MBA

– Semester I

Accounting f or Decision Makers 01

Introduction to Accounting

Tutorial Prepared by

Sanjeewa Guruge
B.Sc. Accountancy (Special) - 1st Class (USJ)
M.Sc. Investments (UK)
FCA, FCMA

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 Introduction to Accounting

Accounting can be defined as a systematic process of identifying (collecting), recording,

classifying, verifying, summarizing, and analyzing financial information of an organization. In
broad terms, the main objective of accounting is to provide relevant and reliable information
to stakeholders to make economic decisions.

Accounting reveals profit or loss for a given period, and the value and nature of a firm's assets,
liabilities and owners' equity. Accounting provides information on the resources available to a
firm, the sources of financing those resources, and the results achieved through their use.

The output of accounting process is financial reports that include financial information
which can effectively be used for making economic decisions.

What is a Business?
Business is an organization or economic system where goods and services are exchanged for
one another or for money. Every business requires some form of investment and enough
customers to whom its output can be sold on a consistent basis in order to make a profit.
Businesses can be privately owned, not-for-profit or state-owned.

All of us need food, clothing and shelter. We also have many other household requirements to be
satisfied in our daily lives. We met these requirements from the shopkeeper. The shopkeeper
gets from wholesaler. The wholesaler gets from manufacturers. The shopkeeper, the wholesaler,
the manufacturer are doing business and therefore they are called as Businessmen.

Objectives of an Organization
Any organization is driven by what it wants to achieve in the future. This is called objective and
determined based on the interests and expectations of owners, organizations’ capabilities,
nature of the market, requirements of the society, etc. According to primary objectives,
organizations can be divided into two categories:

 For-Profit organizations – Organizations with profit motive follows some economic

benefit to owners from its operations. Therefore, the activities of these organizations are
driven by any financial benefit such as profit, revenue, market share, brand strengthening,
etc. Profit-motive organizations can often be seen in the private sector.

(a) Limited companies - These are organizations having a large number of owners. They
are a separate legal entity from their owners’ means that the company may both
sue and be sued under English law. Accounting of these organizations must meet
certain minimum obligations imposed by legislation via the Companies Acts.

(b) Partnerships - These are organizations owned by two or more persons working in
common with a view to making a profit. The greater number of owners compared
to a sole trader increases the availability of finance and this is often the reason for
forming such a structure.

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 (c) Sole trader (sole proprietor) - These are organizations which are owned by one
person. They tend to be small because the constrained by the financial resources
of their owner & the extent to which they may borrow from friends, family &
banks.

 Not-for-profit organizations – These are the organizations which have a primary

objective other than an economic related objective. In general, not-for-profit
organizations are involved in providing certain goods and services that profit-oriented
firms are less interested in providing.

(a) Local and central Government - Government departments are financed by

members of society (including) limited companies). Their finances are used to
provide the infrastructure in which we live; and to re-distribute wealth to other
members of society.

(b) Charities - These exist to provide services to particular groups, for example people
with special needs and to protect the environment. Although they are regarded as
non-profit making, they too often carry out trading activities, such as running
shops.

(c) Clubs and societies - These organizations exist to provide facilities and
entertainments for their members. They are often sports and / or social clubs and
most of their income is derived from the members who benefit from the club's
facilities.

Form of ownership
Based on the party who has the ownership of the organization it can be classified as follows:

 Private sector organizations - This is one that is owned and controlled by one or
more individuals, not the government. A private sector organization does not have the
same responsibility to the public or society that a public sector organization does,
because it is mainly responsible to the people who own it (e.g. Sole proprietorships,
Partnerships, Limited liability companies, Non-government organizations (NGOs), etc.).

 Public sector organizations - is one that is owned by the entire public and controlled by
the government of a country. It is called "public" because the government is
responsible to the entire public. A majority of these organizations have non-profit
objectives such as public welfare, infrastructure development, providing human aids, etc.

Legal Status
Certain organizations have the separate legal identity from their owners i.e. the regulatory
bodies of a country accepts the organization is a separate legal person which is distinguished
from its owners. Organizations such as limited liability companies, co-operatives and most of
government sector entities fall into this category while sole proprietorships and partnerships
do not have a separate legal identity.

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Nature of the business operation
Based on the nature of the business operations, entities can be categorized as follows:

 Manufacturing businesses - organization acquires resources and convert them into

consumable products.

 Trading businesses - organization buys completed goods and sells them to customers.

 Service sector businesses - organizations that produce services rather than goods. The
service sector includes education, finance, communications, health care, utilities,
wholesale and retail trade, and transportation.

Information
Information is everything which adds knowledge. Information enhances the knowledge.
 Quantitative information

Information which could be presented or said in numbers

Eg: Number of employees are 30
There are 5 Lorries in the business

 Non quantitative information

Information which could not be presented in numbers

Eg: The manager is a skillful person
The cashier is very trustworthy

 Financial information

Information which can be presented in monetary terms i.e. in rupees and cents
Eg: The annual profit is Rs 120,000/-
The total assets are Rs 50,000/-

 Non- financial information

Information which cannot be presented in monetary terms

Eg: The owner is 60 years old.
The experience of the manager is 10 years

Users of Accounting Information

The basic objective of accounting is to provide information which is useful for stakeholders.
A stakeholder is a person, group or an organization that has an interest (stake) in the
organizations. It can affect or be affected by the organization's actions, objectives, and policies.
Key stakeholders in a business organization include creditors, customers, directors,
employees, government, owners, suppliers, trade unions, environmental groups, competitors
and the community.
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Internal users (Primary Users) of accounting information include the following:

 Management: for analyzing the organization's performance and position and taking
appropriate measures to improve the company results.
 Employees: for assessing company's profitability and its consequence on their future
remuneration and job security.
 Owners: for analyzing the viability and profitability of their investment and determining
any future course of action.

