Financial and Managerial Accounting

Financial System & Conceptual Understanding of Accounting for Managers

Learning Objectives

Conceptual

Analytical

Procedural

Conceptual Objectives
C1: Explain the purpose and importance of accounting. C2: Identify users and uses of accounting. C3: Explain why ethics are crucial to accounting. C4: Explain generally accepted accounting principles and define and apply several accounting principles. C5: Cost concepts

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Analytical Objectives
A1: Define and interpret the accounting equation and each of its components. A2: Compute and interpret return on assets.

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Procedural Objectives
P1: Analyze business transactions using

the accounting equation. P2: Identify and prepare basic financial statements and explain how they interrelate. P3: Mechanism of cost accounting, costing cycle

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C1

Importance of Accounting
is a Accounting
system that Identifies

Records
information Relevant that is Communicates

Reliable
Comparable about an organizations business activities.
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C1

Accounting Activities
Recording Business Activities

Identifying Business Activities

Communicating Business Activities

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C2

Users of Accounting Information

Internal Users External Users

Lenders

Consumer Groups

Managers Officers

Sales Staff Budget Officers

Shareholders External Auditors Governments Customers

Internal Auditors Controllers

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C2

Users of Accounting Information

External Users Internal Users

Financial accounting provides external users with financial statements (shareholders, lenders, etc.).

Managerial accounting provides information needs for internal decision makers (officers, managers, etc.).
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C2

Opportunities in Accounting
Financial Managerial
General accounting Cost accounting Budgeting Internal auditing Consulting Controller Treasurer Strategy Lenders Consultants Analysts Traders Directors Underwriters Planners Appraisers

Taxation
Preparation Planning Regulatory Investigations Consulting Enforcement Legal services Estate plans FBI investigators Market researchers Systems designers Merger services Business valuation Forensic accountant Litigation support Entrepreneurs
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Preparation Analysis Auditing Regulatory Consulting Planning Criminal investigation

Accountingrelated

C2

Accounting Jobs by Area

Public accounting 24%

Private accounting 60%

Government, not-for-profit, & education 16%

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C3

EthicsA Key Concept

Ethics
Beliefs that distinguish right from wrong
Accepted standards of good and bad behavior

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C3

Guidelines for Ethical Decisions

Identify ethical concerns Analyze options Make ethical decision

Use personal Consider all good ethics to and bad recognize an consequences. ethical concern.

Choose best option after weighing all consequences.

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C4

Generally Accepted Accounting Principles

Financial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP).
Relevant Information
Reliable Information

Affects the decision of its users.

Is trusted by users.
Used in comparisons across years & companies.
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Comparable Information

C4

Setting Accounting Principles

In the United States, the Securities and Exchange Commission, a government agency, has the legal authority to establish reporting requirements and set GAAP for companies that issue stock to the public.
The Financial Accounting Standards Board is the private group that sets both broad and specific principles.

The International Accounting Standards Board (IASB) issues international standards that identify preferred accounting practices in other countries. More than 100 countries now require or permit companies to prepare financial reports following IFRS standards.
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C4

Principles and Assumptions of Accounting

Going-concern assumption means that accounting information reflects a presumption the business will continue operating. Monetary unit assumption means we can express transactions in money. Time period assumption presumes that the life of a company can be divided into time periods, such as months and years. Business entity assumption means that a business is accounted for separately from its owner or other business entities.
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Measurement principle (also called cost principle) means that accounting information is based on actual cost. Revenue recognition principle provides guidance on when a company must recognize revenue. Matching principle (expense recognition) prescribes that a company must record its expenses incurred to generate the revenue. Full disclosure principle requires a company to report the details behind financial statements that would impact users decisions.

C4

Principles and Assumptions of Accounting

Business Entity The business and its owner(s) are two separate existence entity Any private and personal incomes and expenses of the owner(s) should not be treated as the incomes and expenses of the business.
EXAMPLE: Insurance premiums for the owners house should be excluded from the expense of the business The owners property should not be included in the premises account of the business Any payments for the owners personal expenses by the business will be treated as drawings and reduced the owners capital contribution in the business.

Money Measurement Meaning All transactions of the business are recorded in terms of money It provides a common unit of measurement. Examples Market conditions, technological changes and the efficiency of management would not be disclosed in the accounts.

