Question 1

Explain using various examples, how the major accounting concepts are used in preparing
financial statements.
Answer: Accounting concepts are those rules and principles that are followed while preparing
financial statements. The concepts and how they are used in preparing different financial
statements are given below.
Accrual Concept:
Revenue and expenses are recorded when they occur, not when the cash is received. If a service
is given or a service is enjoyed on credit, it will be recorded immediately.
Example: Service is provided on account $5000. Here cash is not yet received, yet $5000 will go
to income statement as revenue and $5000 will go in the balane sheet under current asset.
Salaries payable $500, Here cash is not yet paid, yet $500 will go to income statement as
expense and $500 will go in the balance sheet under liabilities and owners equity.
Consistency Concept:
Consistency concept tells that once a method is chosen for calculating an expense or revenue,
that method will be followed until a sound reason comes up to do otherwise.
Example: Equipment is purchased for $50000 on January 1
st
, 2010. Its lifetime is 5 years. If a
company decides to accumulate the depreciation on the basis of straight line method, it will keep
on doing the same for its whole lifetime. If the straight line method is followed. Accumulated
depreciation will be posted in the balance sheet from 2010 to 2015 for $10000.
Cost concept:
A fixed asset is always posted at its original purchasing price. It doesnt matter whether the
market price of that asset has increased or decreased.
Example: Equipment was purchased for $50000 on January 1
st
, 2010, now the market price of
that equipment is $60000. Still for the equipments whole lifetime it will remain as $50000 in the
balance sheet, under fixed assets.
Economic Entity:
The economic entity concept suggests that the activities of the business organization needed to
be kept separate from its owners and vice versa. In partnership and proprietorship organization it
is suggested to follow this concept to prepare financial statement while corporations are
obligated to follow this concept.
Example: The owner of an organization purchased a car for $500000. It is a personal expense for
the owner. So it will not be posted in any financial statement of the business.

Monetary Concept:
A business organization does various activities but among those only the activities that can be
measured by money will be included in financial statements.
Example: An employee is hired. Here in this case the employee is hired but not paid his salary
yet. So this incident wont be included in the financial statements.
Matching Concept:
Matching concept requires a company to match expenses with related revenues in order to report
a company's profitability during a specified time interval. Ideally, the matching is based on a
cause and effect relationship. Sales cause the cost of goods sold expense and the sales
commission expenses. If no cause and effect relationship exists, accountants will show an
expense in the accounting period when a cost is used up or has expired. Lastly, if a cost cannot
be linked to revenues or to an accounting period, the expense will be recorded immediately. An
example of this is Advertising Expense and Research and Development Expense.
Example: The cost incurred in the manufacture or purchase of inventory is charged to the income
statement of the accounting period in which the inventory is sold. Therefore, any inventory
remaining unsold at the end of an accounting period is excluded from the calculation of cost of
goods sold.
Accounting Period:
A business organizations lifetime is divided in certain periods. All the financial statements are
prepared after specific periods of time.
Example: Some business organizations prepare their balance sheets after 1 year, some after 6
months and some after 3 months. Preparing financial statements on yearly basis is mostly
followed.





Lower of Cost or Market value:
A company has to value its inventory either at the cost or market value, whichever is lower. It
falls under conservative valuation rule of accounting.
Example: the cost of inventories is $50000 and their market price is $45000. Here the market
price is lower. So it will be posted in balance sheet for $45000.

These are the major concepts of accounting and examples of how they are applied.



