I – Introduction to Accounting & finance

Learning Outcomes

 What is Accounting & finance

 The role of accounting in business

 Various legal forms of business

 Describe how accounting can be viewed as an information

system

 Explain the role of accounting information in an organization

 Understand the information requirements of the users of

accounting

 Explain how information is made more reliable

 Explain the fundamental principles of accounting

What is ACCOUNTING and finance

Accounting
Accounting may be defined as the process of Recording, Classifying,
summarizing, Analyzing and Interpreting the financial transactions
and communicating the results thereof to the persons interested in such
information.

1 Recording: This is the basic function of Accounting. It is essentially

concerned with not only ensuring that all business transaction of financial
character are in fact recorded but also that they are recorded in an orderly
manner. Recording is done in the book called “journal”.

2 Classifying: Classification is concerned with the systematic analysis of the

recorded data, with view to group transactions or entries of one nature at
one place .The work of classification is done in the book called “Ledger”.

3 Summarizing: This involves presenting the classified data in a manner,

which is understandable and useful to the internal as well as external end –
users of accounting statements. This process leads to the preparation of the
following statement :-

1. Trial Balance
2. Trading Account
3. Profit &Loss Account
4. Balance Sheet

4 Analyses and Interprets: This is the final function of accounting. The

recorded financial data is analyzed and interpreted in a manner that the end-
users can make a meaningful judgment about the financial condition and
profitability of the business operations.

5 Deals with financial transactions: - Accounting records only those

transactions and events of money, which are of a financial character.

What is Finance Anyway

Companies do not work in a vacuum, isolated from everything else. It
interacts and transacts with the other entities present in the economic
environment. These entities include Government, Suppliers, Lenders, Banks,
Customers, Shareholders, etc. who deal with the organisation in several
ways. Most of these dealings result in either money flowing in or flowing out
from the company. This flow of money (or funds) has to be managed so as to
result in maximum gains to the company.

Managing this flow of funds efficiently is the purview of finance. So we can

define finance as the study of the methods which help us plan, raise and use
funds in an efficient manner to achieve corporate objectives. Finance grew
out of economics as a special discipline to deal with a special set of common
problems.

The corporate financial objectives could be to:

1. Provide the link between the business and the other entities in the
environment and
2. Investment and financial decision making
Let us first look at what we mean by investment and financial decision
making.

1. Investment Decision
The investment decision also referred to as the capital budgeting decision,
simply means the decisions to acquire assets or to invest in a project. Assets
are defined as economic resources that are expected to generate future
benefits.

2. Financing Decision
The second financial decision is the financing decision, which basically
addresses two questions:
a. How much capital should be raised to fund the firm’s operations
(both existing & proposed)
b. What is the best mix of financing these assets?
Financing could be through two ways: debt (loans from various sources like
banks, financial institutions, public, etc.) and equity (capital put in by the
investors who are also known as owners/ shareholders). Shareholders are
owners because the shares represent the ownership in the company.

Funds are raised from financial markets. Financial markets is a generic term
used to denote markets where financial securities are teat. These markets
include money markets, debt market and capital markets. We will
understand them in detail later in the 3rd chapter.

Financing and investing decisions are closely related because the company is
going to raise money to invest in a project or assets. Those who are going to
give money to the company (whether lenders or investors) need to
understand where the company is investing their money and what it hopes
to earn from the investments so that they can assure themselves of the
safety of their money.

The questions that you may thinking about right now are “Why do we need
to learn finance? Shall we not leave it to the people who are going to
specialise in finance? Finance won’t help me in the area that I am going to
work in, so why learn?” This is to say that the knowledge of finance does not
add any value to you. Is it so? Think about it. When you get your pocket
money from your parents, you do not go out and blow the whole lot in one
day because if you do, your parents are not going to give you more money to
last through that month. You quickly learn that you need to plan your
expenditure so that the money lasts throughout the month and you may
actually plan to save some of it. Those who do not get enough to meet their
requirements, think about some clever means to raise more money (like
falling sick!). Alternatively if they need more money for the month because
of certain special events (like Valentine’s day) they can plan to borrow
money for a month and repay in the next month.
So you plan, raise and efficiently utilise funds that are your disposal (or at
least try to). That a business organisation also needs to do the same can
hardly be overemphasised. The scale of operations is much bigger and to
efficiently manage funds at this scale, decisions cannot be taken without
sound methodology. Finance teaches you this terminology.