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C4

Principles and Assumptions of Accounting

Historical Cost Meaning Assets should be shown on the balance sheet at the cost of purchase instead of current value Example The cost of fixed assets is recorded at the date of acquisition cost. The acquisition cost includes all expenditure made to prepare the asset for its intended use. It included the invoice price of the assets, freight charges, insurance or installation costs.

Going Concern Meaning The business will continue in operational existence for the foreseeable future Financial statements should be prepared on a going concern basis unless management either intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so.
Example Possible losses form the closure of business will not be anticipated in the accounts Prepayments, depreciation provisions may be carried forward in the expectation of proper matching against the revenues of future periods Fixed assets are recorded at historical cost.

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C4

Principles and Assumptions of Accounting

Materiality: Meaning Immaterial amounts may be aggregated with the amounts of a similar nature or function and need not be presented separately Materiality depends on the size and nature of the item . Example
Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses. The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to the profit and loss account as revenue expenditures, although they can last for more than one accounting period.

Prudence/Conservatism Meaning Revenues and profits are not anticipated. Only realized profits with reasonable certainty are recognized in the profit and loss account However, provision is made for all known expenses and losses whether the amount is known for certain or just an estimation This treatment minimizes the reported profits and the valuation of assets
Example Stock valuation sticks to rule of the lower of cost and net realizable value The provision for doubtful debts should be made Fixed assets must be depreciated over their useful economic lives

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C4

Principles and Assumptions of Accounting

Consistency: Meaning Companies should choose the most suitable accounting methods and treatments, and consistently apply them in every period Changes are permitted only when the new method is considered better and can reflect the true and fair view of the financial position of the company The change and its effect on profits should be disclosed in the financial statements.

Objectivity: Meaning The accounting information should be free from bias and capable of independent verification The information should be based upon verifiable evidence such as invoices or contracts. Example The recognition of revenue should be based on verifiable evidence such as the delivery of goods or the issue of invoices.

Example
If a company adopts straight line method and should not be changed to adopt reducing balance method in other period If a company adopts weight-average method as stock valuation and should not be changed to other method e.g. first-in-first-out method.

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C4

Principles and Assumptions of Accounting

Problems in the recognition of expenses: Normally, expenses represents resources consumed during the current period. Some costs may benefit several accounting periods, for example, development expenditures, depreciation on fixed assets.
Association b/w cause & effect: Expenses are recognized on the basis of a direct association between the expenses incurred on the basis of a direct association between the expenses incurred and revenues earned. For example, the sales commissions should be accounted for in the period when the products are sold, not when they are paid.
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Accruals/Matching: Meaning Revenues are recognized when they are earned, but not when cash is received Expenses are recognized as they are incurred, but not when cash is paid The net income for the period is determined by subtracting expenses incurred from revenues earned Example
Expenses incurred but not yet paid in current period should be treated as accrual/accrued expenses under current liabilities Expenses incurred in the following period but paid for in advance should be treated as prepayment expenses under current asset Depreciation should be charged as part of the cost of a fixed asset consumed during the period of use.

C4

Principles and Assumptions of Accounting

When the cost benefit several accounting periods, they should be recognized on the basis of a systematic and rational allocation method For example, a provision for depreciation should be made over the estimated useful life of a fixed asset.
Realization: Revenues should be recognized when the major economic activities have been completed Sales are recognized when the goods are sold and delivered to customers or services are rendered. Recognition of Revenue: The realization concept develops rules for the recognition of revenue The concept provides that revenues are recognized when it is earned, and not when money is received A receipt in advance for the supply of goods should be treated as prepaid income under current liabilities Since revenue is a principal component in the measurement of profit, the timing of its recognition has a direct effect on the profit .
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Systematic allocation of costs

Immediate recognition
If the expenses are expected to have no certain future benefit or are even without future benefit, they should be written off in the current accounting period, for example, stock losses, advertising expenses and research costs.

C4

Principles and Assumptions of Accounting

Recognition criteria for Revenue: The uncertain profits should not be estimated, whereas reported profits must be verifiable Revenue is recognized when
1. 2.
3.

The major earning process has substantially been completed Further cost for the completion of the earning process are very slight or can be accurately ascertained, and The buyer has admitted his liability to pay for the goods or services provided and the ultimate collection is relatively certain.

