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Part I

FINANCIAL ACCOUNTING

INTRODUCTION TO ACCOUNTING
Introduction to Accounting
Information
 Objectives:
1. Understand accounting and its roles
2. Identify uses and users of accounting information
3. Describe the way in which accounting helps managers
in making decisions
 Contents
1. Definition of accounting
2. Purpose of accounting information
3. Users of accounting information
4. Limitation of accounting information

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Introduction to Accounting
Information
 Two Key Questions:
1. Why is accounting complex and interesting?
 Diversity of businesses and events (economic events to be
reported)
 Many different players
 Diverse incentives (economic and non-economic)
 Uncertainty
 Many regulations
2. Why do we need financial accounting?
 Financial accounting promotes the exchange of resources
(see Figure 1.1)
 Accounting is a complex field contrary to common
perceptions
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Fig. 1.1: Financial Accounting promotes the exchange of
resources
Resources
Today

Outsiders
Company Investors
Suppliers
Accounting Information (e.g financial Creditors
statements)

Resources
Tomorrow

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Fig. 2: Financial Reporting Supply Chain

Source: Pounder, Bruce (2009)


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Financial Reporting Supply Chain
refers to “the people and processes involved in
the preparation, approval, audit, analysis and
use of financial reports.
Financial information flows through various stages:
•The flow of information starts with raw data about the
financial effects of transactions and events on an
enterprise.

•That raw data is processed progressively until it is


eventually presented to end users in a highly filtered,
summarized, and structured fashion.

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Then what is Accounting
 An information system to account for business
transactions and communicate the financial
information to users.
 Accounting provides a vital service by supplying the
information decision makers need to make reasoned
choice among alternative uses of scarce resources in the
conduct of business and economic activities
 It is a link between business activities and decision
makers
 Measures business activities by recording data about them for future
use
 Data are stored until needed when they are processed to get
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Then what is Accounting
 Conventional definitions of Accounting.
American Institute of Certified Public Accountants
(AICPA)
Accounting is the art of recording, classifying and summarizing in a
significant manner and in terms of money transactions and events
which are, in part at least, of a financial character and interpreting the
results thereof
American Accounting Association (AAA)
Accounting is the process of identifying, measuring and communicating
economic information to permit informed judgments and decisions by
users of the information

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Then what is Accounting
 Analysis of the two definitions provides the following
characteristics of accounting.
 Accounting is the art of recording and classifying business
transactions
 The business transactions may be completely or partially of
financial nature
 Generally the business transactions are described in
monetary terms
 The business transactions are summarised and analysed to
arrive at meaningful interpretation
 The analysis obtained are communicated to those who are
responsible to take certain decisions to determine the future
course of business 1-9
What are the business goals
 Profitability
Business must make enough money to pay for all the
costs of doing business, with enough left over as profit
for the owners to want to stay in business
 Liquidity
A business must have enough cash available to pay
debts of the organization when they are due

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What are the business activities
1. Financing activities
 Obtaining capital from owners
 Repaying creditors and a return to owners
2. Investing activities
 Spending the capital received in a productive manner to
ensure that business achieves its objectives
 Buying and selling assets to be used in the business
3. Operating activities
 Selling goods and services to customers
 Employing managers and workers,
 Buying and producing goods and services
 Paying taxes 1-11
Types of Accounting
Accounting

Financial Accounting/
Traditional Accounting/ Management
Financial Reporting Accounting


• Oriented toward the need of external
decision makers
• Provide information in the form of • Oriented toward the need of internal
financial statements decision makers
• Financial statements report directly • Provides managers with information
regarding how they have done in the past
on the goals of profitability and and what they can expect in the future
liquidity • Emphasizes usefulness and timeliness
•Emphasizes accuracy and compliance which are key components of relevance

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Business transactions
 Business transactions as the object of measurement.
 Business transactions are economic events that effect
the financial position of a business entity.
 Transactions are the raw material of accounting reports.
 Transactions must relate directly to a business entity.