Accounting information is presented to internal users usually in the form of management

accounts, budgets, forecasts and financial statements.

External users (Secondary Users) of accounting information include the following:

 Creditors: for determining the credit worthiness of the organization. Terms of credit
are set by creditors according to the assessment of their customers' financial health.
Creditors include suppliers as well as lenders of finance such as banks.
 Tax Authourities: for determining the credibility of the tax returns filed on behalf of the
company.
 Investors: for analyzing the feasibility of investing in the company. Investors want to
make sure they can earn a reasonable return on their investment before they commit
any financial resources to the company.
 Customers: for assessing the financial position of its suppliers which is necessary for
them to maintain a stable source of supply in the long term.
 Regulatory Authorities: for ensuring that the company's disclosure of accounting
information is in accordance with the rules and regulations set in order to protect the
interests of the stakeholders who rely on such information in forming their decisions.

External users are communicated accounting information usually in the form of financial
statements. The purpose of financial statements is to cater for the needs of such diverse users of
accounting information in order to assist them in making sound financial decisions.

Accountancy encompasses the recording, classification, and summarizing of transactions and

events in a manner that helps its users to assess the financial performance and position of the
entity. The process starts by first identifying transactions and events that affect the financial
position and performance of the company. Once transactions and events are identified, they are
recorded, classified and summarized in a manner that helps the user of accounting information
in determining the nature and effect of such transactions and events.

Accounting is a very dynamic profession which is constantly adapting itself to varying needs of
its users. Over the past few decades, accountancy has branched out into different types of
accounting to cater for the different needs of the users.

Each of these stakeholders may require different information regarding the business entity.

Users Need for information

Internal
Owners To know the profitability and financial stability of the business
Management To take prompt decisions to manage the business efficiently
Employees and Trade unions To form judgment about the remuneration, bonus and the job security

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 Users Need for information
External
Creditors, banks and lenders To determine whether the principal and the interest thereof will be paid on
time
Potential investors To decide whether to invest in the business or not
Customers To evaluate the organization’s ability to provide goods and services at the
expected quality and price
Government To know the earnings in order to assess the tax liabilities of the business
Regulatory bodies To evaluate the business operation is being carried out in accordance with
the legislation domestically and internationally
Students To use in their research and other academic works
Competitors To develop competitive strategies in pricing, product or service quality,
promotions, distribution, etc.

Types of Accounting
Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and
varying needs of its users. Over the past few decades, accountancy has branched out into
different types of accounting to cater for the diversity of needs of its users.

Financial Accounting, or financial reporting, is the process of producing information for

external use usually in the form of financial statements. Financial Statements reflect an entity's
past performance and current position based on a set of standards and guidelines known as
GAAP (Generally Accepted Accounting Principles). GAAP refers to the standard framework of
guideline for financial accounting used in any given jurisdiction. This generally includes
accounting standards (e.g. International Financial Reporting Standards), accounting
conventions, and rules and regulations that accountants must follow in the preparation of the
financial statements.

Management Accounting produces information primarily for internal use by the company's
management. The information produced is generally more detailed than that produced for
external use to enable effective organization control and the fulfillment of the strategic aims and
objectives of the entity. Information may be in the form budgets and forecasts, enabling an
enterprise to plan effectively for its future or may include an assessment based on its past
performance and results. The form and content of any report produced in the process is purely
upon management's discretion.

Cost accounting is a branch of management accounting and involves the application of various
techniques to monitor and control costs. Its application is more suited to manufacturing
concerns.

Governmental Accounting, also known as public accounting or federal accounting, refers to

the type of accounting information system used in the public sector. This is a slight deviation
from the financial accounting system used in the private sector. The need to have a separate
accounting system for the public sector arises because of the different aims and objectives of the
state owned and privately owned institutions. Governmental accounting ensures the financial
position and performance of the public sector institutions are set in budgetary context since
financial constraints are often a major concern of many governments. Separate rules are
followed in many jurisdictions to account for the transactions and events of public entities.

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Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules
prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that
govern the preparation of financial statements for public use (i.e. GAAP). Tax accountants
therefore adjust the financial statements prepared under financial accounting principles to
account for the differences with rules prescribed by the tax laws. Information is then used by
tax professionals to estimate tax liability of a company and for tax planning purposes.

Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of
litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and
criminal disputes that require an assessment of the financial effects of a loss or the detection of
a financial fraud. Common litigations where forensic accountants are hired include insurance
claims, personal injury claims, suspected fraud and claims of professional negligence in a
financial matter (e.g. business valuation).

Project Accounting refers to the use of accounting system to track the financial progress of a
project through frequent financial reports. Project accounting is a vital component of project
management. It is a specialized branch of management accounting with a prime focus on
ensuring the financial success of company projects such as the launch of a new product. Project
accounting can be a source of competitive advantage for project-oriented businesses such as
construction firms.

Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability
Accounting, refers to the process of reporting implications of an organization's activities on its
ecological and social environment. Social Accounting is primarily reported in the form of
Environmental Reports accompanying the annual reports of companies. Social Accounting is
still in the early stages of development and is considered to be a response to the growing
environmental consciousness amongst the public at large.

