Accounting Foundations

FINANCIAL AND MANAGEMENT ACCOUNTING

Unit - 1
Accounting – Defination – According for historical function and
managerial function – Scope of accounting – Financial accounting and
Management accounting – Managerial uses – Differences.

Financial Accounting: Accounting concepts – Convections –
Principles – Accounting standards – International Accounting
standards.

Unit-2
Double entry system of accounting - Accounting books –
Preapartion of journal and ledger, subsidiary books - Errors and
rectification – Preparation of trial balance and final accounts.

Accounting from incomplete records - Statements of affairs
methods -Conversion method - Preparation of Trading, Profit & Loss
Account and Balance Sheet from incomplete records.

Unit - 3
Financial Statement Analysis - Financial statements - Nature of
financial statements - Limitations of financial statements - Analysis of
interpretation -Types of analysis -- External vs Internal analysis -
Horizontal vs Vertical analysis - Tools of analysis - Trend analysis -
Common size statements -Comparative statements.

Ratio Analysis - Types - Profitability ratios - Turnover ratios -
Liquidity ratios - Proprietary ratios - Market earnings ratios - Factors
affecting efficiency of ratios - How to make effective use of ratio
analysis - Uses and limitation of ratios - Construction of Profit and
Loss Account and Balance Sheet with ratios and relevant figures -
Inter-firm, Intra-firm comparisons.

Unit -4
Fund Flow Statements - Need and meaning - Preparation of
schedule of changes in working capital and the fund flow statement -
Managerial uses and limitation of fund flow statement.

Cash Flow Statement - Need - Meaning - Preparation of cash
flow statement - Managerial uses of cash flow statement - Limitations
– Differences between fund How and cash tlow analysis.

Unit-5
Budgeting and Budgetary Control: Preparation of various types
of budgets - Classification of budgets - Budgetary control system -
Mechanism -Master budget.

Unit-6
Capital Budgeting System - Importance - Methods of capital
expenditure appraisal - Payback period method - ARR method - DCF
methods - NPV and
IRR methods - Their rationale - Capital rationing.

REFERENCES:
1. Arulanandam & K.S. Raman, Advanced Accounting.
2. Gupta & Radbasamy, Advanced Accountmg.
3. Shukla & T.S. Grewal, Advanced Accounting.
4. Jain &Narang, Advanced Cost Accounting,
5. Das Gupta, Advanced Studies in Cost Accounting.
6. Maheswari, Management Accounting & Financial Accounting.
1. Manmohan & Goyal, Principles of Management Accounting.
7. Prasad, Advanced Cost Accounting.

FINANCIAL AND MANAGEMENT ACCOUNTING

LESSON TITLE
1. Accounting an Introduction
2. Management Accounting
3. Theory Base of Accounting - Accounting Standards
4. Practical Base of Accounting - Origin and Analysis of
Business Transactions
5. Financial Statements of Profit-making Entities
Manufacturing-cum-Trading Organisations
6. Financial Statements of Non-Profit-making Entities
7. Errors Management
8. Accounts from Incomplete Records - Single Entry System
9. Financial Statement Analysis
10. Ratio Analysis
11. Fund Flow Analysis
12. Cash Flow Analysis
13. Budgeting and Budgetary Control
14. Capital Budgeting
15. Case Study

LESSON - 1

ACCOUNTING: AN INTRODUCTION

Learning outcomes; on completion of this chapter, you should be able
to:

 Explain the nature of accounting.
 Identify the various branches of accounting.
 Explain the process of creation of financial statements and their
interpolation.
 Explain the various objectives of financial statements.
 Identify the various uses of accounting information.

INTRODUCTION
Accounting discipline deals with measurement of economic
activities affecting inflow and outflow of economic resources to develop
useful information for decision making. At household level information
about outflow and inflow of cash resources helps -.0 assess financial
position and plan household activities. At Government level,
information about inflow from taxes (direct as well as indirect) and
expenditure on various activities (developmental and non
developmental) is needed for planning and budgeting. Although
accounting can be discipline has universal applicability, but its
growth is closely associated with the developments in the business
world. Thus to understand accounting as a field of study for universal
application, it is best identified with recording of business transaction
and thereby creating economic information about business enterprises
to facilitate decision making.

NATURE OF ACCOUNTING:

1.2 Accounting
i. is man-made;

ii. has evolved over a period of time;
iii. is practiced in a social system;
iv. is a systematic exercise;
v. is judgmentat at times;
vi. follows flexible, not a rigid approach;
vii. is essentially a language;
viii. as a language, has a very well defined syntax of its own; and
ix. Communicates financial information for decision making.

Accounting being a man-made system has evolved over a period
of time to provide financial information of business enterprises to
users of accounting information. A large number of groups with varied
interests in affairs of a business enterprise have emerged over a period
of time, especially after emergence of corporate forms of organization
involving separation of ownership management. These user groups
include those who;
 manage the activities of the
enterprise( management)
 own the enterprise( owners/ shareholders)
 extend credit for supply of goods to the enterprises
(creditors)
 buy goods from the enterprises( customers)
 lend money to the enterprises( banks and
financial information)
 are employed in the enterprises (employees)
 intend to make investment in the
enterprises(mvestors)
 are doing research(researchers)
 are engaged in collection of taxes ( sales tax and
income tax
 authorities)

 formulate fiscal and monetary policies
(other Government
 department)
 are members of the public at large(general public)
Internal users of accounting information are inside the
enterprise and need information to control and plan the activities of
the business to manage it effectively. These include Owners in case of
non corporate enterprises and managers and directors in case of
corporate business. Their information needs are satined through
various reports which are generally prepared internal use and remain
unpublished. External users of accounting information are outside the
enterprise. The information need of these user groups are met by
measuring the desired information by following a systematic process.
It results in creation of financial statements which are generally
published to make the information available to external user group for
decision making. The need for communicating relevant and useful
information to that potential internal and external users is always
there and accounting is intended to perform that role.
Thus, accounting may be defined as:

"the process of identifying, measuring and communicating
information to permit judgement and decision by the users"
( American Accounting Association)

BRANCHES OF ACCOUNTING

Financial Accounting:

It primarily concentrates on creation of financial
information for external user groups such as creditors, investors,
lenders and so on. It deals with business events which have already
occurred and is, therefore, historical in nature. Traditionally, the aim
was to develop information about income and financial position on the

basis of events which had taken place during a period of time. Recent
trend in corporate form of organization is to provide information about
cash flows and earnings per sh^e also as part of published financial
statements.

Management Accounting - The information provided by
the financial accounting system is significant but not sufficient for
smooth orderly and efficient conduct of business. Management needs
more information to discharge its function of stewardship, planning,
control and decision-making. As information needs of management
vary from enterprise to enterprise, the grouping and reporting of
information takes different forms. Trie different ways of grouping
information and preparing reports as desired by managers for
discharging their functions are referred to a management accounting.
Management accounting provides information to the management not
only about cost but also revenue, profit, investment etc., for managing
business more efficiently and effectively. A very important component
of management accounting is cost accounting which deals with cost
ascertainment and cost control.

Few other branches of accounting which are of recent
origin are social responsibility accounting and human resources
accounting. The first one involves accounting for social costs incurred
by the enterprise and social benefits created by it while the second
deals with accounting for human resources.

In the present book, we are concerned with financial
accounting only. The word accounting and financial accounting are
used interchangeably.

Financial accounting provides information to external
user groups in the form of published financial statements. As these
users are involved in preparation of financial statements, it is very

essential that the published statements have credibility and regarded
as reliable by external users. Therefore, accounting, as a language for
communicating information, needs to have a strong syntax of its own
for preparing credible financial statements.

The syntax of accounting language comprises of analysis
and recording of business transactions on the basis of double Entry
system of book keeping and the basic principles on which the
practical system is based. The theory base; of accounting consists of
Generally Accepted Accounting Principles (GAAP), Conceptual
framework and Accounting Standards (AS) issued by the professional
accounting bodies all over the world,

The credibility of the financial statements is established
through analysis independent examinations by a chattered
accountant who certifies that the information provided therein gives
true and fair view of the activities of tM business in conformity with
accepted principles and practices. This process of attestation of
account is known as auditing of accounts.

MEANING OF FINANCIAL ACCOUNTING

Measurement of accounting information involves three
basic steps as per the traditional definition of accounting by the
American Institute of Certified Public Accounts (AICPA) which defines
accounting as "the are of recording, classifying and summarizing in a
significant manner and in terms of money, transaction- and events
which are negative part atleast of financial character and interpreting
the results thereof.
On this basis of above information, Accounting or more
precise financial accounting can be basically divided into two parts",
A. Creation of financial information.
B. Use of financial information.