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Common terminologies
in Financial Accounting
Accounting concepts and conventions
Accounting has adopted certain concepts and
conventions which help to ensure that accounting
information is presented accurately and consistently

Historical cost
Monetary measurement Conventions
Separate entity
Realisation
Materiality

Going concern
Consistency Concepts
Prudence
Matching/Accruals
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Common terminologies
in Financial Accounting
Elements of financial statements
The financial position of an enterprise is primarily
provided in the Statement of Financial Position. The
elements include:
 Asset: An asset is a resource controlled by the enterprise as a result of past
events from which future economic benefits are expected to flow to the
enterprise. (Examples: cash, office supplies, inventories, accounts receivable, buildings,
equipment, etc)
 Liability: A liability is a present obligation of the enterprise arising from the
past events, the settlement of which is expected to result in an outflow from
the enterprise' resources, i.e., assets. (Examples: accounts payable, bonds payable etc)
 Equity: Equity is the residual interest in the assets of the enterprise after
deducting all the liabilities under the Historical Cost Accounting model.
Equity is also known as owner's equity. Under the units of constant
purchasing power model equity is the constant real value of shareholders´
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equity.
Common terminologies
in Financial Accounting
Elements of financial statements
The financial performance of an enterprise is primarily
provided in an income statement or profit and loss account.
The elements of an income statement or the elements that
measure the financial performance are as follows:
 Revenues: increases in economic benefit during an accounting
period in the form of inflows or enhancements of assets, or decrease
of liabilities that result in increases in equity. However, it does not
include the contributions made by the equity participants, i.e.,
proprietor, partners and shareholders.
 Expenses: decreases in economic benefits during an accounting
period in the form of outflows, or depletions of assets or incurrences
of liabilities that result in decreases in equity.
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Purpose of Accounting

Here now we can be able to identify purposes of


accounting
1. To record the business transactions in a systematic
manner
2. To determine the gross profit and net profit earned by a
firm during a specific period
3. To know the financial position of firm at the close of the
financial year
4. To facilitate management control
5. To assess the taxable income and tax liability
6. To provide information to different parties
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Users of Accounting information
1. Internal Users vs External Users
 Internal Users: managerial accounting is used to produce
information for managers to make decisions
 External Users: financial accounting produce financial
statements for external users who include investors, creditors,
tax authorities, CMSA etc
2. Direct Financial Interest and Indirect Financial
Interest
 Direct Financial Interest users: Two groups: Management and
Those who are not Managers (Investors, Creditors).
 Those with indirect financial interest: Tax Authorities,
Regulators, Trade Unions, Customers, Economic Planners etc
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Limitation of Accounting information
 Accounting information is expressed in terms of money. Non
monetary events or transactions, however important, are completely
omitted.
 Fixed assets are recorded in the accounting records at the original
cost, that is, the actual amount spent on them plus all incidental
charges. In this way, the effect of inflation (or deflation) is not taken
into consideration. The direct result of this practice is that balance
sheet does not represent the true financial position of the business.
 Accounting information is sometimes based on estimates; estimates
are often inaccurate.
 Accounting information cannot be used as the only test of
managerial performance on the basis of more profits. Profit for a
period of one year can readily be manipulated by omitting such costs
as advertisement, research and development, depreciation etc
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Limitation of Accounting information
 Accounting information is not neutral or unbiased.
Accountants calculate income as excess of revenues over
expenses. But they consider only selected revenues and
expenses. They do not, for example, include, cost of such items
as water or air pollution, employee’s injuries, etc.
 Accounting like any other discipline has to follow certain
principles, which in certain cases are contradictory. For
example, current assets (e.g., stock of goods) are valued on the
basis of cost or market price whichever is less following the
principle of conservatism. Accordingly, the current assets may
be valued on cost basis in some year and at market price in
another year. In this manner, the rule of consistency is not
followed regularly.
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Questions which we have to ask in
learning accounting
1. What do accountants produce and who are their customers?
2. What do accountants’ customers do with accounting
information?
3. What are the input to the accounting process?
4. What factors influence the design of accountants’ products?
5. What kind of information would accountants’ customers
like? And why don’t they get it?
6. How do accountants’ customers assess the quality of
accounting information?
7. Why organizations have to maintain supporting documents
(such as receipts and vouchers)? Is there any motivation for
not doing so?
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Key challenges for us who are learning
1. If I’m preparing records, having determined
numbers to record for an economic event, how
do I record them? (choice of method). How does
it affect accounting reports?

2. As user, given the reported numbers, do I know


how they were computed? (Likewise how would
I compute them myself)?

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