Difference between Bookkeeping and Accounting

Both are different sections of finance department, bookkeeping involves the keeping of
systematical record of company’s financial activity, whereas accounting is the next section,
which analyzes these records to prepare different reports and proposals. Bookkeeping in the
procedure, which helps the management to manage day-to-day financial activity of company,
whereas Accounting justifies these financial actions and find their reasons.

Basis Book-keeping Accounting

It is not only recording and maintenance of
Recording and maintenance of books
Scope books of accounts but also includes analysis,
of accounts
interpreting and communicating the
Stage Primary stage information
Secondary stage
To find out the net result of the
Objective To maintain systematic records of transactions
business operation
Nature Often routine and clerical in nature Analytical and executive in nature

A book-keeper is responsible for An accountant is also responsible for the work

Responsibility of a book-keeper
recording business transactions
The book-keeper does not supervise An accountant supervises and checks the
Supervision
and check the work of the accountant work of the book-keeper

Staff involved Work is done by the junior staff of entity Senior staff performs the accounting work

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The Accounting Cycle
The primary objectives of the accounting in an organization are to process financial
information and to prepare financial statements for the accounting period. Because this
process is repeated in each reporting period, it is referred to as the accounting cycle. This is
a series of activities that begins with a transaction and ends with the closing of the accounts.

Generally, the followings are the key steps in the accounting cycle:

1. Collection of data from transactions and events:

Once financial transactions and events occur they need to be captured as they
become the input f or the accounting process. Therefore, the data of every such
transaction or event should be documented and maintain for verification purposes. A
source document provides evidence that an economic event has actually occurred.

2. Recording of transactions in the prime entry books

The prime entry books, also called journals, are the accounting records in which
business transactions are initially recorded. Generally, every transaction should be
recorded in prime entry books and depending on the nature of transaction of the
business, an entity may keep specific journals to record similar nature's
transactions.

3. Posting the journal entries for transactions from prime entry books to the ledger
accounts
Once transactions are recorded in prime entry books they must be posted to the ledger
accounts in the ledger to shows which ledger account balances have increased as a result
of the transaction, and which ledger account balances have decreased.

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4. Preparation of an unadjusted trial balance
At the end of the accounting period, debits and credits recorded in the general ledger
accounts should be equal according to double entry model of accounting. Some
accounts normally have debit balances (e.g. assets and expenses) and other accounts
have credit balances (e.g. liabilities, equity and revenues). As transactions are recorded
in the prime entry books and subsequently posted to the ledger, the total of amounts
recorded on the debit side of accounts must equal the total of amounts recorded on the
credit side of accounts.

In a trial balance, separate debit and credit columns are used to list the balances of
the individual ledger accounts. This will test the equality of debits and credits as
recorded in the general ledger. If unequal amounts of debits and credits are found in this
step, the reason for the inequality is investigated and corrected before proceeding to the
next step.

While a trial balance proves the equality of debit and credit entries in the ledger, it
does not detect certain errors which do not affect the tallying of the trial balance,
such as failure to record a business transaction completely, improper analysis of the
accounts affected by the transaction, or the posting of debit or credit entries to the
wrong accounts.

5. Recording of the adjusting entries in the journal and posting to the ledger accounts
At the end of each accounting period adjustments are required to bring accounts to their
proper balances after considering transactions and events that have not yet been
recorded. Under accrual accounting, revenue is recorded when earned and expenses
when incurred. Thus, an entry may be required at the end of the period to record
revenue that has been earned but not yet recorded on the books. Similarly, an
adjustment may be required to record an expense that may have been incurred but not
yet recorded.

In addition, certain adjustments related with accounting policies adopted by the business
entity will be made on periodic basis (e.g. depreciation, provision for bad debts, etc.).

6. Preparation of an adjusted trial balance

The adjusted trial balance sheet is used to verify debit and credit balances after making
adjusting entries, and to review the balances of each account in preparation of financial
statements.

7. Preparation of financial statements

Financial statements are prepared using the corrected balances from the adjusted trial
balance. These are one of the primary outputs of the financial accounting system. The
followings are the components of typical set of financial statements:

Profit and loss account: Also called income statement, shows the revenues from
business operations, expenses of the business, and the resulting net profit or loss of
an entity over a specific period of time.
Balance sheet: is a summary of the balances of assets, liabilities and equity of a
business entity as at a specific date, such as the end of accounting period.
Statement of changes in equity: shows all changes in owner’s equity during a specific
accounting period.
Cash flow statement: shows how the balances of cash and similar items of an entity
have changed during a specific accounting period. This is an indication of how profit
and cash balance are linked.
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 8. Recording of the closing entries in the journal and post to the ledger accounts

Revenues and expenses are accumulated and reported for each accounting period
(monthly, quarterly or annually) as they are temporary accounts in nature. To prevent
the revenues and expenses of one accounting period posting to another period, such
accounts should be closed to arrive at zero balances at the end of the period. The
relevant revenue or expense for the period should be transferred to profit & loss
account to arrive at the profit or loss of the period. Such difference of revenues and
expenses are finally transferred into equity.

Once revenue and expense accounts are closed, the only permanent accounts that have
balances are the asset, liability, and equity accounts. Their balances can be carried
forward to next periods.

9. Preparation of a post-closing trial balance

This is to determine that all revenue and expense accounts have been closed properly
and to test whether debit balance of assets accounts equal to credit balance of liabilities
and equity accounts in the general ledger.

As this process is carried out routinely the above steps are continuously followed by
accountants in business entities to achieve the objectives of accounting.