EXAMPLE: Goods sent to our customers on sale or return basis This means the customer do not pay for the goods until they confirm to buy. If they do not buy, those goods will return to us Goods on the sale or return basis will not be treated as normal sales and should be included in the closing stock unless the sales have been confirmed by customers .

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C4

Principles and Assumptions of Accounting

Problem in recognition of Revenues: Normally, revenue is recognized when there is a sale The point of sales in the earning process is selected as the most appropriated time to record revenues However, if revenue is earned in a long and continuous process, it is difficult to determine the portion of revenue which is earned at each stage Therefore, revenue is permitted to be recorded other than at the point of sales Exceptions to the rule of sales recognition: Long-term contracts
Owning to the long duration of long-term contracts, part of the total profit estimated to have been arisen from the accounting period should be included in the profit and loss account

Hire Purchase Sale

Hire purchase sales have long collection period. Revenue should be recognized when cash received rather than when the sale (transfer of ownership) is made The interest charged on a hire purchase sale constitutes the profit of transaction.
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C4

Principles and Assumptions of Accounting

A publisher receives subscriptions before it sends newspapers or magazines to its customers It is proper to defer revenue recognition until the service is rendered. However, part of subscription income can be recognized as it is received in order to match against the advertising expenses incurred.

Exception to rules (continued) Receipts from subscriptions

-

Disclosure: Meaning Financial statements should be prepared to reflect a true and fair view of the financial position and performance of the enterprise All material and relevant information must be disclosed in the financial statements Uniformity: Meaning Different companies within the same industry should adopt the same accounting methods and treatments for like transactions The practice enables inter-company comparisons of their financial positions. 1-25

C4

Principles and Assumptions of Accounting

DEFERRED TAXATION Due to difference between taxable income (as per Income Tax Act) and accounting profit
Permanent Difference Dont reverse subsequently Expenses disallowed, exempt income Timing Difference Reversed in the subsequent period Expenses allowed on payment basis, depreciation Cause
Accounting Income > Taxable Income Accounting Income < Taxable Income

Effect
Tax on Accounting Income > Tax payable as per Income Tax Act Tax on Accounting Income < Tax payable as per Income Tax Act

Accounting
Create Deferred Tax Liability Create Deferred Tax Asset

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C4

Business Entity Forms & Related Sophistication

Sole Proprietorship

Partnership

Corporation

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C4

Companies Ordinance 1984

It helps curb financial abuses at companies that issue their stock to the public. The ordinance requires that public companies apply both accounting oversight and stringent internal controls. The desired results include more transparency, accountability, and truthfulness in reporting transactions.

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C4

Cost Accounting Concepts

Material (direct, indirect) - Labor (direct, indirect) - FOH (fixed, variable) - Prime Cost - Conversion Cost - FOH control account - Budgeted, Actual and Applied FOH - FOH application basis - Standard Costing and Common Variances - WIP Account & its mechanism - Cost of goods manufactured and sold statement - Process costing / Job Order Costing - Marginal Costing / Absorption Accounting
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C4

Cost Accounting Concepts

Prime cost = direct materials + direct labor + direct expenses

Production cost = Prime cost + factory overhead OR = Direct materials + Conversion cost

*Conversion cost is the production cost of converting raw materials into finished product
Total cost = Prime cost + Overheads (admin, selling, distribution cost) OR = Production cost + period cost (administrative, selling,

distribution and finance cost) Period cost is treated as expenses and matched against sales for calculating profit, e.g. office rental
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C4

Cost Accounting Concepts

Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing Absorption Costing: It is costing system which treats all manufacturing costs including both the fixed and variable costs as product costs Marginal Costing: It is a costing system which treats only the variable manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

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Absorption Costing
Manufacturing cost

Cost
Non-manufacturing cost

Direct Materials

Direct Labour

Overheads

Period cost

Finished goods

Cost of goods sold

Profit and loss account

Marginal Costing
Manufacturing cost

Cost
Non-manufacturing cost

Direct Materials

Direct Labour

Variable Overheads

Fixed overhead

Period cost

Finished goods

Cost of goods sold

Profit and loss account 32

Trading and profit and loss account

Absorption costing Sales Less: Cost of goods sold Gross profit Less: Expenses Selling expenses X Admin. expenses X Other expenses X $ X X X Marginal costing Sales Less: Variable cost of Goods sold Product contribution margin Less: variable non- manufacturing expenses Variable selling expenses Variable admin. expenses Other variable expenses Total contribution expenses $ X X X

