GCMS Haripur

Prepared by Faris
Lecturer

Why study Accounting

The primary purpose of accounting is to provide information that is useful for decision
making purposes. The final product of accounting information is the decision that is
ultimately enhanced by the use of accounting information weather that decision are made by
owner, management, creditor, government regulatory bodies, labor unions, or the many other
groups that have an interest in the financial performance of an enterprise.

 Definition of Accounting

Accounting is the art of recording, summarizing, reporting, and analyzing financial

transactions.

Or

Accounting is the process of collecting, identifying, recording, posting, classifying and

summarizing the data, events and transactions, in terms of money, into financial information
and interpreting the financial information for the decision making of a business.

Interested users of financial Information

(1) Shareholders (existing and potential)

(2) Employees

(3) Loan creditors

(4) Financial analysts and investment advisors

(5) The government (Inland Revenues Department)

(6) The general public

(7) Others: - suppliers, customers, competitors

Accounting concepts

Accounting concepts are basic assumptions and rules which guide accountants in producing
periodic financial accounts.

When an accountant prepares financial accounts, he has to assume that:

1. Prudence / conservatism

Meaning:

(a) Revenues and profits should not be anticipated but recognised only when they are
realised in the form of cash or of other assets which can be treated as cash.

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Prepared by Faris
Lecturer
(b) Provision should be made for any known liabilities at the end of the financial period.

Examples (a) Stock is valued at lower of cost and net realisable value. (Stock is an asset for
resale to earn a profit.) (b) Provision is made for depreciation and doubtful debts.

2. Going concern

Meaning:

(a) An enterprise will continue in operational existence for the foreseeable future.

(b) An enterprise will not liquidate or curtail significantly its scale of activities.

(c) The financial statements do not indicate assets at net realisable value (market value).

Examples (a) On the balance sheet, fixed assets are shown at their net book value, ie, cost less
accumulated depreciation.

(b) If the accountant has reasons to believe that the enterprise wil liquidate soon, he
should indicate all assets at the NRV, and make a note of the account.

3. Historical cost

Meaning: (a) All assets should be recorded at their cost. This method is consistent,
simple and less costly.

(b) Historical cost is an objective and verifiable cost.

(c) Cost includes the purchase price and all expenses incurred in bringing the asset
to its present location and condition.

Examples (a) Investment in shares is recorded at its cost, even though the share prices
change over time.

4. Business entity

Meaning: (a) The business and its owners are separate existence entity.

(b) The business transactions are separate from its owners’ private transactions.

Examples (a) Any payments for the owners’ personal expenses by the business

are treated as drawings, and not expenses.

5. Materiality

Meaning: (a) Any insignificant items and events may be disregarded, but important
information should be disclosed.

(b) If the information may affect the users in making decision, it is regarded as
material. A material item is regarded as an asset and should be shown as a separate item on
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Prepared by Faris
Lecturer
the balance sheet.

Examples (a) Stationery involves small amount of capital expenditure, so it is treated as

an expense and to be written of in the profit and loss account.

6. Quantifiability / stable monetary measures

Meaning: (a) We only record those transactions which are measurable in money terms.

(b) The factor of “inflation” is ignored.

(c) This forms a common base for comparison.

Examples (a) Expenses can be added or subtracted.

(b) The morale of the enterprise, the experience of the staff, the good relationship
with others are not recorded and reflected in accounts.

7. Consistency

Meaning: (a) Similar items should be treated by similar methods.

Such methods, once adopted, should not be change within an accounting period
or from one period to another.

(b) If a new policy is considered better and necessary, the nature and reason
for the change must be disclosed as a note to the accounts.

Examples (a) depreciation method

(b) stock valuation method

8. Accrual / matching

Meaning: (a) Revenues and expenses are recognised as they are earned and incurred, and
not as money is received or paid.

(b) The profit and loss account is prepared on this basis.

(c) The revenues earned must be matched with the expenses incurred in calculating
the profit in an accounting period.

(d) If an expense has been paid but the related revenue has not been earned, the cost
should be carried forward as a prepayment.

If a revenue has been earned but the related expense has not been paid, the cost
should also be counted and carried forward as an accrual.

(e) The cost of capital expenses (assets) should be spread over a period of time
during which the benefits are going to be received.

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 GCMS Haripur
Prepared by Faris
Lecturer
Examples (a) Credit sales but not yet received should still be treated as an income in the
profit and loss account, and the receivable amount is treated as an asset in the balance sheet.

9. Objectivity

Meaning: (a) Personal bias should be avoided by those who are responsible for the
preparation of the books and final accounts.

(b) Different accountants should arrive at similar (the same) treatment of an

item.

Examples (a) The Companies Ordinance requires that the published accounts of
limited company should give a true and fair view.

(b) Directors’ suggestions which are “window dressing” and subjective should
not be considered.