What are Financial Statements?

Financial Statements represent a formal record of the financial activities of an entity. These
are written reports that quantify the financial strength, performance and liquidity of a company.
Financial Statements reflect the financial effects of business transactions and events on the
entity.

Four Types of Financial Statements

The four main types of financial statements are:

1. Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the financial
position of an entity at a given date. It is comprised of the following three elements:

o Assets: Something a business owns or controls (e.g. cash, inventory, plant and
machinery, etc)
o Liabilities: Something a business owes to someone (e.g. creditors, bank loans,
etc)
o Equity: What the business owes to its owners. This represents the amount of
capital that remains in the business after its assets are used to pay off its
outstanding liabilities. Equity therefore represents the difference between the
assets and liabilities.

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2. Income Statement
Income Statement, also known as the Profit and Loss Statement, reports the company's
financial performance in terms of net profit or loss over a specified period. Income
Statement is composed of the following two elements:

o Income: What the business has earned over a period (e.g. sales revenue,
dividend income, etc)
o Expense: The cost incurred by the business over a period (e.g. salaries and
wages, depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period.
The movement in cash flows is classified into the following segments:

o Operating Activities: Represents the cash flow from primary activities of a

business.
o Investing Activities: Represents cash flow from the purchase and sale of assets
other than inventories (e.g. purchase of a factory plant)
o Financing Activities: Represents cash flow generated or spent on raising and
repaying share capital and debt together with the payments of interest and
dividends.

4. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings,
details the movement in owners' equity over a period. The movement in owners' equity
is derived from the following components:

o Net Profit or loss during the period as reported in the income statement
o Share capital issued or repaid during the period
o Dividend payments
o Gains or losses recognized directly in equity (e.g. revaluation surpluses)
o Effects of a change in accounting policy or correction of accounting error.

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The following diagram summarizes the link between financial statements.

Statement of Financial Position (Balance Sheet)

Statement of Financial Position, also known as the Balance Sheet, presents the financial
position of an entity at a given date. It is comprised of three main components: Assets,
liabilities and equity.

Statement of Financial Position helps users of financial statements to assess the

financial soundness of an entity in terms of liquidity risk, financial risk, credit risk and
business risk.

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Example
Following is an illustrative example of a Statement of Financial Position prepared under the format
prescribed by IAS 1 Presentation of Financial Statements.

Statement of Financial Position as at 31st December 2013

2013 2012
Notes
USD USD
ASSETS
Non-current assets
Property, plant & equipment 1 130,000 120,000
Goodwill 2 30,000 30,000
Intangible assets 3 60,000 50,000
220,000 200,000
Current assets
Inventories 4 12,000 10,000
Trade receivables 5 25,000 30,000
Cash and cash equivalents 6 8,000 10,000
45,000 50,000
TOTAL ASSETS 265,000 250,000

EQUITY AND LIABILITIES

Equity
Share capital 4 100,000 100,000
Retained earnings 5 50,000 40,000
Revaluation reserve 6 15,000 10,000
Total equity 165,000 150,000

Non-current liabilities
Long term borrowings 7 35,000 50,000

Current liabilities
Trade and other payables 8 35,000 25,000
Short-term borrowings 7 10,000 8,000
Current portion of long-term borrowings 9 15,000 15,000
Current tax payable 10 5,000 2,000
Total current liabilities 65,000 50,000
Total liabilities 100,000 100,000
TATAL EQUITY AND LIABILITIES 265,000 250,000

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Classification of Components
Statement of financial position consists of the following key elements:

Assets

An asset is something that an entity owns or controls in order to derive economic benefits from
its use. Assets must be classified in the balance sheet as current or non-current depending on
the duration over which the reporting entity expects to derive economic benefit from its use. An
asset which will deliver economic benefits to the entity over the long term is classified as non-
current whereas those assets that are expected to be realized within one year from the
reporting date are classified as current assets.

Assets are also classified in the statement of financial position on the basis of their nature:

 Tangible & intangible: Non-current assets with physical substance are classified as
property, plant and equipment whereas assets without any physical substance are
classified as intangible assets. Goodwill is a type of an intangible asset.
 Inventories balance includes goods that are held for sale in the ordinary course of the
business. Inventories may include raw materials, finished goods and works in progress.
 Trade receivables include the amounts that are recoverable from customers upon credit
sales. Trade receivables are presented in the statement of financial position after the
deduction of allowance for bad debts.
 Cash and cash equivalents include cash in hand along with any short term investments
that are readily convertible into known amounts of cash.

Liabilities

A liability is an obligation that a business owes to someone and its settlement involves the
transfer of cash or other resources. Liabilities must be classified in the statement of financial
position as current or non-current depending on the duration over which the entity intends to
settle the liability. A liability which will be settled over the long term is classified as non-current
whereas those liabilities that are expected to be settled within one year from the reporting date
are classified as current liabilities.

Liabilities are also classified in the statement of financial position on the basis of their nature:

 Trade and other payables primarily include liabilities due to suppliers and contractors
for credit purchases. Sundry payables which are too insignificant to be presented
separately on the face of the balance sheet are also classified in this category.
 Short term borrowings typically include bank overdrafts and short term bank loans with
a repayment schedule of less than 12 months.
 Long-term borrowings comprise of loans which are to be repaid over a period that
exceeds one year. Current portion of long-term borrowings include the installments of
long term borrowings that are due within one year of the reporting date.
 Current Tax Payable is usually presented as a separate line item in the statement of
financial position due to the materiality of the amount.