For managing these funds the first thing you would need is information.
External information has to be collected from the environment and
accounting provides internal information about the firm’s operations.
Accounting can be defined as an information and measurement system that
identifies, records, and communicates relevant information about a
company’s economic activities to people to help them make better decisions.

So the purpose of this book is to help you understand the accounting

information and how this information is utilised by the users to make better
decisions. Two sections of the book are devoted to that. The last two
sections are devoted to various methodologies of financial decision making
that an organisation needs to follow to meet its financial goals.

Do We Need to Learn Finance?

You would now agree that a company needs to manage its own funds
efficiently but your question still remains “Why am I concerned with it?”
Further arguing, you say that, “I am going to specialise in Marketing/
Information Technology/ Human Resource Management/ Operations
Management and there is no need for me to learn finance. Also Finance is a
separate function in my organisation (or the organisation that I am going to
work for) and I am hardly going to use finance to work in my respective
department.”
Think again. Everything that you do has an impact on the profitability of the
company (including drinking ten cups of coffee in a day!). So if you want to
grow up to be the CEO of the company in a few years from now (which I
undoubtedly think that you would love to) you should take the advice of the
top CEOs.

Corporate World Connection

79 per cent of the top CEOs rate Finance skills, as the most required for the
CEO of the future.
KPMG survey.

Better take the CEOs advice. But don’t get the feeling that only the CEOs
require the Finance Skills, all other functions of management also cannot do
without finance and the financial information.

Relationship of Finance with Other Functions of Management

If you are in marketing, the first thing that you wonder about is how the price
of the product is calculated. It is not always based upon what your
competitors are charging or what the market can absorb but also upon the
costs that you are incurring in producing that product. This information
comes from the finance department (generic term used to denote finance
and accounting section in the organisation) but the analysis of this
information is only upto you. Finance department will also provide you with
information on your customers, do an credit analysis for you, give you
information on outstandings from your customer, provide information on
what segments (customerwise, regionwise, etc.) are doing well (or doing
badly) as compared to last year, etc. Finance also helps you decide which
products are profitable and which are not.
If you plan to specialise in Information Technology, you would be glad (or
sad) to know that the first process the company automates is the accounting
process. There is no way you can understand what the hell is going on out
there without understanding finance and accounting. In fact, any other
process when it is being automated in the company would normally deal with
quantitative (number based) information. All these quantitative processes
involve money and fund flows and to understand these processes the
knowledge of finance and accounting is very important. For example, if you
are planning to implement an Enterprise Resource Planning (ERP) package in
your organisation, most of the information that will go in to ERP is financial
(i.e. quantitative) whether it is marketing related, production related or HR
related. Therefore, it would pay if you learn finance well so that you do not
have problems later on when you automate the business processes.

If you planning to specialise in HR, the first thing that concerns you is how
much to pay to your employees and how to structure the pay packet so as to
minimise the incidence of tax on the employees as well as the company. You
also need to learn how innovative financial mechanisms can be used to
reward your employees like Employee Stock Option Plans (ESOPs). If you are
planning to invest in training and development of your employees, you need
to justify the value added to your business by the training of your
employees. Accounting and finance supplies all this information to you.

If you were planning to specialise in Operations Management, finance would

help you in many ways. It would help you schedule your production, reduce
your inventory costs, provide information on bad suppliers, help you know
which products are selling so as to help you produce them, help you do cost
analysis on the material purchased and monitor the productivity of the
processes. There is no way that you can imagine efficiently managing your
production processes without the help of finance and accounting.
If you are planning to specialise in International Business, you are basically
going to learn the international aspects of all the functions of the business.
So, you need to learn the international aspects of finance also and how do
you learn the international aspects if you do not even know the
fundamentals!