10. Timeliness

Meaning: (a) The timeliness of the reported financial statements will provide a true
picture of the business for the users to make decisions in time.

(b) Timeliness may conflict with accuracy. They should be balanced when the
financial accounts are prepared.

Examples (a) The amount of the proposed final dividends of ordinary shares will be
subjected to the timeliness of the reported statements.

Conclusion:

1. Objectively – It is the use of a method that everyone can agree to.

2. Consistency – Accounting keeps to the same method, except in special cases.

(Accounting tries not to change a method.)

3. Money measurement – Accounting only records transactions that are measurable in

money.

4. Stable monetary measures – The value of money is assumed very stable.

5. Ouantifiability – It is the ability to make a measure of a transaction in money.

6. Dual aspect – In a double entry system, accounting deals with both the debit and credit
aspects of a transaction.
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Lecturer
7. Business entity – Accounting only records transactions that affect the business; and not the
owner’s private transactions.

8. Accrual – Accounting records revenues when they are earned (not only when cash is
received). Accounting records expenses when they are incurred (not only when cash is paid).

9. Prudence (conservatism) – Accounting tries not to overstate profits or revenues..

Accounting tries not to understate losses or expenses.

10. Realisation – Accounting records a profit at the point at which the profit is earned

. (not at a point at which cash is received).

11. Going concern – A business is assumed to continue for a very long time.

12. Materiality – Accounting records a transaction as an asset only when it is significant.

For small amount items, they are only treated as expenses.

OTHERS KEY TERMS

Capital expenditure – It is the payment of

1. buying an asset (cost price and other expense that

bring the asset to its present location and condition)

2. increasing the value of an existing asset

Revenue expenditure – It is the payment for daily running of the business.

It is an expense necessary to earn a profit.

Asset

1. An asset is anytime that can generate future benefit to the enterprise.

The asset is purchased not for resale at a profit, so the disposal of it is regarded as an
extraordinary item.

Major fields of accounting

1. Financial accounting
2. Management accounting
3. Cost accounting
4. Tax accounting
5. Operational accounting
6. Advance accounting

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Users of accounting system
1. Investors
2. Creditors
3. Managers
4. Owners
5. Customers
6. Employees
7. Regulatory agencies
8. Trade associations
9. General public
10. Labor union
11. Government agencies
12. Suppliers.

Functions and Importance of Financial Statements

The following are some of the functions and importance of financial statements.

1. Importance of Financial Statements to Management: Management needs the financial

statements for proper execution of managerial functions. If there is a correct and reliable
information, the management can plan properly and perform the functions of operation and
control very easily. The financial statements guide the management for effective use of
capital employed and determine the level of credit obtained from the banks and financial-
institutions.

The well drawn and properly constructed financial statements helps for effective policy
formulation. Moreover, the management may examine and analyze the net results of different
activities and the efficiency of employees concerned with those activities. The expansion
activities of the business concern are determined on the basis of financial position and
strength of the company.

2. Importance of Financial Statements to Government: The financial statements are highly

useful to assess the tax liability of the business concern. The economic condition of a nation
is identified by collecting such financial statements from various industrial sector. Both state
and central government can find out whether the business concern is following rules and
regulations or not. These statements provide a basis for framing new laws and amending the
existing laws for regulating the business.

3. Importance of Financial Statements to Banker: The bankers can find out the ability of
the business to meet its obligations, short term and long term solvency, credit worthiness and
earning capacity. Besides, the bankers make comprehensive analysis of customers’ policies
and plans. The extent of loan can be easily fixed by the banker on analyzing the financial
statements.

4. Importance of Financial Statements to trade Association: It provides service to its

members i.e. business concern. The extent of service and types of services are determined on

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 GCMS Haripur
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Lecturer
the basis of information contained in financial statements. They may develop standard ratios
and design uniform system of accounts.

5. Importance of Financial Statements to trade Suppliers: The sales volume of the trade
suppliers are increased if the financial statements are properly analyzed and assess the
financial position of the customers i.e. business concern. A customer is faithful and regular in
payment of trade credit if his financial position is sound. The use of financial statements is
very imperative since these statements can convey the delay in payment or regularity in
payment and can suggest about customer’s ability to make the payment in future.

6. Importance of Financial Statements to Stock Exchange: The shares and debentures of a

company are traded in the stock exchanges. The value of shares and debentures are
determined on the basis of financial position and credit worthiness of the company. The
financial statements are giving correct information to fix the price for shares and debentures.

7. Importance of Financial Statements to Investors: Both present and prospective

investors are reading the contents of financial statements. They assess the financial position
of the company from a different angle. Long term solvency, earning capacity, prospects for
growth, utilization of funds, sources of funds and managerial ability are identified from the
financial statements.

If the investor happens to be debenture holder, he/she studies the financial statements in such
a manner whether the company is able to redeem the debentures at the date of redemption. A
shareholder considers the liquidity of the company but the debenture holder considers the
earning capacity of the company.