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Equity

Equity is what the business owes to its owners. Equity is derived by deducting total liabilities
from the total assets. It therefore represents the residual interest in the business that belongs to
the owners.

Equity is usually presented in the statement of financial position under the following categories:

 Share capital represents the amount invested by the owners in the entity
 Retained Earnings comprises the total net profit or loss retained in the business after
distribution to the owners in the form of dividends.
 Revaluation Reserve contains the net surplus of any upward revaluation of property,
plant and equipment recognized directly in equity.

Rationale - Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an entity equal to the
sum of liabilities and equity. This may lead you to wonder as to why the balance sheet
must always be in equilibrium.

Assets of an entity may be financed from internal sources (i.e. share capital and profits)
or from external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a
business must be equal to the amount of capital invested by the owners (i.e. in the form
of share capital and profits not withdrawn) and any borrowings, the total assets of a
business must equal to the sum of equity and liabilities.

This leads us to the Accounting Equation: Assets = Liabilities + Equity

Exercises 1:
Evaluate the impact of the following transactions to the accounting equation:
- Initial capital investment Rs.65,000 in cash
- Purchase of furniture and fittings for Rs.35,000 on credit terms
- Pay Rs.24,000 to the creditor
- Payment of the private telephone bill of the owner Rs.7,500
- Payment of sales commission to staff Rs.3,600
- Sale of goods for Rs.125,000 on credit terms
- Additional capital introduced by the owner for Rs.45,000
- Purchase of goods on credit for Rs.25,000
- Collection of debtors for the sales made for Rs.125,000

Purpose & Importance

Statement of financial position helps users of financial statements to assess the financial
health of an entity. When analyzed over several accounting periods, balance sheets may
assist in identifying underlying trends in the financial position of the entity. It is
particularly helpful in determining the state of the entity's liquidity risk, financial risk,
credit risk and business risk. When used in conjunction with other financial statements
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of the entity and the financial statements of its competitors, balance sheet may help to
identify relationships and trends which are indicative of potential problems or areas for
further improvement. Analysis of the statement of financial position could therefore
assist the users of financial statements to predict the amount, timing and volatility of
entity's future earnings.

Income Statement (Profit & Loss Account)

Income Statement, also known as Profit & Loss Account, is a report of income, expenses
and the resulting profit or loss earned during an accounting period.

Example

Following is an illustrative example of an Income Statement prepared in accordance

with the format prescribed by IAS 1 Presentation of Financial Statements.

Income Statement for the Year Ended 31st December 2013

2013 2012
Notes
USD USD
Revenue 11 120,000 100,000
Cost of Sales 12 (65,000) (55,000)
Gross Profit 55,000 45,000

Other Income 13 17,000 12,000

Distribution Cost 14 (10,000) (8,000)
Administrative Expenses 15 (18,000) (16,000)
Other Expenses 16 (3,000) (2,000)
Finance Charges 17 (1,000) (1,000)
(15,000) (15,000)
Profit before tax 40,000 30,000

Income tax 18 (12,000) (9,000)

Net Profit 28,000 21,000

Basis of preparation
Income statement is prepared on the accruals basis of accounting.

This means that income (including revenue) is recognized when it is earned rather than when
receipts are realized (although in many instances income may be earned and received in the same
accounting period).

Conversely, expenses are recognized in the income statement when they are incurred even if
they are paid for in the previous or subsequent accounting periods.

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Income statement does not report transactions with the owners of an entity. Hence, dividends
paid to ordinary shareholders are not presented as an expense in the income statement and
proceeds from the issuance of shares is not recognized as an income. Transactions between the
entity and its owners are accounted for separately in the statement of changes in equity.

Components
Income statement comprises of the following main elements:

Revenue
Revenue includes income earned from the principal activities of an entity. So for example, in
case of a manufacturer of electronic appliances, revenue will comprise of the sales from
electronic appliance business. Conversely, if the same manufacturer earns interest on its bank
account, it shall not be classified as revenue but as other income.

Cost of Sales
Cost of sales represents the cost of goods sold or services rendered during an accounting period.

Hence, for a retailer, cost of sales will be the sum of inventory at the start of the period and
purchases during the period minus any closing inventory.

In case of a manufacturer however, cost of sales will also include production costs incurred in
the manufacture of goods during a period such as the cost of direct labor, direct material
consumption, depreciation of plant and machinery and factory overheads, etc.

Other Income
Other income consists of income earned from activities that are not related to the entity's main
business. For example, other income of an entity that manufactures electronic appliances may
include:
 Gain on disposal of fixed assets
 Interest income on bank deposits
 Exchange gain on translation of a foreign currency bank account

Distribution Cost
Distribution cost includes expenses incurred in delivering goods from the business premises to
customers.

Administrative Expenses
Administrative expenses generally comprise of costs relating to the management and support
functions within an organization that are not directly involved in the production and supply of
goods and services offered by the entity.

Examples of administrative expenses include:

 Salary cost of executive management

 Legal and professional charges
 Depreciation of head office building
 Rent expense of offices used for administration and management purposes
 Cost of functions / departments not directly involved in production such as finance
department, HR department and administration department

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Other Expenses
This is essentially a residual category in which any expenses that are not suitably classifiable
elsewhere are included.

Finance Charges
Finance charges usually comprise of interest expense on loans and debentures.

The effect of present value adjustments of discounted provisions are also included in finance
charges (e.g. unwinding of discount on provision for decommissioning cost).