So as you can see, finance and accounting integrates with and supplements
all the functions of the organisation and no successful manager can think
about growing in an organisation if he does not understand the financial
aspects of the decisions that he is going to take.
Is Accounting Useful for Business?

You now agree that finance is useful but what about accounting? Accounting
plays a vital role in the decision-making process. An accounting system
provides information in a form that can be used to make knowledgeable
financial decisions. The information supplied by accounting is in the form of
quantitative data, primarily financial and relates to specific economic
entities. Accounting provides the means for tracking activities and measuring
results. Without accounting information, many important financial decisions
would be made blindly. For example, investors would not be able to
distinguish between a healthy company and a company which is on the
verge of failure; bankers would not be able to know whether to lend to that
company or not because they would not be able to judge the
creditworthiness of that company; managers would not be able to rightly
price their products or control the operations of the company, etc. The list of
problems is endless. As we said earlier, without accounting information
business is impossible.

Imagine your telephone company with no system to record who calls whom
and how long they talk. Or your institute not noting down which papers have
you passed and whether you have paid your fees or not. These settings
illustrate a problem with bookkeeping, the least glamorous aspect of
accounting. Bookkeeping can be defined as the preservation of a systematic,
quantitative record of an activity. Without bookkeeping, business is
impossible, as you would not know what is going on in your business.
The bookkeeping data has been used to keep a track of things and activities
that the business is performing. In the last 500 years, bookkeeping data has
also been used to evaluate the performance and health of the business. This
use of bookkeeping data is an evaluation tool may look too obvious but is
most of the time not done or done improperly. Bookkeeping is only a small
part of the whole accounting system.

Accounting system can be defined as a information system which helps

analyse the transactions that the business is entering into, handle routine
bookkeeping tasks and structure information so that it can be used to
evaluate the performance and health of the business.

We defined accounting as a system for providing quantitative information,

primarily financial in nature, about economic entities that is intended to be
useful in making economic decisions. The four key components of this
definition are substantiated below:

1. Quantitative: Accounting relates to numbers. This means that only the

events that can be captured in numbers are the ones registered by the
accounting system. This is the strength because numbers can be easily
tabulated and summarised. It can also be a weakness because one or
two numbers cannot capture many important business events. For
example, the factory burning down or the death of a key visionary of
the company cannot be measured in quantitative figures.

2. Financial: The performance and the health of the business is affected by

and reflected in many dimensions. Financial, personal, social impact,
public image etc. Accounting focuses on only the financial dimension.

3. Useful: Accounting rules have a theoretical conceptual framework, which

has been developed over a long period of time. The conceptual clarity
makes accounting a very useful business tool as it is widely understood
and used.
4. Decisions: Accounting is the structured reporting of what has already
happened in the past, and provides the basis for taking decisions about
the future.

Often called the “Language of Business” accounting provides the means of

recording and communicating the successes and failures of business
organisations. Still you should always remember that accounting can only
record and report the financial effects of business activities and not other
qualitative information.

Accounting Information Flow in Business

All business enterprises have some common activities. As shown in figure

1.1, one common activity is the raising of financial resources. These
resources, often referred to as “capital,” can be raised from three sources: 1)
Investors (Owners/ shareholders), 2) Lenders (Creditors) and 3) The business
itself by retaining the earnings that it generates.
 Figure 1.1: Common Activities of Business Organisations

Once resources are raised, they are used to buy land, buildings, plant and
machinery; to purchase raw material and supplies; to pay employees; and to
meet other operating expenses involved in the production and marketing of
goods or services. When the product or service is sold to the customer,
additional monetary resources (revenue or sales) are generated. These
resources are used to pay loans & interest, to pay taxes, to buy new
material, equipment and other items needed to continue the operations of
the business. In addition, some of the resources may be distributed to
owners as a return on their investment.
Accountants measure and report (communicate) the results of these
activities. To measure these results as accurately as possible, accountants
follow a fairly standard set of procedures, usually referred to as the
accounting cycle. The accounting cycle includes various steps, involving
analysing, recording, classifying, summarising and reporting the transactions
of a business. These steps are explained in detail in the next chapter.