Question 2
Critically evaluate the role of financial reporting in aiding the decision making processes of
four different non-management stakeholder groups. Your answer should include
explanations of the decisions each of these stakeholders are likely to be taking in relation to
their interactions with a business.
Answer:
Stakeholder groups are those groups of people who have financial interest in a particular
business. Stakeholders can be part of the management team or not. While taking any financial
decision regarding that particular business, they check the financial reports provided by it. These
financial reports consist of information about the sources and amount of the businesss income
and also its expenses. These reports also tell if the company has made profit or incurred loss.
These reports give clear view of where the company is headed. Below the role of financial
reporting in aiding the decision making processes of four different non-management stakeholder
groups is going to be described.
The four non-management stakeholders:
Shareholders
Creditors
Suppliers
Labor Unions


Shareholders: Shareholders invest their hard earned moneys in the business. They expect that
their money is utilized properly and that they are going to gate a return from their investments.
Financial recording or financial statements are an easy way for shareholders to know the
financial condition of the company. These recordings allow them to keep in touch with the
financial decisions, growth of the company and strategy. The shareholders are paid a certain
percentage of companys profit after specific periods. Shareholders check the statements to be
sure that they are being paid correctly. BY evaluating the statements the shareholders come to
the decision that if they should invest more money in the business or should they pull their
money out. If they see the rate of growth of the company is increasing, the company is garbing
opportunities successfully and taking profitable strategies, they will invest more and more
money. On the other hand if they see the company is going down, its sale and profit is decreasing
at an increasing rate, they will decide to sell their share and get their money back.
Creditors: Creditors are those people who lend money to a business organization. With the help
of financial recordings they get a clear view of the financial organization. These recordings show
cash position, debt level, sales performance and expenses that help a creditor to take credit
decisions. They use different financial statements to gather different information. At first from
balance sheet they look for information about the state of a company's cash position, receivables
management, inventory management and its debt levels. They compare these results with
previous years to find out if the company is going towards distress. In that case creditors will
decide not to extend their credit and would want to get their money back. They will also look in
the income statement for sales performance and the expenses incurred during a period, or range
of periods. Creditors use this information to find out how profitable a business has been in a
historical period. They will also have close looks at the cash flow statements. The statement of
cash flows simplifies a creditor's research, as it shows the true cash position of a company. While
a company may be profitable on an income statement, they may be cash-poor, due to poor
collections on its receivables. The relationship of the balance sheet to statement of cash flows in
this case is obvious: As the receivables balance increases, the statement of cash flows shows
more cash leaving the business than coming in. With this information creditors will come to
know that, it is not clever to lend money to this business and they will stop extending their
Credit. On the other hand, if the creditors find out that the business is paying debts quickly,
making healthy profit and maintaining a high reputation, they are likely to extend credits for a
longer period.
Suppliers: Suppliers are those groups of people who supply raw materials for producing product
or products for resell, sometimes in advance. So before supplying products in advance they need
to make sure that they are going to get their receivables quickly. Financial recordings help them
to make these decisions with reliable information. So, financial recordings are as important for
suppliers as any other stakeholder. Suppliers mainly depend on financial statements to evaluate
the economic soundness of customers, especially those they intend to deal with on a long-term
basis. Suppliers rely on specific bits of data when going through customers' financial profiles.
These relate to solvency indicators in balance sheets as well as liquidity information in
statements of cash flows. Suppliers also go through income statements of its customers to
differentiate the businesses that are making money and those who are hardly surviving. Suppliers
also use financial information with an internal focus, meaning they use to understand their
operations and determine whether they're making money. They will supply product or raw
materials to those solvent businesses. If they have been already supplying products to a company
that is going toward distress, they will stop their supply.
Labor union: Labor unions are organized associations of workers, often in a trade profession,
formed to protect and further their rights and interests. Financial statements are useful to labor
unions and other employee representatives because they provide important information that may
be used in salary or employment benefit discussions with top management. Labor unions
typically evaluate corporate profitability, expense levels and business trends by evaluating data
included in financial recordings and statements. They evaluate the balance sheet, income
statement as well as cash flow statement. If in balance sheet the find out company has a huge
amount of cash, they might ask for a pay rise. On the other hand, if the cash available does not
seem to be enough, they might ask the management to take necessary steps, so that employees
rights are not hindered. Labor unions also look at the income statement. They compare revenue
with expense and if they see the expense is can be increased, they might ask for pay raise. They
always keep a close eye on financial health of the business; so that the employees are not going
to fall into any trouble and that their interests are given enough priority. If any problem occurs in
the recordings they speak for all the employees or labors and try to solve the crisis.