Income tax
Income tax expense recognized during a period is generally comprised of the following three
elements:
 Current period's estimated tax charge
 Prior period tax adjustments
 Deferred tax expense

Prior Period Comparatives

Prior period financial information is presented alongside current period's financial results to
facilitate comparison of performance over a period.

It is therefore important that prior period comparative figures presented in the income
statement relate to a similar period.

For example, if an organization is preparing income statement for the six months ending 31
December 2013, comparative figures of prior period should relate to the six months ending 31
December 2012.

Purpose & Use

Income Statement provides the basis for measuring performance of an entity over the course of
an accounting period.

Performance can be assessed from the income statement in terms of the following:
 Change in sales revenue over the period and in comparison to industry growth
 Change in gross profit margin, operating profit margin and net profit margin over the
period
 Increase or decrease in net profit, operating profit and gross profit over the period
 Comparison of the entity's profitability with other organizations operating in similar
industries or sectors

Income statement also forms the basis of important financial evaluation of an entity when it is
analyzed in conjunction with information contained in other financial statements such as:

 Change in earnings per share over the period

 Analysis of working capital in comparison to similar income statement elements (e.g. the
ratio of receivables reported in the balance sheet to the credit sales reported in the
income statement, i.e. debtor turnover ratio)
 Analysis of interest cover and dividend cover ratios

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Statement of Cash Flows
Statement of Cash Flows, also known as Cash Flow Statement, presents the movement in cash
flows over the period as classified under operating, investing and financing activities.

Example
Following is an illustrative cash flow statement presented according to the indirect method
suggested in IAS 7 Statement of Cash Flows:

ABC PLC
Statement of Cash Flows for the year ended 31 December 2013
2013 2012
Notes
USD USD
Cash flows from operating activities

Profit before tax 40,000 35,000

Adjustments for:
Depreciation 4 10,000 8,000
Amortization 4 8,000 7,500
Impairment losses 5 12,000 3,000
Bad debts written off 14 500 -
Interest expense 16 800 1,000
Gain on revaluation of investments (21,000) -
Interest income 15 (11,000) (9,500)
Dividend income (3,000) (2,500)
Gain on disposal of fixed assets (1,200) (1,850)
35,100 40,650
Working Capital Changes:
Movement in current assets:
(Increase) / Decrease in inventory (1,000) 550
Decrease in trade receivables 3,000 1,400
Movement in current liabilities:
Increase / (Decrease) in trade payables 2,500 (1,300)
Cash generated from operations 39,600 41,300

Dividend paid (8,000) (6,000)

Income tax paid (12,000) (10,000)
Net cash from operating activities (A) 19,600 25,300

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Cash flows from investing activities
Capital expenditure 4 (100,000) (85,000)
Purchase of investments 11 (25,000) -
Dividend received 5,000 3,000
Interest received 3,500 1,000
Proceeds from disposal of fixed assets 18,000 5,500
Proceeds from disposal of investments 2,500 2,200
Net cash used in investing activities (B) (96,000) (73,300)

Cash flows from financing activities

Issuance of share capital 6 1000,000 -
Bank loan received - 100,000
Repayment of bank loan (100,000) -
Interest expense (3,600) (7,400)
Net cash from financing activities (C) 896,400 92,600

Net increase in cash & cash equivalents (A+B+C) 820,000 44,600

Cash and cash equivalents at start of the year 77,600 33,000
Cash and cash equivalents at end of the year 24 897,600 77,600

Basis of Preparation
Statement of Cash Flows presents the movement in cash and cash equivalents over the period.

Cash and cash equivalents generally consist of the following:

 Cash in hand
 Cash at bank
 Short term investments that are highly liquid and involve very low risk of change in
value (therefore usually excludes investments in equity instruments)
 Bank overdrafts in cases where they comprise an integral element of the organization's
treasury management (e.g. where bank account is allowed to float between a positive
and negative balance (i.e. overdraft) as opposed to a bank overdraft facility specifically
negotiated for financing a shortfall in funds (in which case the related cash flows will be
classified under financing activities).

As income statement and balance sheet are prepared under the accruals basis of accounting, it is
necessary to adjust the amounts extracted from these financial statements (e.g. in respect of
non-cash expenses) in order to present only the movement in cash inflows and outflows during
a period.

All cash flows are classified under operating, investing and financing activities as discussed
below.

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Operating Activities
Cash flow from operating activities presents the movement in cash during an accounting period
from the primary revenue generating activities of the entity.

For example, operating activities of a hotel will include cash inflows and outflows from the hotel
business (e.g. receipts from sales revenue, salaries paid during the year etc), but interest income
on a bank deposit shall not be classified as such (i.e. the hotel's interest income shall be
presented in investing activities).

Profit before tax as presented in the income statement could be used as a starting point to
calculate the cash flows from operating activities.

Following adjustments are required to be made to the profit before tax to arrive at the cash flow
from operations:

1. Elimination of non-cash expenses (e.g. depreciation, amortization, impairment losses,

bad debts written off, etc)
2. Removal of expenses to be classified elsewhere in the cash flow statement (e.g. interest
expense should be classified under financing activities)
3. Elimination of non-cash income (e.g. gain on revaluation of investments)
4. Removal of income to be presented elsewhere in the cash flow statement (e.g. dividend
income and interest income should be classified under investing activities unless in case
of for example an investment bank)
5. Working capital changes (e.g. an increase in trade receivables must be deducted to
arrive at sales revenue that actually resulted in cash inflow during the period)

Investing Activities
Cash flow from investing activities includes the movement in cash flow as a result of the
purchase and sale of assets other than those which the entity primarily trades in (e.g.
inventory). So for example, in case of a manufacturer of cars, proceeds from the sale of factory
plant shall be classified as cash flow from investing activities whereas the cash inflow from the
sale of cars shall be presented under the operating activities.