A. Creation of financial information:

Creation of financial information involves three steps:

1. Recording:

The process of creation of financial information starts with the
occurrence of a business transaction which can be Qualified. The
transaction is evidenced by some document such as Sales bill, Pass
book, Salaries slip etc., The systematic record of those transactions is
chronological order (i.e. the order in which they occur ) is made in a
book called JOURNAL BOOK. The four basic questions need to be
addressed while recording namely, what to record, when to record,
how to record and at what value to record?

What to record? Since-accounting is regarded as language of the
business, it should systematically record all the transaction and
events which affect the results of business and ignore the person
transaction of the proprietor. Before recording in the journal book, all
business transaction expressed in terms of money. Consequently
business activities which cannot be expressed in terms of money such
as strikes, changes in the composition of board of directors etc., are
not recorded. Thud decision makers will get informa^on only about
money aspects of the business enterprise from a accounting records.

When to record? Usually business transaction is recorded only when
it has occurred. Thus accounting is basically historical in nature.

How to record? Usually business transaction has two aspects and
both these are recorded by passing analysts entry in an journal book.
This system of recording is called double entry book keeping system.

At what value to record? To record occurrence of an event in journal
book, decision about the value of the transaction is needed.
A number of different valuation bases are used in
accounting in varying degrees and include historical cost, current
cost, realizable value and present value. These valuation based

generally assume significance in case of valuation of assets. Historical
cost refers to amount paid / payable to acquire an asset. The current
cost means the amount that would have to be paid, if the asset is to
be acquired currently. The realizable value refers to the net realizable
value of the assets if it is to be disposed. The present value of an asset
is the present discounted value of the future inflows that analysis item
is expected to generate in the normal course of business.

2. Classifying:

After recording monetary transactions in the journal
book, next step is to classify the recorded information into related
groups to put information in compact and usable forms. For e.g., all
transactions involving cash inflows (receipts) and cash outflows
(payments) can be grouped to develop useful information is called
ledger book. Mechanism used for classification of recorded
information is to open accounts which are called ledger accounts.

3. Summarizing:

Basic aim of accounting is to create financial information in a
form which will be useful to the decision makers. To achieve this end,
accounts containing classified information in the ledger book are
balanced. After balancing of the ledger book, account balances are
listed statement giving names of theses accounts and their balance is
called " TRIAL BALANCE " on the basts of trail balance, summaries
are prepared to give useful information about the financial results
during a time period and the financial position at a point of time.
Reporting of summarizes of the business transaction is done in the
form of financial statements which are known as FINAL ACCOUNTS.
According to international Accounting standard - 1 the term financial
statements covers balance sheet, income statements or profit and loss
accounts, notes and other statements and explanatory material which

are identified as being part of the financial statements. The process of
creation of financial information can be summarized as follows:

Analysis of Recording Classificati Summariza
business Journal on in ledger tion first in
transaction Book book trial
evidenced balance
by source and then in
document financial
statements

Thus recording, classifying and summarizing are three basic
steps involved in creation of financial statement which ascertain and
communicate result of business entity. For this is assumed that
business and its owner have separate existence. For accounting
purpose, even a division of the business or a branch of it may be
treated as an accounting entity.

B. Use of Financial Information / Statements:

Financial statements prepared by a business enterprise
are published and are available to the decision makers. Sound
division making requires analysis and interpretation of these financial
statements. A very commonly used tool for financial analysis is ratio
analysis. However, there are other tools which are used by the
decision makers to undertake analysis. The widely used tools for
carrying out analysis are :
• Cash flow statement
• Fund flow statement Ratio analysis
• Comparative statement
• Common size statement

However to analyze and interpret these financial
statements, the user shou/d be aware of purpose and nature of these
statements can be described as follows :
"Financial statements are prepared for the purpose of
presenting a periodical review or report on progress by management

and deal with the status of investment in the business and the results
achieved during the period under review. They reflect a combination of
recorded facts, accounting, conventions and personal judgements and
judgements and conventions applied after them materially. The
soundness of the judgement necessarily depends on the competence
and integrity of those who make them and on their adherence to
Generally Accepted Accounting Principles and Conventions. (Bombay
Stock Exchange Official Directory).

OBJECTIVES OF ACCOUNTING

The main objective of accounting are as follows:
 The main records of business: In accounting, systematic record
of monetary aspects of business events are maintained. The first
step in preparation of financial statements. This is referred to as
book-keeping.
 Calculation of profit or loss: To calculate profit earned or losses
suffered during a period of time, a business enterprise prepares
an Income Statement. It is also referred to a trading and profit
and loss account.
 Depiction of financial position: In addition to profit (or loss),
sound decision-making requires information about the financial
position of a busiriess enterprises. To depict financial position of
a business, financial position statement is prepared. On the one
hand, it gives details of resources owned by the business
enterprise. Resource owned are termed as assets. On the other
hand it contains the information about obligations of business.
Obligation of the business towards outsiders and owner are
referred to as liabilities and capital respectively. Financial
position statement is also termed as balance sheet which
provide information about sources of finance (e.g. outside
liability and owners equity) and the resources (eg. assets) of the
business.

 To portiay the liquidity position: Financial reporting should
provide information about how an enterprise obtains and
spends cash, about its borrowing and repayment of borrowing
about its capital transactions, cash dividends and other
distribution of resources by the enterprise to owners and about
other factors that may affect an enterprise's liquidity and
solvency.
 Control over the property and asset of the firm: Accounting
provides up-to-date information about the various assets that
the firm possess and the liabilities the firm owes so that nobody
can claim a payment which is not due to him.
 To file tax returns: This is the objective which really hardly
needs emphasis. The credible accounting records provide the
best bases for filing returns of both, direct as well as indirect
taxes.
 To make financial information available to various groups and
users: Accounting is called the language of business. It aims to
communicate information about financial results and financial
position of a business enterprise to decision makers,

USERS OF ACCOUNTING INFORMATION
Users of accounting information can be grouped as
follows
Owners: Owners refers to a person or group of persons who have
supplied capital for running the business. It refers to individual in
case of joint stock companies. Information needs of shareholders have
assumed great significance in the corporate business world because of
separation of ownership and management in case of joint stock
companies owners are interested in the financial information, to
know"about safety of amount invested and return on amount
invested.

Managers: For managing business profitably information
aboutHnancial result and financial position is needed by management
By providing this information, accounting helps managers in efficient
and smooth running of a business enterprise.

Investors: Prospective investors would like to know about the past
performance of the business enterprise before making investment in
that concern. By analyzingihistorical information provided by
accounting records, they can arrive at a decision about the expected
return and risk involved in investing in particular business enterprise.

Creditors and Financial Institutions: Whosoever is extending credit
or loan to a business'enterprise, would like to have information about
its repaying capacity, creditworthiness etc., The required information
can be obtained by analyzing and interpreting the financial
statements of the business enterprise.

Employees: Employees are concerned about job security and future
prospectus. Both of thpse are intimately related with the performance
of the business enterprise, Thus by analyzing financial statements
they can draw conclusions about their job security and future
prospectus.

Government: Government policies relating to taxation, providing
subsidies etc., are guided by the relevance of the industry in the
economic development of the country and the past performance of the
industry. Information about the past performance is provided by the
accounting system, collection of taxes is also based on accounting
records.

Researchers: Researchers need financial information for testing
hypothesis and development of theories and models. The financial
statement provides the recorded information.

Customers: (Customers who have developed loyalties to a business
are ceitainly interested in the continuance of the business. They
certainly want to know about the future directions of the enterprise
with which they are associating themselves. The way to information
about the enterprise is through their financial statements.

Public: An enterprise affects the public at large in many ways such as
provider of the employment to a number of persons being a customer
to many supplier a provider of amenities on the locality, a cause of
concern to the public due to pollution etc., Hence public at large is
interested in knowing the future directions of the enterprise and the
only window to peep inside the enterprise is their financial
statements.

ACCOUNTING AND THEIR DISCIPLINES:
Accounting is the best understood when the other related
disciplines are conceptually clear to the user. For e.g., a user can
hardly understand financial statements with lots of tables and graphs
in it. He is not comfortable with the basics of mathematics and
statistics. Accounting is very intimately connected with many
disciplines more important of which are economics, law, management,
statistics and mathematics.