Legal forms of Business Organisations

Three forms of business organisations are the most prevalent ones in India
(and in the world). The first is sole proprietorship, the second is partnership
and the third is company. There are other forms of organisations also like
Trusts, Government, etc. but these are not normally used for conducting
businesses so we will not discuss them. Each of the three forms mentioned
above has advantages & disadvantages associated with
them so let us try to understand which organisational form suits the
businesses most.

Sole Proprietorship
Sole proprietorship is the most predominant form of business organisation
the world over. In this form, the owner maintains the title to the assets and is
personally liable for all the liabilities of the business. Liabilities can be
defined as creditors’ claims on an organisation’s assets. Therefore, the
proprietor is entitled to all the profits from the business and is also required
to absorb the losses that the business generates.

Partnership
Partnership and the sole proprietorship differ in only one aspect that the
partnership has more than one owner. So the various owners (called
partners) form an agreement which states the relationship between them as
far as the business is concerned. It allows them to state the level of
investments each one of them is making as also the share of profits/ losses
each one of them will get. There could also be sleeping partners (partners
who make investments in the partnership but do not take active participation
in running the business). As in sole proprietorship, the organisational
requirements and legal requirements are minimal and so are the
government regulations. Sharing of resources means that bigger
investments can be made in the project then possible under proprietorships.
But the major disadvantage is the same as the proprietorship that all the
partners have unlimited liability and the partnership is dissolved when any
one of the partners dies or withdraws from the partnership.

Company
Company can be defined as an impersonal legal entity having the power to
purchase, sell and own assets and to incur liabilities while existing separately
from its owners. The ownership to the company is by holding the shares in
the company and the ownership is to the extent of proportion of shares held
in the company. Company is the entity, which functions legally separate from
its owners. It can be sued and sue, sale, purchase and own property and its
employees are subject to criminal punishment for the crimes conducted by
the company. Despite the legal separation, the owners control and direct the
company and its policies. The owner shareholders select the Board of
Directors who in turn select individuals to serve as managers and monitor
their activities.

As the shares representing the ownership are transferable in nature, the

ownership can change hands by simply transferring the shares from one
shareholder to someone who wants to become one. Due to this, the liability
of the owner shareholder is limited to the investment he has made in the
company thereby preventing the lenders to take over the personal assets of
the owners in case of unresolved settlement of claims.

So, seeing the advantages of a company, you would feel that the company is
the best form of doing a business. This is particularly true if you are running
a big business and want to raise money from others. But there are certain
disadvantages associated with the company also. The legal requirements are
much higher than in the case of either sole proprietorship or the partnership.
Also the Government controls and monitors companies much more than it
monitors the other two organisational forms. The impracticalities of having a
large number of partners and unlimited liabilities (both in proprietorship and
partnerships) makes it unsuitable to have any other form than company form
for businesses that are big and growing. Therefore, when we will use any of
the decision models, we will focus more on the company form. Still any of
these decision models would apply also to other organisation forms, as the
basic principles would remain the same.

Fundamental Principles of Finance

There are ten fundamental principles of finance (as there are Ten
Commandments) which everyone needs to be aware of.

1. Risk Return Tradeoff

You won’t take additional risk unless you expect to be compensated with
additional return.
Risk can be defined as the level of uncertainty about the return to be earned.
Almost all-financial decisions involve some sort of risk-return trade off. When
you put your money in a bank you expect a low return because you know
that your money is safe and you can withdraw it whenever you need it. When
you are investing in a lottery you know that your chances of getting a return
are very low so you expect a bigger return as compared to your investment.
The return that you desire from your investment depends on three
parameters:

1) You are foregoing consumption today to be better off in the future so

you would like to be compensated for foregoing your consumption
option,
2) As the value of the money goes down with inflation, you would like to
be compensated for inflation also, and
3) You would like to be compensated for the risk that accompanies that
investment that you are going to make.