X X X X

Variable and fixed manufacturing

Net Profit

Less: Expenses Fixed selling expenses Fixed admin. expenses Other fixed expenses Net Profit
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X X X X

A1

Accounting Equation
Assets

Liabilities

Equity

Assets

Liabilities + Equity

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A1

Assets
Cash Accounts Receivable Notes Receivable

Vehicles

Resources owned or controlled by a company

Land

Store Supplies

Buildings Equipment
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A1

Liabilities
Accounts Payable Notes Payable

Creditors claims on assets

Taxes Payable Wages Payable

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A1

Equity
Contributed Capital Retained Earnings

Owners claim on assets

Dividends
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A1

Expanded Accounting Equation Assets Assets

= =
_

Liabilities Liabilities

+ +
Revenues

Equity Equity

Contributed Capital

Dividends

_ Expenses

Retained Earnings
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P1

Transaction Analysis
Business activities can be described in terms of transactions and events. External transactions are exchanges of value between two entities, which yield changes in the accounting equation. Internal transactions are exchanges within any entity; they can also affect the accounting equation. Events refer to happenings that affect an entitys accounting equation and can be reliably measured. Transaction analysis is defined as the process used to analyze transactions and events.
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P1

Transaction Analysis
J. Scott invests $20,000 cash to start the business in return for stock.
Assets =

Cash Supplies Equipment (1) $ 20,000

Liabilities Accounts Notes Payable Payable

Equity Common Stock $ 20,000

$ 20,000 $

$ $

20,000

$ 20,000

$ 20,000

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P1

Transaction Analysis
Purchased supplies paying $1,000 cash.
Assets = Liabilities Accounts Notes Payable Payable + Equity Common Stock $ 20,000

Cash Supplies Equipment (1) $ 20,000 (2) (1,000) $ 1,000

$ 19,000 $ 1,000 $ $ 20,000

$ $

20,000

$ 20,000

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P1

Transaction Analysis
Purchased equipment for $15,000 cash.
Assets = Liabilities Accounts Notes Payable Payable + Equity Common Stock $ 20,000

Cash Supplies Equipment (1) $ 20,000 (2) (1,000) $ 1,000 (3) (15,000) $ 15,000

4,000 $ 1,000 $ $ 20,000

15,000 =

$ $

20,000

$ 20,000

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P1

Transaction Analysis
Purchased Supplies of $200 and Equipment of $1,000 on account.
Assets =

Cash Supplies Equipment (1) $ 20,000 (2) (1,000) $ 1,000 (3) (15,000) $ 15,000 (4) 200 1,000 $ 4,000 $ 1,200 $ $ 21,200 16,000 =

Liabilities Accounts Notes Payable Payable

Equity Common Stock $ 20,000

$ 1,200 $ 1,200 $ $ 21,200

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$ 20,000

P1

Transaction Analysis

Borrowed $4,000 from 1st American Bank.

Assets Cash Supplies Equipment (1) $ 20,000 (2) (1,000) $ 1,000 (3) (15,000) $ 15,000 (4) 200 1,000 (5) 4,000 $ 8,000 $ 1,200 $ 16,000 $ 25,200 = = Liabilities Accounts Notes Payable Payable + Equity Common Stock $ 20,000

$ 1,200 $ $ 1,200 $ $ 4,000 4,000 25,200

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$ 20,000

P1

Transaction Analysis
The balances so far appear below. Note that the Balance Sheet Equation is still in balance.
Assets Cash Supplies Equipment Bal. $ 8,000 $ 1,200 $ 16,000 = Liabilities Accounts Notes Payable Payable $ 1,200 $ 4,000 + Equity Common Stock $ 20,000

$ 8,000 $

1,200 $

16,000 =

1,200 $

4,000

$ 20,000

$ 25,200

$ 25,200

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P1

Transaction Analysis

Now, lets look at transactions involving revenue, expenses and dividends.

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P1

Transaction Analysis

Provided consulting services receiving $3,000 cash.