Financial recordings always keep the non-management stakeholders related to the business
organization and help them to take financial decision.


Question 3
Describe the limitations of Trial Balance.
Answer:
A Trial balance is a list of accounts and their balances at a given time. Usually, Companies
prepare a trial balance at the end of an accounting period to prove that the debits are equal to the
credits after posting. Though one of the main purposes of preparing a trial balance is to uncover
errors in journalizing and posting, it cannot uncover all errors. This inability of trial balance to
identify particular errors is called limitations of trial balance.
The limitations of trial balance are given below.

Not Journalizing a transaction at all:
If a transaction is not journalized at all, it cannot be identified through preparing trial balance. In
this case that transaction is not recorded. So, if now the trial balnce is prepared, the error will not
affect any side of it and the debits will remain equal to credits.
Example: Purchased equipment on account $5000. If this transaction is not recorded at all, it
will not affect any side of the trial balance. The error of not recording this transaction will remain
uncovered.
Error of recording amount:
While journalizing a transaction, if an error is made in recording the amount of money and later
posted using the same amount, trial balance wont be able to uncover that error. As because of
this error both debit and credit side will have the same amount.
Example: Purchased equipment on account $5000. If the transaction is journalized for $500, it
wont cause any imbalance in the trial balance.


One journal posted twice:
If a particular journal entry is posted twice, it will have the same effect on trial balance twice.
Thus no abnormality will be noticed in the trial balance.
Example: Purchased equipment on account $5000. The correct journal will be
Equipment $5000
Accounts Payable $5000
If this journal entry is posted twice, the balance of equipment account, an asset account will be
$10000 as well as the balance of accounts payable, a liability account will be $10000.
So, trial balance will fail to find this error.
Use of Incorrect accounts in Journalizing and posting:
If incorrect accounts are used in journalizing and posting a specific transaction, that wont affect
the trial balance to show any imbalance. So despite this mistake both sides of the trial balance
will balance.
Example:
Equipment purchased on account $5000. If this transaction is journalized as
Equipment $5000
Notes Payable $5000
Here instead of accounts payable another liability account notes payable is recorded while
journalizing. So the credit side will remain the same and both sides of trial balance will balance.
Errors of Principle: If an error is made principle wise while treating an account it can not be
traced by doing a trial balance.
Example: If purchase of equipment is debited as inventory it is an error of principle. Equipment
is a fixed asset whereas inventory is a current asset. This error can not be detected using trial
balance.
Compensating Errors: Offsetting errors refer to two or more errors in accounts whose
combined effect, accidentally, does not make the overall balance erroneous. This type of error is
very rare.
Example: Salaries expense is debited by $1000 instead of its original amount $100 and rent
expense is debited by $100 instead of its original amount $1000. The error in rent expense
account will compensate for the error in salaries expense account. This is an offsetting error.
Trial balance wont be able uncover this error.

As long as equal debits and credits are posted, even to the wrong account or in the wrong
amount, the total debits will equal the total credits. The trial balance does not prove that the
company has recorded all transactions or that the ledger is correct.




Question 4
Briefly explain what makes goodwill different from other intangible assets.
Answer:
When a company is bought the amount that purchaser pays more than the companys net asset
value is called goodwill. Goodwill means the value of an asset owned by a company that is
intangible but has a measurable value. Goodwill is seen as an intangible asset on the balance
sheet because it is not a physical asset like buildings or equipment. Goodwill typically reflects
the value of intangible assets such as a strong brand name, good customer relations, good
employee relations and any patents or proprietary technology. It is different from other intangible
assets.

The main difference between Goodwill and other intangible assets is that it cannot be separated,
sold, transferred, licensed or exchanged like other intangible assets. The best explanation is that
goodwill is different to other intangible assets because it can not be directly identified. It is
considered to be an indefinite asset, as it stays with the company as long as the company
continues operations. It goes to balance sheet differently from other intangible assets. It can be
thought of to represent certain values, such as branding and employee relations but they are
wrapped up together in the one number, cannot be separated and hence are unidentifiable.