If you were getting the same return on your investment from a private
company and the government, you would like to invest your money with the
government because you consider it to be safer than the private company.
Therefore the private company has to give you higher return to induce you
to invest money with it. In other words, the private company has to
compensate you for the additional risk that you would be taking up when you
are investing money with it by offering you higher return. As the level of risk
goes up, so also the expected return as depicted in the figure 1.3.

Figure 1.3: The Risk-Return Relationship

This simple relationship makes a great deal of sense and helps us value the
different investment options that are available to us in the right perspective.

2. Time Value of Money

A rupee received today is worth more than a rupee received in the future.

Simply because we can earn some return on the rupee received today, it is
better to receive money earlier rather than later. In your economics
textbooks this return is referred to as opportunity cost of passing the earning
potential of a rupee today. This concept helps us in bringing the cash flows
that we are receiving from our investments in the future to the present. This
makes it easier for us to compare the costs and benefits because both values
are in today’s terms. If the present value of benefits are greater than the
costs, the project is creating wealth otherwise it is destroying it. This concept
also makes it easier for us to compare different projects and choose the one
that offers the best return.

To make rupees of different time periods comparable, we need to assume a

specific opportunity cost of money. This opportunity cost is governed by the
first principle (Risk-Return Trade off). We will learn in Chapter 13 how to do
it.

3. Cash is King
In measuring value we will use cash flows rather than accounting profits
because it is only cash flows that the firm receives and is able to reinvest.

When a company invest its money in a project, it gets certain returns as cash
flows from the project. These cash flows are different from the accounting
profits that are shown in the books of accounts and in financial statements.
But the cash flows are the real funds that can be used and not the
accounting profits. Therefore, only the cash flows that the business is
generating are relevant and not the accounting profits for us to accurately
measure the returns from the project.

4. Incremental Cash Flows

It’s only cash flow changes that counts. In making business decisions we will
only concern ourselves with what happens as a result of that decision.

We have just said in fundamental principal three that we should use cash
flows to measure the benefits from a new project. But we still need to ask
ourselves what the cash flows will be if the project is taken on versus what
they will be if it is not. That is to say, we will only consider incremental cash
flows and not the cash flows, which would have occurred regardless of the
project that we were planning to undertake. Incremental here means, over
and above the cash flows that were possible without it.

5. Curse of Competitive Markets

It’s hard to find exceptionally profitable projects. In competitive markets,

extremely large profits cannot exist for very long because of competition
moving in to exploit those large profits. As a result, profitable projects can
only be found if the market is made less competitive, either through product
differentiation or by achieving a cost advantage.
Extra ordinary returns are only possible if the industry is very new, has only
few specialised players, or there are niches that are exploited. In other
words, you either need to have product differentiation or cost advantage to
be able to derive more profits from the projects then is the industry norm.
Patents, service and quality are three of the most used methods for
differentiating products. Pharmaceutical is the prime example for patents
and their use to generate above average profits. In service industry,
McDonalds stands out for its fast services, cleanliness and consistency of
products, which makes the customers keep coming back. Bose Music
Systems uses superior quality as a differentiating factor to charge higher
price. Similarly, cost advantages due to economies of scale, better
management, or technological factors helps the companies generate above
average profits in a competitive industry. You should remember that if your
normal project is projected to generate above average profits in a
competitive industry it can not last for long and you should always double
check the assumptions that you made when you were making those
projections.

6. Efficient Capital Markets

The markets are quick and the shares are rightly priced.
We had talked about wealth maximisation as the goal of the company (or of
any business organisation). The decisions that maximise shareholder wealth
are those that help increase the market price of the company shares
because the value of these shares is the wealth of the shareholders. In order
to understand how does the shares are valued or priced in the capital
markets, we need to understand the concept of efficient markets.