Cash flow from investing activities consists primarily of the following:

 Cash outflow expended on the purchase of investments and fixed assets

 Cash inflow from income from investments
 Cash inflow from disposal of investments and fixed assets

Financing activities

Cash flow from financing activities includes the movement in cash flow resulting from
the following:

 Proceeds from issuance of share capital, debentures & bank loans

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  Cash outflow expended on the cost of finance (i.e. dividends and interest
expense)
 Cash outflow on the repurchase of share capital and repayment of debentures &
loans

Purpose & Importance

Statement of cash flows provides important insights about the liquidity and solvency of
a company which are vital for survival and growth of any organization. It also enables
analysts to use the information about historic cash flows to form projections of future
cash flows of an entity (e.g. in NPV analysis) on which to base their economic decisions.
By summarizing key changes in financial position during a period, cash flow statement
serves to highlight priorities of management.

For example, increase in capital expenditure and development costs may indicate a
higher increase in future revenue streams whereas a trend of excessive investment in
short term investments may suggest lack of viable long term investment opportunities.
Furthermore, comparison of the cash flows of different entities may better reveal the
relative quality of their earnings since cash flow information is more objective as
opposed to the financial performance reflected in income statement which is
susceptible to significant variations caused by the adoption of different accounting
policies.

Statement of Changes in Equity

Statement of Changes in Equity, often referred to as Statement of Retained Earnings in
U.S. GAAP, details the change in owners' equity over an accounting period by presenting
the movement in reserves comprising the shareholders' equity.

Movement in shareholders' equity over an accounting period comprises the following

elements:

 Net profit or loss during the accounting period attributable to shareholders

 Increase or decrease in share capital reserves
 Dividend payments to shareholders
 Gains and losses recognized directly in equity
 Effect of changes in accounting policies
 Effect of correction of prior period error

Example

Following is an illustrative example of a Statement of Changes in Equity prepared

according to the format prescribed by IAS 1 Presentation of Financial Statements.

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ABC Plc
Statement of changes in equity
for the year ended 31st
December 2012

Share Retained Revaluation Total

Capital Earnings Surplus Equity

USD USD USD USD

Balance at 1 January 2011 100,000 30,000 - 130,000

Changes in accounting policy - - - -

Correction of prior period error - - - -

Restated balance 100,000 30,000 - 130,000

Changes in equity for the year 2011

Issue of share capital - - - -

Income for the year - 25,000 - 25,000
Revaluation gain - - 10,000 10,000
Dividends - (15,000) - (15,000)

Balance at 31 December 2011 100,000 40,000 10,000 150,000

Changes in equity for the year 2012

Issue of share capital - - - -

Income for the year - 30,000 - 30,000
Revaluation gain - - 5,000 5,000
Dividends - (20,000) - (20,000)

Balance at 31 December 2012 100,000 50,000 15,000 165,000

Components
Following are the main elements of statement of changes in equity:

Opening Balance
This represents the balance of shareholders' equity reserves at the start of the comparative
reporting period as reflected in the prior period's statement of financial position. The opening
balance is unadjusted in respect of the correction of prior period errors rectified in the current
period and also the effect of changes in accounting policy implemented during the year as these
are presented separately in the statement of changes in equity (see below).
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Effect of Changes in Accounting Policies
Since changes in accounting policies are applied retrospectively, an adjustment is required in
stockholders' reserves at the start of the comparative reporting period to restate the opening
equity to the amount that would be arrived if the new accounting policy had always been
applied.

Effect of Correction of Prior Period Error

The effect of correction of prior period errors must be presented separately in the statement of
changes in equity as an adjustment to opening reserves. The effect of the corrections may not be
netted off against the opening balance of the equity reserves so that the amounts presented in
current period statement might be easily reconciled and traced from prior period financial
statements.

Restated Balance
This represents the equity attributable to stockholders at the start of the comparative period
after the adjustments in respect of changes in accounting policies and correction of prior period
errors as explained above.

Changes in Share Capital

Issue of further share capital during the period must be added in the statement of changes in
equity whereas redemption of shares must be deducted therefrom. The effects of issue and
redemption of shares must be presented separately for share capital reserve and share
premium reserve.

Dividends
Dividend payments issued or announced during the period must be deducted from shareholder
equity as they represent distribution of wealth attributable to stockholders.

Income / Loss for the period

This represents the profit or loss attributable to shareholders during the period as reported in
the income statement.

Changes in Revaluation Reserve

Revaluation gains and losses recognized during the period must be presented in the statement
of changes in equity to the extent that they are recognized outside the income statement.
Revaluation gains recognized in income statement due to reversal of previous impairment
losses however shall not be presented separately in the statement of changes in equity as they
would already be incorporated in the profit or loss for the period.

Other Gains & Losses

Any other gains and losses not recognized in the income statement may be presented in the
statement of changes in equity such as actuarial gains and losses arising from the application of
IAS 19 Employee Benefit.

Closing Balance
This represents the balance of shareholders' equity reserves at the end of the reporting period
as reflected in the statement of financial position.