Linkage with Economics:

Accounting has strong linkages with economics. It has acquired
its most important concepts of income and capital from economics.
The accountant as well as economist agree that capital should be
maintained intact while calculating income and this income can be
distributed without affecting capital. However, the interpretation of
the two concepts by accountant and economist differ a great deal
despite similarities. The capital to an economist is like a tree and

income is like a fruit on that tree. In technical terms, a stock of wealth
(Tree) or assets existing at a point of time is called capital whereas
flow of benefits from the wealth through a given periodvs called
income. Hence capital and wealth are synonyms for the economist.
The methodology adopted by economist is finding income is to find out
the excess of capital at the end of the year over the beginning of the
year. If the capital increases, it is more income. However as the capital
decreases it is called loss. To arrive at the value of the capital or
wealth, the present value of the future benefits is calculated by
discounting expected benefits at the required rate of return. Hence to
find out the worth of an asset, the economist will have to estimate the
life of the asset and the likely benefits to be desired from it. The
benefits will be discounted at the requires rate of return of the asset
has an exceptionally long life. Hence economists valuation of capital
and income are highly subjective.

Accountant tries to impart practicability to the concept of
capital and income. Recognizing that future benefits of an asset with
long life of say 100 years are difficult to estimate, the accountant puts
a value of the asset at which it was acquired. However, his attitude is
quite flexible and makes use of other bases of measurement wherever
the need arises. The income of business belongs to a owner. The
accountant finds income as a direct result of matching of revenue and
expense of the same period. It is always calculated at the end of a
period. The matching of revenues and expense can be done on
different basis viz accrual, cash and hybrid bases. The bases are
discussed in detail later:

Linkage with Mathematics:

Accounting is all about figures and operations on these
figures. The basic system of accounting can be very conveniently
converted in the mathematical form in the form of an accounting

equation. Simple mathematical operations involved in accounting are
addition, subtraction, multiplication and division. Besides many
aspects of accounting involve calculations which involve strong
knowledge of mathematics. For e.g., calculation of interest, calculation
of the annuity needed to depreciate an asset with a defined rate of
interest over its estimated useful life, bifurcation of a hire purchase
instalment in cash price component and interest component etc.,

Linkages with Statistics:

Accounting is not only about the preparation of accounting
information, it also involves the presentation and interpretation of
accounting information. The presentation aspects involved creation of
tables and graphs etc., the knowledge of which essentially lies in the
discipline of statistics. One of the most debated topic of accounting
namely inflation accounting involves extensive conversation of
historical accounting information with the help of price indices, 'an
important constituent of the discipline of statistics. The interpretation
of accounting information involves making absolute and relative
comparison with the help of ratio analysis. The knowledge of statistics
is needed for the purpose. An important way of calculating interest is
through the concept of average due date, which is based on the
knowledge of averages.

Linkages with Law:

Accounting essentially operates within a legal
environment. Many business organizations are governed by their
respective statues which prescribe the many aspects of their
accounting information including the presentation of information. For
e.g., the Indian Companies Activities, 1956 prescribes the rules for
managerial remuneration. It also prescribes the format of balance
sheet as well as profit and loss account, The banking, insurance and

electricity companies have also to prepare their accounts as per the
requirement of the respective statutes governing them.

LESSON - 2

MANAGEMENT ACCOU NTING

DEFINITION OF MANAGEMENT ACCOUNTING
The accounting activity can be classified into two parts.
Financial Accounting and Management Accounting. Though both of
them are interlinked, Management accounting is future oriented,
dynamic and is made to be decisive and control relevant.
International Federation of Accountants (IFAC) defined
Management Accounting process as "the process of identification,
measurement, accumulation, analysis, preparation, interpretation and
communication of information both financial and operating used by
management to plan, evaluate and controJ within an organisation and
to assure use of and accountability for its resources".
ICWAI published Glossary of Management Accounting terms
defining Management Accounting as "a system of collection and
presentation of relevant economic information relating to an enterprise
for planning, coordinating and decision making",
Management Accounting : Official Terminology of CIMA is defined
Management Accounting as "the provision of information required by
management for such purposes as:
1. Formulation of policies
2. Planning and controlling the activities of the enterprise
3. Decision taking on alternative course of action
4. Disc losure to those external to the entity (shareholders and
others)
5. Disclosure to employees
6. Safeguarding assets

The assets involves participation in management to ensure that there
is effective:

• Formulation of plans to meet objectives (long-term
planning)
• Formulation of short-term operation plans
(budgeting/ profit making)".

American Accounting Association defines Management
Accounting as "the application of appropriate techniques and concepts
in processing historical and projected economic data of an entity to
assist management in establishing plans for reasonable economic
objectives and in the making of rational decisions with a view towards
these objectives".
Richard M.S. Wilson and Wai Fong Chua define Managerial
Accounting as "Managerial Accounting encompasses techniques and
processes that are intended to provide financial and non-financial
information to people within an organisation to make better decisions
and thereby achieve organisational control and enhance
organisational effectiveness"

The Management Accounting is used by management to plan
the activity, evaluate performance, ensure integrity of financial
information and to irnplement the system of reporting that is linked to
organisational responsibilities and contributes to the effective
performance measurement. The definition of Management Accounting
embraces all functions undertaken by accountants in an organisation.
Management Accounting needs to be dynamic and forward looking. It
also comprises the preparation of financial reports for non-
management groups such as shareholders, creditors, regulatory
agencies and tax authorities. The role of Management Accountant is
not determined by an isolated concept. It is determined by the
requirements of business as Expressed in its structures.

SCOPE OF MANAGEMENT ACCOUNTING
Management Accounting includes Financial Accounting and
extends to the operation of a system of cost accounting and financial
management. While meeting the legal and conventional requirements
regarding the presentation of financial statements (profit and loss
account, balance sheet and funds flow statements) it stresses upon
the establishment and operation of internal controls. The scope of
Management Accounting, inter alia, includes:
 Formation, installation and operation of accounting, cost
accounting, tax accounting and information systems.
Management Accountant has to
 construct and re-construct these systems to meet the changing
needs of management functions
 The compilation and preservation of vital data for management
planning. The account and document files are respository of
vast quantities of details about the past progress of the
enterprise, without which forecasts of the future is very difficult
for the enterprise. The Management Accountant presents the
past data in such a way as to reflect the trends of evbnts to the
management.

 Providing means of communicating management plans to the
various levels of organisation. This, on the one hand, ensures
the coordination of various segments of the enterprise plans and
on the other defines the role of individual segments in the whole
plan and assists the management in directing their activities.

 Providing and installing an effective system of feedback reports.
This would enable the management in its controlling function.
By pinpointing the significant deviations between actual and
expected activities, and by adhering to the principles of
selectivity and relevance, such reports help in jthe installation
and operation of the system of 'Management by Exception'. The

Management Accounting is expected to analyse the deviation by
reasons and responsibility and to suggest appropriate corrective
measures in deserving cases.

 Analysing and interpreting accounting and other data to make it
understandable and usable to the management. It is only
through such analysis and clarification that the management is
enabled to place the various data and figures in proper
perspective in the performance of its functions. Such analysis
assists management- in the location of responsibilities and to
effect necessary changes in the organisational setup to achieve
the objectives of the enterprise in a more efficient manner.

 Assisting management in decision making by (i) providing
relevant accounting and other data and (ii) analysing the effect
of alternative proposals on the profits and position of the
enterprise. Management Accountant helps the management in
proper understanding and analysis of the problem in hand and
presentation of factual information obviously in financial terms.

 Providing methods and techniques for evaluating the
performance of the management in the light of the objectives of
the enterprise, thus assisting in the jrnpiementation of the
principle 'Management by Objectives'.

 Improving, modifying and sharpening the effectiveness of the
existing techniques of analysis. The Management Accountant
would always think of increasing the practicability of existing
techniques. He should be on the look-out of the development of
new techniques as well.

Thus, Management Accounting serves not only as a tool in the
hands of management, but also provides for a technique evaluating

the performance of its functions of planning/decision making and
control, and at the same time, enabling the owners and other
interested parties to evaluate and appraise the management of the
enterprise.

FUNCTIONS OF MANAGEMENT ACCOUNTING

Management Accountant is one of the best assets for
management. His contribution has been growing with passage of time.
He will continue to deliver the goods in a magnificent manner in
future with varied experiences. Scope is expanding and managements
of various sectors are benefiting. Excerpts from the "Preface to
Statements on International Management Accounting" issued oy the
international Federation of Accountants in February 1987 are
reproduced below:
"Management Accounting is used by management to;
Plan - to gain an understanding, to expected business
transactions and other economic events and their impact on the
organisation, and to use this understanding as a basis for a
course of action to be followed by the organisation in the future;

Evaluate - to judge the implications of various past and/or
future events;

Control - to ensure the integrity of financial information
concerning an organisation's activities or its resources;

Assure accountability - to implement the system of reporting that
is closely aligned to organisational responsibilities and that
contributes to the effective measurement of management
performance"

The functions of Management Accounting can be broadly classified
into;
(a) Periodic interval accounting reports, and
(b) Ad hoc analysis of data decision making.