When we talk about efficient markets, we talk about the speed with which
the information is reflected in the share prices. An efficient market is one
where all the available information is reflected in the share prices with such
a speed that there is no opportunity for any investor to benefit from publicly
available information. As the information arrives in the market, the large
number of investors present in the market react to the new information and
buy & sell the shares of that company till they feel that the market price
correctly reflects the new information. If this adjustment process is not
biased, the market is said to be efficient.
There are two implications of efficient markets.
1. The share price in the market accurately reflects the value of the
company and
2. Artificial manipulation of earnings through accounting changes will not
result in price changes.

7. Agency Problem
Managers won’t work for the owners unless it’s in their best interest. The
agency problem is a result of the separation between the decision-makers
and the owners of the firm. As a result managers may make decisions that
are not in line with the goal of maximisation of shareholder wealth.

Agency problem is the result of separation of the owner shareholder and the
managers of the company. Most of the time professional managers, who
have little or no ownership in the company, run them. This is especially true
for large companies. As the managers would like to maximise their own
wealth, they would like to benefit themselves in terms of salaries and other
benefits & perks which may not be justified for the work they are doing and
is at the expense of the owners of the company. You would say that the
owners could fire the managers if they are not performing a good job and act
in their best interest. It’s not that easy and if it was possible that way the
agency problem would not exist at all. Precisely for this reason, shareholders
spend lot of time in monitoring managers through the boards of directors so
as to protect their own interest. Also because of the same reason Employee
Stock Option Plans (ESOPs) were introduced so that the managers also
become the part owners of the company and have an interest in maximising
the wealth of the company.

8. Taxes Bias Business Decisions

Different tax treatments for different types of assets and liabilities make it
mandatory for the company measure the impact of all the decisions on an
after-tax basis.

Taxes play a major role in investment decisions and determining the capital
structure of the company. For example, a company sets up a project in the
backward area because it gets tax incentives, which helps it reduce the cost
and increase the returns. Also, the interest that the company pays on the
debt is deductible from profits before the income tax is paid to the
government. It is crucial to determine the benefit that the shareholders will
get and allows them to save money by structuring the capital structure in
such a way that the profits to them are maximised without increasing the
cost. Whenever we talk about incremental cash flows, we will only concern
ourselves with after tax incremental cash flows to the company as a whole.

9. All Risks are not Equal

All risks are not equal since some risks can be diversified away and some
cannot. The process of diversification can reduce risk, and as a result,
measuring a project or an asset’s risk is very difficult.

When you are investing in a project and you already have an existing
company, the effect this project has is to reduce risk associated with a
company as a whole. This is only possible when both the projects do not offer
good returns and bad returns at the same time. The more unrelated the
returns are from the two projects the more their diversification would help
you in reducing the risk associated with a company as a whole. Still, some of
the risks associated with a company cannot be diversified away and have to
be borne by the company. When the company has invested in two or more
unrelated projects it becomes very difficult to measure the precise risk
associated with that project making it difficult for you to value the company.
Care must be taken to not to take the average risk associated with the
company as a whole as a measure of the risk associated with individual
projects or assets belonging to that company.

10. Ethical Behavior

Ethical behaviour is doing the right thing, and ethical dilemmas are
everywhere in finance. Ethical behaviour is important in financial
management, just as it is important in everything we do. Unfortunately,
precisely how we define what is and what is not ethical behaviour is
sometimes difficult. Nevertheless, we should not give up the quest.

Ethical behaviour means doing the right thing. How would you define the
right thing? The basic problem is that all of us have our own individual set of
values which forms the basis for our personal judgements about what we
think is the right thing to do. You understand that we live in a society and
society has a set of rules or laws that describe what it believes to be the
right thing. The manager is an employee of the shareholders and it is his
duty to do as the shareholder wishes him to do. Now the question that comes
in if the shareholder wants him to do something wrong, does manager has a
right to stop the shareholder from getting the wrong thing done. He may not
be in a position to do so.

Then, there is a question of social responsibility, which means that a

company has responsibilities to society beyond the goal of maximisation of
shareholder’s wealth. There are several opinions for either side of the
argument that the company has social responsibilities or not. The only
critical factor is that the shareholders need to decide whether their company
should take care of social obligations or not. Still the role of the manager in
achieving these objectives cannot be undermined.