Assets Cash Supplies Equipment Bal. $ 8,000 $ 1,200 $ 16,000 (6) 3,000 = Liabilities Accounts Notes Payable Payable $ 1,200 $ 4,000 + Equity Common Stock Revenue $ 20,000 $ 3,000

$ 11,000 $

1,200 $

16,000 =

$ 1,200 $ 4,000 $ 28,200

$ 20,000 $ 3,000

$ 28,200

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P1

Transaction Analysis
Paid salaries of $800 to employees.
Assets = Liabilities Accounts Notes Payable Payable $ 1,200 $ 4,000 + Equity Common Stock Revenue Expenses $ 20,000 $ 3,000 $ (800) $ 20,000 $ 3,000 $ (800)

Cash Supplies Equipment Bal. $ 8,000 $ 1,200 $ 16,000 (6) 3,000 (7) (800) $ 10,200 $ 1,200 $ 16,000 =

$ 1,200 $

4,000

$ 27,400

$ 27,400

Remember that expenses decrease equity.

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P1

Transaction Analysis

Dividends of $500 are paid to shareholders.

Assets Cash Supplies Equipment Bal. $ 8,000 $ 1,200 $ 16,000 (6) 3,000 (7) (800) (8) (500) $ 9,700 $ 1,200 $ 16,000 $ 26,900 = = Liabilities Accounts Notes Payable Payable $ 1,200 $ 4,000 + Equity Common Stock Dividends Revenue Expenses $ 20,000 $ 3,000 $ (800) $ (500) $ 20,000 $ (500) $ 3,000 $ (800)

$ 1,200 $

4,000

$ 26,900

Remember that dividends decrease equity.

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P2

Financial Statements
Lets prepare the Financial Statements reflecting the transactions we have recorded.
1. Income Statement

2. Statement of Retained Earnings

3. Balance Sheet 4. Statement of Cash Flows

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P2

Income Statement
Scott Company Income Statement For Month Ended December 31, 2011 Revenues: Consulting revenue Expenses: Salaries expense Net income

3,000 800 2,200

Net income is the difference between Revenues and Expenses.

The income statement describes a companys revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.
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P2

Statement of Retained Earnings

The net income of $2,200 increases Retained Earnings by $2,200.

Scott Company Income Statement For Month Ended December 31, 2011 Revenues: Consulting revenue Expenses: Salaries expense Net income

3,000 800 2,200

Scott Company Statement of Retained Earnings For Month Ended December 31, 2011 2,200 500 1,700
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Retained Earnings, Dec. 1, 2011 $ Plus: Net income Less: Dividends Retained Earnings, Dec. 31, 2011 $

P2

Balance Sheet
The Balance Sheet describes a companys financial position at a point in time.
Scott Company Statement of Retained Earnings For Month Ended December 31, 2011 Retained Earnings, Dec. 1, 2011 Plus: Net income Less: Dividends Retained Earnings, Dec. 31, 2011 $ 2,200 500 1,700

Scott Company Balance Sheet December 31, 2011 Assets $

Cash Supplies Equipment

9,700 1,200 16,000

Total assets

26,900

Liabilities Accounts payable Notes payable Total liabilities Equity Common stock Retained earnings Total liabilities and equity

1,200 4,000 5,200 20,000 1,700

26,900

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P2

Statement of Cash Flows

Scott Company Statement of Cash Flows For Month Ended December 31, 2011 Cash flows from operating activities: Cash received from clients $ 3,000 Purchase of supplies (1,000) Cash paid to employees (800) Net cash provided by operating activities Cash flows from investing activities: Purchase of equipment (15,000) Net cash used in investing activities Cash flows from financing activities: Investment by Shareholders 20,000 Borrowed at bank 4,000 Dividends Paid (500) Net cash provided by financing activities Net increase in cash Cash balance, December 1, 2011 Cash balance, December 31, 2011

1,200

(15,000)

$ $

23,500 9,700 9,700

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A2

Return on Assets (ROA)

Return on assets Net income = Average total assets

ROA is a profitability measure.

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STEPS IN THE ACCOUNTING CYCLE

9. Prepare post-closing trial balance 8. Journalize and post closing entries 7. Prepare financial statements 1. Analyze transactions

2. Journalize the transactions

3. Post to ledger accounts

4. Prepare a trial balance

5. Journalize and post adjusting entries

6. Prepare adjusted trial balance

Jazak Allah

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