It is increasingly felt that Management Accountants should
involve themselves more and more in decision making and problem
solving of organisations. The areas of decision making and problem
solving are dealt in the following paras:
 Strategic Management Accounting: This function helps the
organisation prepare long-term plans, formulate corporate
strategy and forecast and evaluate the competitors.
 Investment Appraisal: This activity includes the (i) appraisal of
long-term investment (ii) funding of accepted programmes
projects, and (iii) post-audit of accepted programmes.
 Financial Management: It deals with raising of funds for
investment, managing surplus funds, controlling working
capital etc,
 Short-term ad hoc decisions: This includes analysing data for
taking decisions c i pricing, product introduction, acceptance of
special orders etc.
 Managing the organisation of information system: This includes
not only organising the enterprise's financial data but fulfilling
the information needs of all the segments of the organisation.

FUNCTIONS OF MANAGEMENT ACCOUNTANT
The term 'Management Accountant' has many Director,
Financial Director, Financial Controller, Finance Comptroller etc., are
some of the terms used to designate with the work Management
Accounting. Depending situation, size, nature arid organisational
setup and his position in the company, the Management Accountant
may be required to perform various and varied functions. The
importance and effectiveness of his function would also depend upon

the confidence reposed in him by the top management and the
functional managers. His functions generally embrace each and every
activity of the management. The essence of Management Accountant's
functions are as follows:

 The Management Accountant will establish, coordinate and :
administer plans to facilitate the forecasting of sales, expense
budgets and cost standards that will permit profit planning,
capital budgeting and financing.
 The Management Accountant will formulate accounting policy
and procedures. Operating data and special reports must be
prepared so that the performance can be compared with plans
and standards, and any variance between actual operations and
pre-determined standards can be analysed for corrective actions
by management Such comparisons between actual and
expected activities should help the management in proper
fixation of responsibility and also in evaluation of various
functional and divisional heads.
 The Management Accountant will be responsible for the
protection of business assets to the extent possible by external
controls and internal auditing and insurance coverage.
 The Management Accountant will be responsible for tax policies
and procedures and will supervise and coordinate the reports
required by various authorities. ;
 The Management Accountant must continually £e aware of
economic and social forces as well as the effect of the
Government policies and actions on business activities.

An analysis of the above list (obviously not exhaustive) o
functions, reflects the status of a Management Accountant. He is the
principal office in-charge of the accounts of the company. He shall be
responsible to the Board of Directors for the maintenance of adequate
accounting procedures and records on the operation of business. He

shall be responsible to the President or the Chairman of the Board or
the Board of Directors. Thus, in his broad functional activities, the
Management Accountant is responsible to the policy making group of
top management, whereas, in his administrative activities he ss
responsible to the top executive offer.

MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING

The financial accounting classifies and records an entity's
transactions normally in money terms, in accordance with established
concepts, principles, accounting standards and legal requirements. It
aims to present a 'true and fair view' jof the overall results of those
transactions. Management Accounting has been described as a
continuous process of analysis, planning and control in the context of
providing decision support for decision makers. Management
Accounting is more concerned with decision making and a key role for
Management Accountant is acting as a provider of financial
information to support these decisions, There are several differences
between Financial Accounting and Management Accounting as are set
out in Table 1.1.

Financial Accounting and Management Accounting both appear to be
similar inasmdch as both study the impact of business transactions
and events of the enterprise, reports and interpret the results thereof.
Both provide information for internals as well as external use. But
Management Accounting although having its roots in Financial
Accounting differs from the latter in following respects:

 Financial Accounting studies the business transactions and
events for the enterprise as a whole. It does not trace the path of
events with in the enterprise. Management Accounting, in
additions to the study of the events in relation to the enterprise
as a whole, takes organisation in its various units and segments

and attempts to trace the impact and effect of the business
transactions and events through these various divisions and
sub-divisions. Thus, while the financial statements -profit and
loss account, balance sheet and flow statements reveal the
overall performance and position of the enterprise. Management
Accounting reports emphasis on the details of operational costs,
inventories, products, processes and jobs. It traces the effect
and impact of the business transactions and events on costs,
inventories, processes, jobs and products.
 Financial Accounting is more attached with reporting the
results and positions of business to persons and authorities
other than management-Government, Creditors, Investors,
Owners, etc. At times, Financial Accounting follows window-
dressing tactics in order to project a better than actual image of
the enterprise. Management Accounting is concerned more with
generating information for the use of internal management and
hence the information reflects the real or really expected
position.

 Financial Accounting is necessarily historical. It records and
analyses business events long after they have taken place.
Management Accounting analyses the events as they take place
and also anticipates such events for the future. Thus, it uses
data which generally has relevance to the future.

 Since Financial Accounting data is historical in nature, it is
more precise than the Management Accounting data, which
generally reflects Ihe expected future, and hence could only be
an estimation. This provides the necessary rapidly to
Management Accounting information.

 The periodicity in reporting financial accounts is much wider
than in case of Management Accounting. In Financial

Accounting, generally, results are reported on year to year basis.
In Management Accounting is free to formulate its own rules,
procedures and forms because the information generates is
solely for internal consumption.

 Financial Accounting has to governed by the 'generally accepted
principles'. This is so because, it has to cater for the
informational needs of the outsiders and legal provisions.
Management Accounting is free to formulate its own rules,
procedures and forms because the information it generates is
solely for internal consumption.

 Financial Statements prepared under Financial Accounting
consists 'of monetary information only. Management Accounting
statements, in addition to monetary information, also consists
non-monetary information viz., quantities of materials
consumed, number of workers, quantities produced and sold
and so on.

TABLE 1.1: MANAGEMENT ACCOUNTING vs. FINANCIAL
ACCOUNTING
Nature Fianacial Accounting Management
Accoutning
1. Governed by Company law etc. Needs of managers

2. Basic functions Transaction Decision support
recording, Publication Provision of
of external financial Management
3. Users statements information
External Internal

4. Availibility Publicly available Confidential
5. Time focus Past and present Present and future
6. Period Usually one year As appropriate
7. Main emphasis Explanation Planning and control
8. Speed of Slow but detailed and Fast but approximate
prepartion
accurate
9. Form of whole of entity Segmented to control
presentations
units
10. Style and Standardized Tailored to
details
requirement and
Objective, verifiable summarized
11. Criteria
and consistent Relevant, useful and
Money understandable
12. Unit of
Somewhat technical Money physical units
account
For use by non-
13. Nature of
accountants
data

LESSON - 3
THEORY BASE OF ACCOUNTING - ACCOUNTING STANDARDS

Accounting is "the process of identifying, measuring and
communicating information to permit judgement and decisions by the
users of accounts" -American Accounting Association. It is absolutely
necessary that accounting information contained in financial
statements are credible and are regarded as reliable by the different
user groups to be consistent. Preparation of financial statements on
uniform and consistent basis improves their comparability and
credibility. It has two aspects, namely,
• The financial statements of an enterprise for different
accounting years are based on similar accounting procedures
and policies so that meaningful comparisons over a period of
time can be made1 about he progress of the enterprise. This is
commonly referred to as 'Time series analysis’.

• The financial statements of many enterprises at a point of
time are based on similar accounting procedures and policies
so that conclusions can be drawn about their relative
performance at a point of time. It is known as 'Cross-sectional
analysis'. ,

It is the function of 'Accounting Standards' -to provide a rational
structural framework so that credible financial statements of the
highest quality can be produced. According to T.P. Ghosh accounting
standards are defined as under’.

“Accounting standards are the policy documents issued by the
recognised
expert accountancy body relating to various aspects of
measurement,

treatment and disclosure of accounting transactions and
events”

It is clear from the above definition that accounting standards
provide a
framework for the preparation of the financial statements. They also
draw the boundaries within which acceptable conduct lies. In the
absence of accounting standards, many alternatives will exist and will
give the accountant the| leverage to colour'his accounting records the
way he likes. Such 'Creative Accounting Practices’ will certainly
create financial statements which are unreliable and lower the
confidence of user in the reported results. Hence the need for a
coherent pet of accounting standards is imperative. The efficient
functioning of the financial system depends upon the confidence that
user groups have in the fairness and reliability of the financial
statements of the businesses ana it is the function of accounting
standards to create this genera) sense of confidence by providing; a
structural framework within which credible financial statements can
be produced. The whole idea of ‘Accounting Standards’ is centred
around harmonisation in the accounting policies and practices
followed by businesses. The basic purpose of 'Accounting Standards'
is to standardize the diverse accounting practices followed for
many aspects of accounting. The harmonisation of accounting
policies and practices is needed at national level as well as
international level. To tackle the problem at national level, the
Institute of Chartered Accountants of" India issues accounting
standards (called AS's) formulated by the Accounting Standards Board
(ASB). At international level, International Accounting Standards
Committee (IASC) issues International Accounting Standards (called
lAS's). The objective of the IASC in terms of standard setting is "to
work generally for the improvement and harmonisation of regulations,
accounting standards and procedures relating to the presentation of
financial statements'. The Institute of Chartered Accountants of India

is a member of IASC and has a tacit understanding with the IASC that
it would adopt the accounting standards issued by IASC after due
recognition of the conditions and practices prevailing in India. At the
international level, IASC has issued 32 international accounting
standards. At the national level, ICAI has issued 15 accounting
standards on various issues of accounting and a preliminary draft
of a proposed accounting standard on borrowing costs is being made
by the ASB in addition to the revision contemplated in existing
standards on valuation of inventories and accounting for construction
contracts.

