Chapter

1 ACCOUNTING:
Information for Decision Making
 Accounting
Accounting is the art of recording, classifying & summarizing
business transactions in monetary terms & interpreting the
results.

Accounting provides financial information about

an organization’s economic activities which is
intended to be used as a basis for decision
making.
It provides the information required to answer
important questions such as: what are the
resources of the organization?
What debts does it owe? How do its operating
expenses compare with its revenue? Is it
sustainable?
 Basic Functions of an Accounting
System
 Interpret
and record
business
transactions.

Payment

Car
 Basic Functions of an Accounting
System
Record  Classify
business similar
transactions. transactions
into useful  Summarize
reports. and
communicate
information to
decision
makers.
 Purpose of accounting:
The purpose of accounting is to provide financial information to the major
stakeholders for decision making. The main decision makers are:
• Managers
• Directors
• Investors
• Suppliers
• Government agencies
• Employees
Financial information is usually provided in the form of reports which are:
• Income Statement (Income and Expenditure Account if it’s nonprofit making
Organization)
• Balance Sheet
• Cash Flow Statement
 Accounting information users:

Internal users (Inside organization).

 Owners: to know the performance & profitability of the business.

 Marketing managers: target customers, set price, monitor sales.
 Production managers: monitor cost and ensure quality.
 Purchasing managers: what, when and where to purchase materials.
 Human resource managers: employees’ performance and
compensation.
Etc
 Accounting information users:

External users (Outside organization):

• Lenders: Whether the firm (borrower) can repay the money?

• Shareholders: whether to buy, hold, or sell stocks?
• Governments: whether the firm pay all due tax?
• Customers: whether the firm can exist to provide post-sale services?
• External Auditors: whether the financial statements are prepared
according to GAAP?
• Etc.
 Areas of accounting:

Managerial accounting:
Managerial accounting is mainly concerned with providing information
to management for planning and control. This wills reports such as
budgets, performance and activity reports.
Mangers use this information to:
 Achieve its goals, objectives & mission.
 Evaluate both past performance & future directions of the enterprise.
 Reward decision making performance.
 Areas of accounting:
Financial accounting:
Financial accounting refers to information describing the financial
resources, obligations & activities of an economic entity that is used by
external decision maker.
Financial Accounting is mainly concerned with providing information
to internal and external consumers through financial statements.
Financial accounting information is designated to help investors &
creditors in deciding where to place their scarce resources.
The difference between financial accounting and management
accounting is based on users of information.
Financial accounting information is provided to external users, that
are investors and creditors while managerial accounting information is
used by management. External users have different objectives than
management & need different information.
 Areas of accounting:
Auditing:
Systematic examination and verification of a firm's books of account,
transaction records, and financial statements and other relevant
documents and physical inspection of inventory by qualified
accountants who render opinions that indicates findings of those
examinations.
Cost accounting:
Cost accounting deals with determining the costs of products,
processes, projects, etc. in order to report the correct amounts on the
financial statements and assisting management in making decisions and
in the planning and control of an organization.
Cost accounting determines the per unit cost of business activities & of
manufacturing product & interpreting these cost data.
 Areas of accounting:

Public accounting:
Public accounting requires a license or certificate by the state. Certified
public accountants (CPAs) offer services to clients such as businesses
(retailers, manufacturers, service companies, etc.), individuals,
nonprofits and governments. Some of the services are:
 Preparation, review and auditing of financial statements.
 Tax planning & income tax return.
 Consultation, management and advisory services.
 Areas of accounting:
Government accounting:
Government accounting is the process of recording, analyzing,
classifying, summarizing communicating and interpreting financial
information about government in aggregate and in detail reflecting
transactions and other economic events involving the receipt, spending,
transfer, usability and disposition of assets and liabilities.
 Generally accepted accounting
principles (GAAP)

Generally accepted accounting principles (GAAP) are the general

guidelines and principles, standards and detailed rules, plus industry
practices that exist for financial reporting.

Generally Accepted Accounting Principles (GAAP) is a term used to

describe, broadly, the body of principles that governs the accounting
for financial transactions underlying the preparation of a set of
financial statements.
 1.Business Entity Concept:

Every business is a separate entity, distinct from its owner and

from every other business.
Therefore, the records and reports of a business should not
include the personal transactions or assets of either its
owner(s) or those of another business.
 2. Objectivity principal:

Objectivity connotes reliability and trustworthiness.

A principle is objective to the extent when the accounting information

is not influenced by personal bias or judgment of those who provide it.
This implies that accounting information is prepared and reported in a
“neutral” way.

In other words, it is not biased towards a particular user group or

vested interest. It also implies verifiability, which means that there is
some way of ascertaining the correctness of the information reported.
Each & every financial event must be evident by sales slips, invoices,
sales slips etc.
 3. Going Concern Concept:
The underlying idea of this concept is that the business would continue
for a fairly long period to come.
At the time of preparing the final accounts, we take into consideration
the outstanding expenses and prepaid expenses on the presumption that
the business will continue in future too.

It is to be noted that the ‘Going Concern Concept’ does not imply

permanent continuation of the enterprise, indefinitely. It rather
presumes that the enterprise will continue in operation long enough that
the cost of the fixed assets would be charged over the usual lives of the
assets.

Moreover, the concept applies to the business, as a whole. Even if a

branch or division of the business were closed, ability of the business to
continue would not be affected.
 4. Cost Principle:
All assets must be recorded on the books of a business at their actual
cost.
This amount may be different from what it would cost today to replace
them or the amount the assets could be sold for.
Cost concept is closely related to the ‘Going Concern Concept’.

