h) Is executive pay related to financial performance?
You can get an idea of the research questions that academic accountants investigate
by looking at academic accounting journals.

RESEARCH INSIGHT
Here are some questions that you might be already askinq:
Accounting and Stock
1. Do accounting numbers influence stock prices?
Prices
2. How important is accounting to the capital market?
3. Are accounting reports a timely source of information to the capital market?
Professors Ray Ball and Philip Brown investigated these questions and reported their findings in a paper that
holds the world record for being the most cited research in accountinq."
They found that stock prices reacted to firms' announcements of financial results. However, most of the
changes in the stock prices occurred prior to the month in which annual results were announced. They noted
that one-half or more of all the information is captured in that year's net profit. However, about 85 to 90 per cent
of the change is captured by more prompt media that would include accounting and non-accounting sources of
information. Thus, while the capital market anticipates much of the information contained in the annual financial
statements, full anticipation does not occur.

Fraud and Ethical Issues in Accounting

learning Objective
Understand the With ~re managers trying to cut ethical corners to accomplish enterprise objectives,
• • importance of ethical standards in business are declining and this has serious implications for the
ethics in
accounting.
19 Ray Ball and Philip Brown, An empirical evaluation of accounting income numbers, Journal
of Accounting Research, Autumn, 1968.