ACCOUNTING STANDARDS (N INDIA
The Institute of Chartered Accountants of India, fully
recognising the need cf harmonizing the diverse accounting policies
and practices established 'Accounting Standards Board' on 21 st April,
1977 so that accounting as a language could develop along the right
lines. Accounting Standard Board's (ASB) main function is to
formulate accounting standards to be issued under the authority of
the council of the institute. Accounting standards provide rules and
criteria of accounting measurement. However the rules' criteria are
intended lo be used if: a sociai system and hence are never intended lo
be rigid as in case of physical sciences.

Constitution of ASB :
The consistitution of ASB gives adequate representation to all
interested parties and, at present, it consists of members of the
council and representatives to industry, banks, Company Law Board,
Central Board of Direct Taxes and the Comptroller and Auditor
General of India, Security Exchange Board of India etc,

Functions of ASB :
The main function of ASB is to fomralate accounting standards. While
formulating accounting standards, ASB takes into consideration the

applicable laws, customs, usage and business environment. The
Institute is the member of International Accounting Standards
Committee (IASC) and has agreed to support the objectives of IASC.
While formulating standards, it gives due consideration to the
International Accounting Standards (IAS) issued by IASC and tries to
integrate them, to the extent possible, in the light of conditions and
practices prevailing in India. It also reviews the accounting standards
at periodical intervals.

FORMULATION OF ACCOUNTING STANDARDS
The following points need to be kept in mind while drafting accounting
standards, namely -
• The accounting standards issued are in conformity with the
provisions of the applicable laws, customs, usage and business
environment of our country;

• The accounting standards are in the nature of laws but not
laws. Though every possible care is taken while drafting
standards that they are in conformity with eh applicable laws,
still the conflict between the law and an accounting standard
might arise due to amendments in the law subsequent to the
issuance of the accounting standard. As clarified in the
'Statements of Accounting Standards', accounting standards
cannot and do not override the statute and in all such cases of
conflicts, the provisions of the law will prevail and the financial
statements should be prepared in conformity with the relevant
laws Obviously, to that extent, the accounting standards shall
not be applicable. However, "the institute will determine the
extenl of disclosure to be made in financial statements and the
related auditor's reports. Such disclosure may be by way of
appropriate notes explaining the treatment of particular items.
Such explanatory notes will be only in the nature of clarification

and therefore, need not be treated as adverse comments on the
related financial statements"

• The accounting standards are intended to apply only to items
which are material and become applicable from the date as
specified by the institute. They are applicable to all classes of
enterprise unless otherwise stated. No standard is applicable
retroactively, unless otherwise stated;

• The accounting standards are to address the basic mattes, to
the extent possible. The idea is to confine them to essentials
only and not to make them complex.

The ASB has drawn an elaborate procedure for formulating
accounting standards. However, it needs to be emphasised that the
standards are issued under the authority of the council of the
institute. The procedure involves the following steps:

a) Firstly, the ASB determines the broad areas in which
accounting standards need to be formulated;

b) Secondly, the ASB takes the assistance of the various study
groups to formulate standards The preliminary drafts of the
standards are prepared by the Study groups which take 'up
the specific subjects assigned to them. The draft prepared
by a Study Group is considered by ASB and sent to various
outside bodies like FICCI, ASSOCHAM, SCOPE, CLB, C&AG,
ICWAI, ICSI, CBDT etc. and the representative of these bodies
are also invited at a meeting of ASB for discussion.

c) Thirdly, after taking into consideration their views, the draft of
the standard is issued as exposure draft for soliciting
comments from members of the institute and public at large.

The draft is issued to a large number of institutions and is
published in the journal of the institute. The exposure draft
includes the following basic points:

• A statement of concepts and fundamental accounting
principles relating to the standard;
• Definitions of the terms used in the standard;
• The manner in which the accounting principles have been
applied for formulating the standard;
• The presentation and disclosure requirements in
complying with the standard;
• Class of enterprises to which the standard will apply,
• Date from which the standard will be effective.

d) Fourthly, the comments on the exposure draft are then
considered by the ASB and a final draft is prepared and
submitted to the council of the institute;

e) Lastly, the council of the institute considers the final draft of the
proposed standard, and if found necessary, modifies the same
in consultation with ASB. The accounting standard on the
relevant subject is then issued under the authority of the
council.

NATURE OF ACCOUNTING STANDARDS

The accounting standards issued by the ICAI-are
recommendatory in nature in the initial years. During the period a
standard is recommendatory, it is expected that the accounting
practices shall be brought in line with the standard. In other words,
the recommendatory period is allowed to smoothen the process of
transition so that no enterprise should have difficulty in conforming to

the accounting standards once they are made mandatory. Once an
accounting standard is made mandatory, it is applicable to all
enterprises whose accounts are audited by the members.
During the period an accounting standard is recommendatory,
tne auditors of companies are required to recommend and persuade
their cfients to comply with the requirements of the accounting
standard even though it is recommendatory in nature. Regarding the
mandatory standards, it is the duty of the auditors to ensure that the
accounting standards are followed in the preparation and presentation
of the financial statements. If the mandatory accounting standards
have not beer, complied with, the auditor is required to make
adequate disclosure in his report so that the users of financial
statements are aware of the non-compliance on the part of the
enterprise. If a member fails to do so, the Chartered Accountants Act
explicitly provides that “a chartered accountant in practice will be
deemed to be guilty of professional misconduct if he ails to invite
attention to any material departure from the generally accepted
procedure of audit applicable to the circumstances”

It is amply clear that standards on their own have no legal
backing and hence, are not enforceable on the public at large. Hence
the institute depends on is members for implementation of accounting
standards issued by it through their attest function. To make it
effective, following steps are needed:

• Self-regulation on the part of the business organisation so that I
hey adhere to these standards while finalising their accounts;

• Legal backing to the accounting standards. The standards as
they are issued not have no legal backing and institute depends
on its memters for their implementation through their attest
function;

• Publicising the use of accounting standards and making the
user: of accounting information more informed about their right
of getting a more true and fair picture of the results of business
based on these accounting standards;

• To avoid duplication of authority. If more than one authority
issues standards, it is bound to create a confusion in the mind
of the user as to which standard needs to be followed. A recent
development, worthy of attention, is the establishment of two
accounting standards by the government under the Income Tax
Act, 1961 which are to be followed in the preparation of
financial statements in case the assessee prefers mercantile
basis accounting, (Accounting Standard I 'relating to disclosure
of accounting policies and Accounting Standard II relating to
disclosure of prior period and extraordinary items and changes
in accounting policies).

To conclude, the Institute and its members are duty bound to
formulate and implement accounting standards to provide objective
and reliable accounting data that would satisfy the information
requirements of the users To achieve this, problem of duality of
authority should be tackled and the system of dual accounting
standards in view of its expertise in the field. To improve their
effectiveness, it is also suggested that the standards should be given a
legal backing with strong punishment for the erring business
organisations. At the same time, to make a genuine case for
recognition of accounting standards and to prevent abuse of financial
statements, more credibility should be provided to the process of
standard setting.

ACCOUNTING STANDARDS ISSUED BY THE INSTITUTE
AS-1 Disclosure of Accounting Policies :

The standard defines 'Accounting Policies' as referring to the
specific accounting principles and the methods of applying those
principles adopted by the enterprise in the preparation and
presentation of financial statements. It recommends the disclosure of
significant accounting policies adopted in the preparation and
presentation of financial statements in a manner that should form
part of the financial statements. It also recommends that he
disclosure should normally be at one place. Any change in the
accounting policies which has a material effect in the current period
or which is reasonably expected to have material effect in later pejods
should be disclosed. It also emphasises that the disclosure of
compliance with fundamental accounting assumption of Going
Concern, Consistency and Accrual is not needed. However, if they are
not followed, the fact must be disclosed.