It does not mean that the fixed assets are valued at the historic cost,
original price at which they are acquired, for all the years.

Cost concept is applied to fixed assets only. Current assets are not
affected by this concept.
 Materiality Concept
The materiality concept, also called the materiality constraint, states
that financial information is material to the financial statements if it
would change the opinion or view of a reasonable person.

The concept of materiality is relative in size and importance. Some

financial information might be material to one company but might be
immaterial to another.
 Cost Benefit Principle
The cost benefit principle or cost benefit relationship states that the cost
of providing financial information in the financial statements must not
outweigh the benefit of that information to the users. In other words,
financial information is not free.

Companies spend millions of dollars every year gathering and

organizing financial information to assemble into financial statements.
 Consistency Principle
The consistency principle states that companies should use the same
accounting treatment for similar events and transactions over time. In
other words, companies shouldn’t use one accounting method today,
use another tomorrow, and switch back the day after that.

Similar transactions should be accounted for using the same accounting

method over time. This creates consistency in the financial information
given to creditors and investors.
 5. Money Measurement Concept
Accounting records only those transactions that can be expressed, in
terms of money, though quantitative records are kept, additionally. If
the events or transactions cannot be expressed in monetary value,
however important they are, they are not recorded in accounts.
 6. Matching principal:

Matching Principle requires that expenses incurred by an organization

must be charged to the income statement in the accounting period in
which the revenue, to which those expenses relate, is earned.

Depriciation
 7. Realization principal:
The realization principle is the concept that revenue can only be
recognized once the underlying goods or services associated with the
revenue have been delivered or rendered, respectively.
Thus, revenue can only be recognized after it has been earned.
Examples:
 Advance payment for goods. A customer pays $1,000 in advance for a customer-
designed product. The seller does not realize the $1,000 of revenue until its work on
the product is complete. Consequently, the $1,000 is initially recorded as a liability
(in the unearned revenue account), which is then shifted to revenue only after the
product has shipped.

 Advance payment for services. A customer pays $6,000 in advance for a full year
of software support. The software provider does not realize the $6,000 of revenue
until it has performed work on the product. This can be defined as the passage of
time, so the software provider could initially record the entire $6,000 as a liability (in
the unearned
revenue account) and then shift $500 of it per month to revenue.
 Forms of business enterprises :
1. The sole proprietorship:
A sole proprietorship or one man’s business is a form of business organization owned
and managed by a single person. He is entitled to receive all the profits and bears all
risk of ownership.

Features: The important features of sole proprietorship are:

1. The business is owned and controlled by only one person.
2. The risk is borne by a single person and hence he derives the total benefit.
3. The liability of the owner of the business is unlimited. It means that his personal
assets are also liable to be attached for the payment of the liabilities of the business.
4. The business firm has no separate legal entity apart from that of the proprietor, and
so the business lacks perpetuity.
5. To set up sole proprietorship, no legal formalities are necessary, but there may be
legal restrictions on the setting up of particular type of business.
6. The proprietor has complete freedom of action and he himself takes decisions
relating to his firm.
 Forms of business enterprises :
2. Partnership :
Section 4 of the Partnership Act, 1932 defines Partnership as “the relation between
persons who have agreed to share the profits of a business carried on by all or any of
them acting for all”
The maximum No of partners in ordinary business are 20 while in banking business
are 10.
Features of Partnership
1.simple procedure of formation, does not involve any complicated legal formalities.
By an oral or written agreement.
2. Capital: The capital of a partnership is contributed by the partners but it is not
necessary that all the partners should contribute equally. Some may become partners
without contributing any capital. This happens when such partners have special skills,
abilities or experience.
3. Control: The control is exercised jointly by all the partners. No major decision can
be taken without consent of all the partners. However, in some firms, there may
partners known as sleeping or dormant partners who do not take an active part in the
conduct of the business.
 Forms of business enterprises :
4. Management: Every partner has a right to take part in the
management of the firm.
5. Unlimited Liability: The liability of each partner in respect of the
firm is unlimited.
7. No separate legal entity: The partnership firm has no independent
legal existence apart from that of the persons who constitute it.
8. Restriction on transfer of share: A partner cannot transfer his share to
an outsider without the consent of all the other partners.
 Forms of business enterprises :
3. Joint stock company:
A company may be defined as a voluntary organization which is an artificial person
created by law, having limited liability of its members and a perpetual succession
with its capital divided into transferable shares & which has a common seal.
The liability of each partner is limited to the face value of the share.
It is formed & controlled under the company ordinance 1984.
Features:
1. A corporation is legal entity having an existence separate and distinct from that of
its owners. The owners of the corporations are called stockholders/ shareholders. &
their ownership is evident by transferable shares of capital stock.
2. A corporation is more difficult & costly to form than other types of organizations.
The corporations must obtain a charter from the state in which it is formed & it must
receive authorization from that state to issue share of capital.
3. As a separate legal entity a corporation may own property in its own name. the
assets of a corporation belong to the corporation itself, not to the stockholders. A
corporation has legal status in courts, a corporation may enter into contracts, is
responsible for its own debts & pays income tax on its earnings.
 Forms of business enterprises :
4. Corporations are run by salaried professional managers, not by their
stockholders. The stockholders are primarily investors rather than
active participants in the business.
5. The top level of a corporation’s professional management is the
board of directors who are elected by the stockholders and are
responsible for hiring the other professional managers.
End of Chapter 1