They are different from other intangible items in this manner and hence they appear differently
on the balance sheet.


Question 5
Identify the differences in between financial and managerial accounting.
Answer:
Financial Accounting: Financial accounting is the field of accounting concerned with the
preparation of financial statements for decision makers, such as stockholders, suppliers, banks,
employees, government agencies, owners, and other stakeholders.
Managerial Accounting: Managerial accounting is concerned with the provisions and use
of accounting information to managers within organizations, to provide them with the basis to
make informed business decisions that will allow them to be better equipped in their
management and control functions.
As both of this accounting system deal with financial events, they have some basic similarities.
But principal wise, objective and user wise there are some significant differences. The main
differences are shown below.













Aspect Financial Accounting Managerial Accounting
Primary Users
of Reports
Financial accounting is mainly for those
outside it, such as shareholders,
stockholders, creditors and regulators.
Management accounting provides
information to people within an organization.
Example: Officers and managers.
Legal
Obligations
Financial accounting is required by law. Management accounting is not required by
law.
Covering Area Financial accounting covers the entire
organization.
Management accounting may be
concerned with particular products or
cost centers.
Types of
Reports
Financial Accounting prepares mainly
financial statements like income
statement, balance sheet, etc.
Management Accounting prepares
internal reports like cost analysis, sales
forecasting, etc.
Frequency of
Reports
Reports are prepared quarterly and
annually.
Reports are made as frequently as needed.
Purpose of
Reports
The reports are prepared for general
purposes.
The reports are prepared in special-purpose
for taking specific decisions.
Focus Financial Accounting focuses on history. Management accounting focuses on future &
Present.
Planning and
control
Financial accounting helps in making
investment decision, in credit rating
Management Accounting helps management
to record, plan and control activities to aid
decision-making process.
Legal Rules Drafted according to GAAP - General
Accepted Accounting Procedure.
Drafted according to management suitability.
Accounting
process
Follows a full process of recording,
classifying, and summarizing for the
purpose of analysis and interpretation of
the financial information.
Cost accounts are not preserved under
Management Accounting. The necessary data
from financial statements and cost ledgers
are analyzed.






Question 6
Explain the basic accounting equation in detail.
Answer:
The basic accounting equation represents the relationship among assets, liabilities and owners
equity of a business organization. This equation shows how they are related to each other and
how an economic event, have effect on an organizations financial condition.
The basic accounting equation is
Assets = Liabilities +Owners Equity
This equation means the sum of liabilities and owners equity will always be equal to the value
of total assets. Any transaction occurs the effects on the equation will be such that, both the sides
will always be equal.
Parts of the Equation:
Assets:
Assets are the things that company owns. Assets are of different types. In basis of tangibility,
they are divided into two categories. Tangible assets, such as equipments, building, land, etc.
Intangible assets, such as cash, inventory, accounts receivable, notes receivable, etc. Moreover,
Assets are also divided based on their usefulness time. If an asset is useful life of 12 months or
less it is known as short term asset and if more it is considered as a log term asset. The total
amount of assets will always be equal to the sum of liabilities and owners equity.
Liabilities:
Liabilities are a companys obligation. Liabilities are the amounts that a company owes to others.
Liabilities are of two kinds. They are current liabilities and fixed liabilities. Current liabilities are
those that are needed to be paid before a small period of time, usually before twelve months.
Accounts payable, Salaries payable, Taxes payable are the examples of short term liabilities.
Long-term liabilities have a maturity date exceeding one year. Examples include bonds and notes
payable.