AS-2 Valuation of Inventories :

The inventories should be normally valued at 'Lower of Cost or
Market' where market value means net realizable value. The historical
cost of inventory can be ascertained by use of 'FIFO', 'Average Cost', of
'LIFO' formulae. When organization have different items in inventory,
each item may be dealt with separately, or similar items may be dealt
with as a group.

The historical cost of manufactured inventories may be arrived
on the basis of either direct costing or absorption costing. Where
absorption costing is used, the fixed costs should be based on the
normal level of production. Overheads other than production
overheads should be included as part of the inventory' cost only 10

the extent that they clearly relate to putting the inventories in their
present location and condition.

The accounting policy in respect of inventories should be
properly disclosed and any change in it which has a material effect in
the current accounting period or which is reasonably expected to have
material effect in later periods should be disclosed. The amount by
which an item in the financial statements is affected by such change
should also be disclosed to the extent ascertainabfe. Where such
amount is not ascertainable, wholly or in part, the fact should be
indicated.

The 'Specific Identification Method', 'Adjusted Selling Price
Method', 'Standard Cost Method' and 'Base Stock Method' are to be
used in specific circumstances. However, if base stock method is
used, the difference between the value at which it is carried and the
value by applying the method at which stock in excess of the base
stock is valued should be disclosed.

AS-3 Changes in Financial Position :

A statement of changes in financial position should be
published along with its published accounts. Such a statement should
be prepared and presented for the period covered by the profit and
loss account and for the corresponding period. It may be prepare on
working capital basis or cash basis. It emphasises that the funds
provided from operation and used in the operation be shown
separately and the form of statement should be most informative in
the circumstances. However, the standard is no longer vaJid as it has
been superseded by new standard AS-3 (Revised) ‘Cash Flow
Statement’ issued in March, 1997.

AS-3 (Revised) Cash Flow Statement:

The cash flow statement should report cash flows coring the
period classified by operating, investing and financing activities. An
enterprise should report cash Hows from operating activities using
either (a) direct method; or (b) indirect method. The inflow and outflow
from the investing and financing activities should be shown
separately. Investing and financing transactions that do not require
the use of the cash or cash equivalents and should present a
reconciliation of the amounts in its cash flow statement with the
equivalent items reported in the balance sheet. The enterprise should
also disclose the amount of significant cash and cash equivalents
balances that are not available for use by it.

AS-4 (Revised) Contingencies and Events Occurring after the
Balance Sheet Date :
A contingency is a condition or situation, the ultimate outcome
of which, gam or loss, will be known or determined only on the
occurrence, or non-occurrence, of one or more uncertain events. A
contingent loss should be recognised if (a) it is probable that future
events will confirm that ari asset has been impaired or a liability has
been incurred on the balance sheet date^ and (b) a reasonable
estimate of the amount of the resulting loss can be made. A
contingent gain should not be recognised. If either of the two
conditions mentioned above are not met, a disclosure should be made
of the existence of the contingency specifying:
• the nature of the contingency;
• the uncertainties which may affect the future outcome; :
• an estimate of the financial effect, or a statement that such ail
estimate cannot be made.

Assets and liabilities should be adjusted for events occurring
after balance sheet date that provide additional evidence to assist the
estimation of the amounts relating to conditions existing at the
balance sheet date (for: example, insolvency of a debtor subsequent to
finalisation of financial statements) or that indicate that the
fundamental accounting assumption of going concern is not
appropriate. Dividends, proposed (or declared) by the enterprise: after
the balance sheet date but before approval of the financial statements,
and pertaining to the period covered by financial statement, should be
adjusted. Adjustments to assets and liabilities are not appropriate for
events occurring after the balance sheet date, if such events do not
relate to conditions existing at the balance sheet date (for example,
decline in market value of the investment). Disclosure should be made
in the report of the approving authority of those events occurring after
the balance sheet date that represent material changes and
commitments affecting the financial position of the enterprise
specifying:

• the nature of the event; I
• an estimate of the financial effect, or a statement that such an
estimate cannot be made.

AS-5 (Revised) Net Profit or Loss for the Period, Prior hems and
Changes in Accounting Policies :

The objective of this standard is to prescribe the classification and
disclosure of certain items in the statement of profit and loss so that
all enterprises prepare and present their financial statements on a
uniform basis to improve 'their comparability. It explains that profit or
loss of a period comprises of ordinary activities, extraordinary
activities and prior period items and all three need to be disclosed

separately. It also includes the impact of change in accounting
estimates and change in accounting policies.

Ordinary activities are any activities which are undertaken by
an enterprise as part of its business and such related activities in
which the enterprise engages in furtherance of, incidental to, or
arising from, these activities. Extraordinary items are incomes or
expenses that arise from events or transactions that are clearly
distinct from the ordinary activities of the enterprise and, therefore,
are not expected to recur frequently or regularly. Prior period items
are'income or expenses which arise in the current period as a result of
errors or omissions in the preparation of the financial statements of
the one or more prior periods. The net profit or loss for the period
comprises the following components, each of which should be
disclosed on the face of the statement of profit and loss;
• profit or loss from ordinary activities; and
• extraordinary items.

Prior period items are normally included in the determination of
net profit or loss for the current period. An alternative approach is to
how such items in the statement of profit and loss after determination
of current net profit or loss. The second approach seems better
because that will help ascertain the result of current period unaffected
by the mistakes of the past, in either case, the objective is to indicate
the effect of such items on the current profit or loss.

Change in Accounting Estimates Vs. Change in Accounting
Policies:
A distinction should always be made between change in accounting
estimates and changes in accounting policies. When it is difficult to
distinguish between the change in accounting estimate and change in
accounting policies, it should be regarded as change in accounting
estimate, with appropriate disclosure in the periods of change, which

may be current period only or current period as well as future periods.
The effect of change in an accounting estimate should be classified as
ordinary or extraordinary depending upon whether the original
estimate was regarded as ordinary or extraordinary item. However, the
revision of estimate, by its nature, cannot be called extraordinary or
prior period item. When change in accounting estimate/ change in
accounting policy takes place which has a material effect, its nature
and amount should be disclosed. If the effect is not ascertainable, the
fact should be disclosed in the financial statement.

AS-6 (Revised) Depreciation Accounting :

The depreciable amount of an asset comprising of its historical
cost, or other amount substituted for historical cost in the financial
statements, less the estimated realizable value should be allocated on
a systematic basis to each accounting period during the useful life of
the asset. The historical cost may undergo revision arising as a result
of increase or decrease in long term liability on account of exchange
rate fluctuations, price adjustments, changes in duties or similar
factors. The useful life of the asset may itself be subjected to revision,
in which case, the unamortised balance of the asset be depreciated
over its remaining life. Any addition or extension to an existing asset
should be depreciated along with the original asset, unless the
extension has a separate identity, in which case it should be
depreciated on the basis of an estimate of its own life. Where
depreciable asses are disposed of, discarded, demolished or destroyed,
the net surplus or deficiency, if material, is disclosed separately. The
change of method, if warranted, should be done with retrospective
effect from the date of asset coming to use. In case of revaluation of
asset, the revalued amount should be amortised over the remaining
useful life of the asset. The information to be included in the financial
statements should comprise of historical cost or any substituted
amount, total depreciation for the period in respect of each class of

asset and related accumulated depreciation. The following information
should be disclosed in the financial statements along with disclosure
of other accounting policies:

• depreciation methods used; and
• depreciation rates or the useful lives of the asset, if they are
different from the principal rates specified in the statute
governing the enterprise.

AS-7 Accounting for Construction Contracts :

The standard deals with the problem of allocation of revenues
and related costs to the accounting periods over the duration of the
contract. The long term construction contracts could be fixed price
contracts where contractor agrees to a fixed contract price or cost plus
contracts where the contractor is reimbursed for allowable or
otherwise defined costs, and is also allowed a percentage of these
costs or a fixed fees. Both these contracts can be accounted by either
percentage of completion method or completed contract method.
Under percentage of completion method, the amount of revenue
recognised is determined with reference to the stage of completion of
the contract activity at the end of each accounting period. The
completed contract method is based on results as determined when
the contract is completed or substantially completed.

Profit in the case of fixed price contract should be recognised
when the work has progressed to a reasonable extent- say 25 or 30%.
While recognising profit under percentage of completion method, the
appropriate allowance for future unforeseeable facts should be made
on either a specific or percentage basis. A foreseeable loss on entire
contract should always be provided for in the financial statements
irrespective of the amount of work done and the method of accounting
followed. Disclosure of changes in accounting policy used for

construction contracts should be made in the financial statements
giving the effect of the change and its amount.