Purpose & Importance

Statement of changes in equity helps users of financial statement to identify the factors that
cause a change in the owners' equity over the accounting periods. Whereas movement in
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shareholder reserves can be observed from the balance sheet, statement of changes in equity
discloses significant information about equity reserves that is not presented separately
elsewhere in the financial statements which may be useful in understanding the nature of
change in equity reserves. Examples of such information include share capital issue and
redemption during the period, the effects of changes in accounting policies and correction of
prior period errors, gains and losses recognized outside income statement, dividends declared
and bonus shares issued during the period.

Limitations of Accounting & Financial Reporting

Accountancy assists users of financial statements to make better financial decisions. It is
important however to realize the limitations of accounting and financial reporting when
forming those decisions.

Following are the main limitations of accounting and financial reporting:

1. Different accounting policies

2. Accounting estimates
3. Professional judgment
4. Verifiability
5. Use of historical cost basis
6. Measurability
7. Limited predictive value
8. Fraud and error
9. Cost benefit compromise

1. Different accounting policies and frameworks

Accounting frameworks such as IFRS allow the preparers of financial statements to use
accounting policies that most appropriately reflect the circumstances of their entities.

Whereas a degree of flexibility is important in order to present reliable information of a

particular entity, the use of diverse set of accounting policies amongst different entities impairs
the level of comparability between financial statements.

The use of different accounting frameworks (e.g. IFRS, US GAAP) by entities operating in
different geographic areas also presents similar problems when comparing their financial
statements. The problem is being overcome by the growing use of IFRS and the convergence
process between leading accounting bodies to arrive at a single set of global standards.

2. Accounting estimates
Accounting requires the use of estimates in the preparation of financial statements where
precise amounts cannot be established. Estimates are inherently subjective and therefore lack
precision as they involve the use of management's foresight in determining values included in
the financial statements. Where estimates are not based on objective and verifiable information,
they can reduce the reliability of accounting information.

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3. Professional judgment
The use of professional judgment by the preparers of financial statements is important in
applying accounting policies in a manner that is consistent with the economic reality of an
entity's transactions. However, differences in the interpretation of the requirements of
accounting standards and their application to practical scenarios will always be inevitable. The
greater the use of judgment involved, the more subjective financial statements would tend to be.

4. Verifiability
Audit is the main mechanism that enables users to place trust on financial statements. However,
audit only provides 'reasonable' and not absolute assurance on the truth and fairness of the
financial statements which means that despite carrying audit according to acceptable standards,
certain material misstatements in financial statements may yet remain undetected due to the
inherent limitations of the audit.

5. Use of historical cost

Historical cost is the most widely used basis of measurement of assets. Use of historical cost
presents various problems for the users of financial statements as it fails to account for the
change in price levels of assets over a period of time. This not only reduces the relevance of
accounting information by presenting assets at amounts that may be far less than their
realizable value but also fails to account for the opportunity cost of utilizing those assets.

The effect of the use of historical cost basis is best explained by the use of an example.

Company A purchased a plant for $100,000 on 1st January 2006 which had a useful life of 10
years.

Company B purchased a similar plant for $200,000 on 31st December 2010.

Depreciation is charged on straight line basis.

At the end of the reporting period at 31st December 2010, the balance sheet of Company B
would show a fixed asset of $200,000 while A's financial statement would show an asset of
$50,000 (net of depreciation).

The scenario above presents an accounting anomaly. Even though the plant presented in A's
financial statements is capable of producing economic benefits worth 50% of Company B's
asset, it is carried at a historical cost equivalent of just 25% of its value.

Moreover, the depreciation charged in A's financial statements (i.e. $10,000 p.a.) does not
reflect the opportunity cost of the plant's use (i.e. $20,000 p.a.). As a result, over the course of
the asset's life, an amount of $100,000 would be charged as depreciation in A's financial
statements even though the cost of maintaining the productive capacity of its asset would have
notably increased. If Company A were to distribute all profits as dividends, it will not have the
resources sufficient to replace its existing plant at the end of its useful life. Therefore, the use of
historical cost may result in reporting profits that are not sustainable in the long term.

Due to the disadvantages associated with the use of historical cost, some preparers of financial
statements use the revaluation model to account for long-term assets. However, due to the

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limited market of various assets and the cost of regular valuations required under revaluation
model, it is not widely used in practice.

An interesting development in accounting is the use of 'capital maintenance' in the

determination of profit that is sustainable after taking into account the resources that would be
required to 'maintain' the productivity of operations. However, this accounting basis is still in its
early stages of development.

6. Measurability
Accounting only takes into account transactions that are capable of being measured in monetary
terms. Therefore, financial statements do not account for those resources and transactions
whose value cannot be reasonably assigned such as the competence of workforce or goodwill.

7. Limited predictive value

Financial statements present an account of the past performance of an entity. They offer limited
insight into the future prospects of an enterprise and therefore lack predictive value which is
essential from the point of view of investors.

8. Fraud and error

Financial statements are susceptible to fraud and errors which can undermine the overall
credibility and reliability of information contained in them. Deliberate manipulation of financial
statements that is geared towards achieving predetermined results (also known as 'window
dressing') has been a unfortunate reality in the recent past as has been popularized by major
accounting disasters such as the Enron Scandal.

9. Cost benefit compromise

Reliability of accounting information is relative to the cost of its production. At times, the cost of
producing reliable information outweighs the benefit expected to be gained which explains why,
in some instances, quality of accounting information might be compromised.

“Do not give your attention to what others do or fail to

do; give it to what you do or fail to do.”
Lord Buddha

Sanjeewa Guruge
M.Sc. Investments (UK), B.Sc. Accountancy (Special) - 1st Class (USJ), FCA, FCMA

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