Owners Equity:
Owners equity, often just called Equity, represents the value of the assets that the owner can lay
claim to. If a company earns revenue owners equity increases. If an expense occurs it decreases.
If the owner invests capital it increases and when the owner draws money from the company it
decreases. Owners equity is the difference between total assets and total liabilities.
Effect of Transactions on the Basic Accounting Equation

1. If equipment is bought for $5000. It will increase assets because the company gets new
equipment which is an asset for the company. At the same time asset will decrease
because cash is an asset and we are purchasing the equipment with cash. That means the
balances of both sides of the accounting equation will remain unchanged.
2. If equipment is bought on account for $5000. It will increase assets because the company
gets new equipment which is an asset for the company. At the same time liabilities will
increase because Accounts Payable is a liability account and we are purchasing the
equipment on account. Thus both assets and liabilities will increase. That means the
balances of both sides of the accounting equation will remain unchanged.
3. Received service revenue $5000. It will increase asset because the company is receiving
cash and it will increase owners equity because its an income for the company. Thus
both assets and Owners Equity will increase. That means the balances of both sides of
the accounting equation will remain unchanged.
4. Provided service on credit $5000. It will increase assets because accounts receivable will
increase which is an asset and will increase owners equity because its an income for the
company. Thus both assets and Owners Equity will increase.
5. If the owner invests capital, both assets and owners equity will increase. Whereas, if the
owners draws cash from the company, both assets and owners equity will decrease. So
the accounting equation balances will remain equal.

Each and every accounting transaction has its effect on the basic accounting equation.




Question 7
Critically evaluate the differences in between periodic and perpetual inventory system
Answer:
Periodic inventory system and perpetual inventory system are the two systems of keeping
records of Inventory. Though both of the systems purpose is to keep the record of inventory,
their recording processes are different. The differences between periodic and perpetual inventory
system are critically evaluated below.
First of all, in perpetual inventory system, after each sale and purchase companies update
merchandise inventory and cost of goods sold account. On the other hand, in periodic inventory
system, companies do not continuously update their merchandise inventory and cost of goods
sold account. They are determined at the end of the accounting period. The formula for
determining cost of goods sold at the end of the accounting period is,
Beginning inventory + Purchase Ending inventory = Cost of goods sold
Example: Purchased inventory on account for $5000
The journal according to perpetual system will be,
Merchandise inventory $5000
Accounts payable $5000
This means immediately after purchase merchandise inventory account is increased.
Whereas according to Periodic system the journal will be,
Purchase $5000
Accounts payable $5000
Here it can be seen, that instead of increasing merchandising inventory account, purchase
account is increased.
Secondly, in periodic inventory system there are purchase, purchase discount, purchase return
and allowance accounts. If inventory is purchased, purchase account increases and if purchased
inventory is returned, purchase return and allowance account increases. On the contrary, in case
of purchase inventory increases and return inventory account decreases.
Example: Previously Purchased inventory returned $2000
The journal according to perpetual system will be,
Accounts payable $2000
Merchandise inventory $2000
This means immediately after purchased inventory is returned merchandise inventory
account is decreased. Whereas according to Periodic system the journal will be,
Accounts payable $5000
Purchase return and allowance $5000
Here it can be seen, that instead of increasing merchandising inventory account, purchase
return and allowance account is increased.

In case of sale transactions it is recorded using two journal entries in perpetual system. One of
them records the sale value of inventory whereas the other records cost of goods sold. In periodic
inventory system, only one entry is made.
Example: Sold $5000 of merchandise on account.
Cost of merchandise sold was $3500
The journal according to perpetual system will be,
Accounts receivable $5000
Sales $5000
Cost of goods sold $3500
Merchandise inventory $3500
It is seen that for every sale two journal entries are posted in perpetual inventory system.
According to Periodic system the journal will be,
Accounts receivable $5000
Sales $5000
It is seen that only one journal entry is recorded according to Periodic accounting system.

Closing Entries are only required in periodic inventory system to update inventory and cost of
goods sold. Perpetual inventory system does not require closing entries for inventory account.

Furthermore, according to periodic inventory system, a physical inventory count is needed at the
end of the accounting period to determine the cost of goods sold. Whereas, in perpetual system it
is done to compare with the balance of cost of goods sold account per book balance.

Both of these inventory systems have some advantages and disadvantages. Companies choose
their preferred accounting inventory system depending on their resources and perspective.