AS-8 Accounting for Research and Development:

The prescribed research and development costs outlined in para
7 of Hie standard relating to a business should be charged to the
revenues of the period in which they are incurred unless the criteria
mentioned in para 9 of the standard are met, in which case, the
charging of these expenses can be deferred to future accounting
periods. The research and development costs, once written off, arc
never reinstated in accounts. The deferred research and development
cost should be allocated on a systematic basis to future accounting
periods by reference to either to the sale or use of the product or
process or to the time period over which the product or process is
expected to be sold or unused. If at any point of time, criteria for
deferral as detailed in para 9 are not met, the unamortised balance of
research and development expenditure should be charged to the profit
and loss account. When the criteria for deferral continue to be met but
the amount of the deferred research and development costs and other
relevant costs exceed the expected filture revenues/ benefits related
thereto, such expenses should be charged as an expense immediately.
The amount charged to profit and loss account should be explicitly
disclosed and unamortised research and development costs should be
shown in the balance sheet under the head "Miscellaneous
Expenditure". ,

AS-9 Revenue Recognition :

The standard mainly deals with the timing of revenue. Revenue
is defined as "gross inflow of cash, receivable or other consideration
arising in the course of ordinary activities of an enterprise from the
sale of goods, from the rendering of services, and from the use by

others of enterprise resources yielding interest, royalties and
dividends. The revenue is recognised in case of sale when:

• the seller of goods has transferred the property in goods tci the
buyer along with significant risks and rewards of the ownership
;
and seller has no effective control over goods transferred;

• no significant uncertainty exists regarding the amount of the
consideration that will be derived from the sale.

The revenue from rendering of services is recognised either
under completed service method or proportionate completion method.
Completed service method is a method of accounting which recognises
revenue in the statement of profit and loss only when the rendering of
services under a contract is completed or substantially completed.
Proportionate completion method is a method of accounting which
recognises revenues in the statement of profit and loss proportionately
with the degree of completion of services under a pontract.
Revenue arising from interest is recognised on a time proportion
basis, royalties on an accrual basis and dividends from investments in
shares when the owner's right to receive payment is established.

AS-10 Recounting for Fixed Assets :

Fixed asset is an asset held with the intention of being used for
the purpose of producing or providing goods or services and is not he!
d for :he sais in the notarial course of business. The gross book vaiue
of a fixed asset shoulo be either historical cost or a revalued amount.
The cost of a fixed asset should normally comprise of its purchase
price and other attributable cost of bringing the asset to its working
condition for its intended use. Financing costs relating to deferred
credits or to borrowed funds attributable to construction or
acquisition of fixed assets for the period up to the completion of

construction or acquisition of fixed assets should also be included in
the gross book value of the asset to which it relates. When a fixed
asset is acquired in exchange or in part exchange for another asset,
the cost of the asset required should be recorded either at fair market
value or at the net book value of the asset given up, adjusted for any
balancing; payment or receipt of cash or other consideration.
Subsequent expenditures related to an item of fixed asset should be
added to its book value only if they increase the future benefits from
the existing asset beyond its previously assessed standards of
performance. Material items retired from active use and held for
disposal should be stated at the lower of their net book value and; net
49haracteri value. Losses arising from the disposal of fixed asset
carried at cost should be 49haracteri in the profit and loss account.

Normally the entire class of asset should be revalued and
revaluation should never result in the net book value of the class of
asset being greater than the recoverable amount of assets of that
class. Gain on revaluation should normally be taken to the owner’s
interest in the form of ‘Revaluation Reserve’ Alternatively it could be
taken to profit and loss account. Loss on revaluation should normally
be taken to profit and loss account except that such a decrease is
related to; an increase which was previously recorded as a credit to
the revaluation reserve and which has not been subsequently reversed
or 49haracte, it may be charged directly to that account. On disposal
of a previously revalued item of fixed asset, the difference between net
disposal proceeds and the net book value should be charged or
credited to the profit and loss statement except that to the extent that
such a loss is related to an increase which was previously recorded as
a credit to revaluation reserve and which has not been subsequently
reversed or 49haracte, it may be charged directly to that account.
Goodwill should he recorded in the books only when some consideration
in money or money’s worth has been paid for it. A proper disclosure of

the gross and net book value of the asset as well as relevant amount,
if the assets are stated at revalued amounts should be made.

AS-H (Revised) Accounting for tbc Effects of Changes in Foreign
Exchange Rates :

The standard deais with (a) accounting for transactions in
foreign currencies; and (b) translating the financial statements of
foreign branches for inclusion in the financial statements of the
enterprise. The standard details the methods to be adopted for
converting foreign transactions denominated in foreign currency in
the reporting currency defined as currency used in presenting the
financial statements of the enterprise. The standard recommends
proper disclosure of the exchange differences arising on foreign
currency transaction. Disclosure is also encouraged of an enterprise’s
foreign currency risk management policy.

AS-12 Accounting for Government Grants :

Government grants are assistance by government in cash or
kind to an enterprise for past or future compliance with certain
conditions. Government grants can be 50haracteri in accounts on the
basis of capital approach or Income approach, based on nature of
relevant grant. However, the government grant should not be
50haracteri until there is reasonable assurance that (i) the enterprise
will comply with the conditions attached to them; and (ii) the grant
will be received. A proper disclosure should be made of the accounting
policy adopted for government grants, including the methods of
presentation in the financial statements including the nature and
extent of government grant 50haracteri in the financial statements,
including grants of non-monetary assets given at a concessional rate
or free of cost.

AS-13 Accounting for Investments :

The standard deals with accounting for investment in financial
statements of enterprises and related disclosure requirements. An
enterprise should disclose current investments and long-term
investments distinctly in the financial statements. A current
investment is an investment that by its nature readily realizable and
is intended to be used for not more than one year from the date on
which such investment is made. A long-tern investment is an
investment other than a current investment. The cost of acquisition
should include charges such as brokerage, fees and duties. If an
investment is acquired by issue of share or other security, the
acquisition cost should be fair value of the security issued. IF an
investment is acquired in exchange for another asset, the acquisition
cost should be the determined cost with reference to the fair value of
the asset given up. Investment properties should be treated as long-
term investments.

Current investments should be carried in the financial
statements at the lower of cost and fair market value determined
either on an individual investment basis or by category of
investments, but not on an overall (or global) basis. Long-term
investments should be carried at their cost, although a provision for
diminution in their value, other than temporary, should be made. Any
change in the carried value of the investment should be carried to the
profit and loss account. Profit or loss on disposal of investments
should be 51haracteri and shown in the profit and loss account.
Significant disclosure requirements are also inserted in the standard
and include among other things, the disclosure of accounting policy
for determination of carrying amount of investments, classification of
investments, profit and loss on disposal of investments and changes
in carrying amounts of these investments, for current and long-term

investment separately and aggregate amount of quoted and unquoted
investments.

AS-14 Accounting for Amalgamation :

The standard deals with the accounting for amalgamation and
the treatment of any resultant goodwill or reserves. Amalgamation is
52haracterized as either in the nature of merger or purchase
depending upon five conditions enumerated. Amalgamation in the
nature of merger is accounted for by ‘Pooling of interest method’ and
amalgamation in the nature of purchase is accounted by ‘Purchase
method’. The consideration for the amalgamation means ihe aggregate
of the shares and other securities issued and the payment made in
the form of cash or other assets by the transferee company to the
shareholders of the transferor company.

The identity of all the reserves in amalgamation in the nature of
merger is preserved. However, in the case of amalgamation in the
nature of purchase, only statutory reserves are preserved by giving
debit to a new account called ‘Amalgamation Adjustment Account’.
Goodwill only arise in case of ‘Purchase method’. Goodwill arising on
amalgamation is amortised over a period not exceeding five years
unless a somewhat longer period can be justified. When an
amalgamation is effected after the balance sheet date but before the
issuance of the financial statements of either party to the
amalgamation, disclosure should be made in accordance with AS-4
but the amalgamation should not be incorporated in the financial
statements.

AS-15 Accounting for Retirement Benefits in the Financial
Statements of Employers:

The standard deals with the accounting of retirement benefits
consisting of (a) Provident funds; (b) Superannuation/ pension; (c)
Gratuity; (d) Leave encashment benefit on retirement; (e) Post
retirement health and welfare schemes; and (f) Other retirement
benefits in the financial statements of employers. The contribution of
the employer towards the provident fund and other contribution
schemes should be charged to the statement of profit and loss for the
period. The accounting treatment of gratuity and other benefit
schemes will depend on the type of arrangement which the employer
has chosen to make. Any alterations in the retirement benefit costs
should be charged or credited to the statement of profit and loss as
they arise in accordance with AS-5.

LESSON-4
PRACTICAL BASE OF ACCOUNTING – ORIGIN AND ANALYSIS OF
BUSINESS TRANSACTIONS

Accounting process begins with the origin of business
transactions and is followed by analyses of these transactions. After
origin and analysis of transactions comes recording, classification and
summarization of business transactions culminating in preparation of
financial statements,

Origin of Business Transactions

Accounting deals with business transactions which have
already taken place, As financial accounting concentrates on monetary
transactions of the past it is basically historical in nature. Since it
amounts to making recording and analysis of historical information
only, it is also known as post-mortem accounting. For recording
business transactions, it is necessary that these transactions are
evidenced by an appropriate document such as cash memo
purchase bill, sales bill, cheque book, pass book, salary slip, etc.,
Document
which provides evide nce cf the transaction is called the Source
Document.

Analysis of Business Transactions

In accounting record is made of monetary transactions which
are evidenced by a source document and double entry system is
applied for recording. According to J.R Batliboi “every business
transaction has a two-foid effect and that it affects two accounts in
opposite directions and if a complete record were to be made of such
transaction, it would be necessary to debit one account and credit

another account. It is this recording of the two-fold effect of every
transaction that has given rise to the term Double Entry System”

To analyze the dual aspect of each transactions and to find out
the accounts to be debited and credited following two approached can
be followed.
7. Accounting Equation Approach
8. Traditional Approach.

9. Accounting Equation Approach:

Equality of assets on one hand and liabilities and capital on the
other hand is called basic accounting equation and is written as

ASSETS = LIABILITIES + CAPITAL

expected Where assets refer to resources which are owned by
business enterprise and are to benefit future operations, liabilities are
debts payable to parties external to business and capital means the
amount payable to owners of the business enterprise (also called
owner’s equity )

The dual aspect of some business transactions is analyzed as
follows:
10. Introduction of resources by the owner:

Rs. 5,00,000 cash and furniture worth Rs. 20, 000 invested by
the owner in the business.
Introduction of Rs.5,00,000 cash increases business cash by
Rs. 5,00,000 and it creates analysis obligation to pay Rs. 5,00,000 to
the owner which is recorded as capital. In terms of accounting
equation its effect is as
follows:

ASSETS = LIABILITIES + CAPITAL
Cash (Rs.5,00,000) =__ + capital (Rs.5,00,000)
Further, if furniture worth Rs.20,000 is provided by the
proprietor, the accounting equation appears as under:
Cash + Furniture = Capital
(Rs.5,00,000) (Rs.20,000) - +(5,00,000 +
20,000 )
Rs. 5,20,000 Rs.5,20,000

11. Purchase of assets for cash and / or credit :

Purchased building for Rs,2,00,000 and paid Rs. 10,000 cash
immediately. It increases business assets or resources by Rs,
1,90,000 as cash decreases by Rs. 10,000 and building increases by
Rs.2,00,000. It also creates an obligation to pay Rs. 1,90,000 in
future. The accounting equation now appears as follows;
Cash + Furniture = Creditors for building + Capital
(Rs.5,00,000 (Rs.20,000) (Rs.1,90,000)
(Rs.5,20,000) –
Rs. 10,000)
+ Building
(Rs. 2,00,000)
-7,10,000 = Rs.7,10,000

12. Paid into bank Rs.3,00,000

It decreases cash balance and increase bank balance and thus,
have no net effect on total assets as shown below:

Cash + Bank = Creditors for building + Capital
(Rs.4,90,000 (Rs.1,90,000) (Rs.5,20,000)
13. (Rs. 3,00,000)

+ Furniture + Building
(Rs. 20,000) (Rs. 2,00,000)

-7,10,000 = Rs.7,10,000

14. Payment of Rs. 1,90,000 by cheque to creditors for
building :

It decreases bank balance by Rs.1,90,000 and creditors for
building by Rs. 1,90,000 as shown below:

Cash + Bank = Creditors for building +
Capital
(Rs.1,90,000 (Rs. 3,00,000) (Rs.1,90,000)
(Rs.5,20,000)
- Rs. 1,90,000) - Rs. 1,90,000)
(Rs. 20,000) (Rs. 2,00,000)

Rs. 5,20,000 = Rs. 5,20,000

15. Purchase of goods for Cash/Credit:

Business enterprise purchase goods worth Rs. 50,000 for cash
and Rs.20,000 on credit.

It increases stock of goods by Rs. 70,000, decreases cash by
Rs.50,000 and creates analysis obligation to pay. Rs.20,000 to the
supplier of goods. After this accounting equation appears as follows:

Cash + Bank + Stock of goods = Creditors + Capital

(Rs.1,90,000 (Rs. 1,10,000) (Rs.70,000) (Rs.20,000)
(Rs.5,20,000)
16. 50,000)
(Rs. 20,000) (Rs.2,00,000)
Rs. 5,40,000 =
Rs.5,40,000

17. Rs. 40,000 cash and Rs.20,000 goods withdrawn for
personal use:
It decreases cash by Rs.40,000 and goods by Rs.20,000. At the same
time, it decreases capital by Rs.60,000 as shown below:

Cash + Bank + Stock of goods = Creditors +
Capital
(Rs. 1,40,000 (Rs. 1,10,000) (Rs.70,000 (Rs.20,000)
(Rs.5,20,000
- 50,000) -Rs,20,000) -
Rs.60,000) + Furniture + Building
(Rs. 20,000) (Rs.2,00,000)

Rs. 4,80,000 = Rs.4,80,000

if accounting equation after above transactions is to be presented in
the form of balance sheet, it will appear as follows :

Balance Sheet
Liabilities Amount Assets amount
Capital 4,65,000 Cash 1,25,000
Creditors 20,000 Bank 1,10,000
Stock 30,000
Furniture 20,000
Building 2,00,000
4,85,000 4,85,000

Classification of Accounts and rules for Recording Transactions :
For recording business transaction all accounts are divided into
three categories,

1) Assets Account
2) Liability Account
3) Capital Account

For recording changes in assets, liabilities and capital two
basic rules are followed :

Rule No. 1 for recording changes in assets :
Increase in asset is debited and decrease in asset in credited.

Rule No. 2 for recording changes in liabilities and capital :
Increase in liabilities and capital are credited and decrease in
liabilities and capital are debited.

Transaction
Assets =
No.
Creditors
Trade
for
Cash + Bank + Stock+ Furniture+ Building = Creditors Capital
Building
+
+
1. 5,00,00 - - 20,000 - = - - 5,20,000

0
2. 5,00,00 - - 20,000 - = - - 5,20,000

0 - - - +2,00,00 + - -

- 10,000 0 1,90,000
3. 4,90,00 - - 20,000 2,00,000 = 1,90,000 - 5,20,000

0 +3,00,00 - - - - - -

- 0

3,00,00

0
4. 1,90,00 3,00,000 - 20,000 20,000 = 1,90,000 - 5,20,000

0 -1,90,000 - - - - - -

- 1,90,000
5. 1,90,00 1,10,000 - 20,000 20,000 = - - 5,20,000

0 - +70,000 - - - + 20,000 -

- 50,000
6. 1,40,00 1,10,000 70,000 20,000 20,000 = - 20,000 5,20,000

0 - -20,000 - - - - - 60,000

- 40,000
7. 1,00,00 1,10,000 50,000 20,000 20,000 = - 20,000 4,60,000

0 - -20,000 - - - - + 50,000

+ 25,000
8. 1,25,00 1,10,000 30,000 20,000 20,000 = - 20,000 4,65,000

0

Analysis of Changes in Capital Account

Increases and decreases in capital account can take place
due to introduction of capital, withdrawal of cash, goods and other
assets for personal use ( called drawings ), revenue and income earned

( resulting in increase in capital) and expenses incurred ( resulting in
decrease in capital). Recording the effect of all these transactions
directly in the capital account will make it unwieldy. In actual
practice, net effect of revenue and expense transaction during an
accounting period as shown by profit and loss account is transferred
to capital account. Similarly cumulative effect of drawings during an
accounting period is recorded in the capital account at the end of the
accounting period. For this purpose, temporary capital accounts are
opened. These are called temporary accounts because these accounts
start with zero balance in the beginning of the accounting period and
at the end of the accounting period, these account are closed and
their net effect it transferred to capital account. These include:

a) Revenue Account(mcluding other incomes and gains)
b) Expense Account(mcludmg losses)
c) Drawing Account.

As these accounts record changes which affect capital account only,
no separate rule is required for recording changes in temporary
accounts. For example:
i. Revenue increases capital and decrease in capital is credited,
therefore revenue earned is credited to revenue account.

ii. Expense decreases capital and decrease in capital is debited,
therefore, expenses are debited to expense account.

iii. Drawings decrease capital and decrease in 'capital is debited,
therefore, the value of assets withdrawn for personal use is
debited to drawings account.

Thus capital at the end of the period may be calculated as
follows:
Closing capital = Opening capital + Additional capital

Accounting Foundations

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