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Accounting for Financial

Services
Questions Selected By:
Mr.Israr Ahmed
Lecturer (Finance & Economics Deptt.)
University of Sargodha, Lahore

Contact: 0321-6813903

Note: These questions have been selected from different books and question
papers of different exams. We appreciate reader’s comments and advice for
future editions. If the readers find any error in the questions, kindly let us
know at above mentioned e-mail address or contact number.

The Basis of Business Accounting

A Brief Review of Accounting History

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There are many books, journals and web sites devoted to accounting history, so we won't go into
any great detail here about the history of accounting. Nevertheless, it is fairly widely known that
accounting records, or proxies for them, have been found from as long ago as the time of the
Ancient Egyptians: notches on sticks if nothing else!

The most famous accounting event in history, though, was the publication of the work by Father
Luca Pacioli, friend and teacher of Leonardo da Vinci. Pacioli is considered by many, rightly or
wrongly, to be the father of modern accounting. If he's the father of anything, it's probably most
fair to say that he is the father of book keeping.
Still, medieval Europe was a time of great mercantilist expansion and the Venetians are most
notable for developing accounting for stewardship: looking after the capital and accounts of
Merchants and their business interests. This is the start of modern interest in book keeping and
accounting.

With the growth of trade and industry throughout the sixteenth to the nineteenth centuries came
the growth and increase in complexity of business and commerce; and that, in turn, led to the
need to develop book keeping and accounting laws and systems.
Accounting Standards

The accounting profession came to realise that the major changes to business and commerce that
came along with the later third of the twentieth century led to the need to upgrade book keeping,
accounting and accounting reporting requirements.
Consequently, we now have the accounting profession itself, an accounting standard setting body
and the International Accounting Standards Board.

At the same time, the Inland Revenue is a major player and point of influence in the accounting
world as it sets standards of its own as they relate to the taxation of businesses.

Accounting Systems and Software


Modern book keeping and accounting systems range from pencil and paper to complex computer
based systems. Along the way we have pre ruled ledgers and books of account, we have free
form papers that trained book keepers and accountants can simply fill in as they go along.

The latter quarter of the twentieth century saw the development of sophisticated computer based
book keeping and accounting systems that can be used for virtually any business, commercial or
even personal set up: large or small, complex or simple, one currency or more. By way of
providing an indicator of the growth of the computer based accounting system, the Sage
Accounting Software company has grown from sales of around £50 million in the mid 1980s to
sales of £2.5 billion by the end of 2001. why. and information accounting uses who about little a
investigate now specific more be Who Uses Accounting Information and Why?
This section is taken from Foster and firstly lists the major users of accounting information and
then outlines some of the information they need and says a little bit about why they need it.

 Shareholders, investors and security analysts


 Managers
 Employees
 Lenders and other suppliers
 Customers

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 Government/Regulatory agencies

Shareholders, investors and security analysts have at least two focus points:
Investment focus with the emphasis on choosing a portfolio of securities that is consistent with
the preferences of the investor for risk, return, dividend yield, liquidity and so on.
Stewardship focus in which the concern of shareholders is with monitoring the behaviour of
management and attempting to affect its behaviour in a way deemed appropriate.
Managers
Managers look for a variety of information, including information relating to their own incentive
contracts.
Managers also use financial statement information in many of their financing, investment and
operating decisions.
Employees
Employees are interested in financial statement information that helps to inform them about the
continued and profitable operation of their employer.
Particularly pertinent at the moment, following the Enron scandal of November/December 2001,
is the realization that employees look to financial statements to monitor the viability of their
pension plans.

Lenders and Other Suppliers


Many bank loans include bond covenants that can result in the bank restructuring the existing
loan agreement: again, the Enron case is directly relevant here. One effect of incorporating such
covenants into the loan agreement is to create a demand by the bank for successive financial
statements of the business.

Customers
Customers, and here we mean industrial and commercial customers rather than domestic or high
street customers, have an interest in monitoring the financial health of an organisation: a long
time customer says it already has reduced its orders sharply so that it doesn't depend on the
company as the single source for any products is the reaction that Foster records vis a vis a
business in trouble and its customers' reaction to that event.

Government/Regulatory Agencies
Revenue raising: income tax, sales tax, VAT
Government contracting: paying suppliers on a cost plus basis, monitoring government suppliers
and their potential for earning excess profitability
Regulatory intervention: whether a government back loan guarantee to a financial distressed
organization needs support

The Trueblood Report


The American Institute of Certified Public Accountants (AICPA) commissioned the Trueblood
Report in 1973: the Trueblood committee study group was asked to report on the Objectives of
Financial Statements.
Trueblood discussed twelve objectives of financial reporting:

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 Decision Making
 Financial Statement
 Cash Flows
 Earnings
 Management Ability
 Disclosure
 Statement of Financial Position
 Uncompleted Transactions
 Expected Information
 Forecasts
 Governmental
 Social Concerns

Let's look at all twelve in a little bit of detail

1. Decision Making: The basic objective of Financial Statements is to provide information


useful for making economic decisions.

2. Financial Statement: An objective of financial statements is to serve primarily those users


who have limited authority, ability or resources to obtain information and who rely on financial
statements as their principle source of information about enterprises economic activities.

3. Cash Flows: An Objective of Financial statements is to provide users with information useful
to investors and creditors for predicting, comparing and evaluating potential cash flows to them
in terms of the amount, timing and related uncertainty.

4. Earnings: An objective of financial statements is to provide users with information for


predicting, comparing and evaluating enterprise earning power.

5. Management Ability: An objective of Financial Statements is to supply information useful in


judging management's ability to utilize enterprise resources effectively in achieving the primary
enterprise goal.
6. Disclosure: An objective of financial statements is to provide factual interpretive information
about transaction and other events which is useful for predicting, comparing and evaluating
enterprise earning power. Basic underlying assumptions with respect to matters subject to
interpretation evaluation prediction or estimation should be disclosed

7. Statement of Financial Position: An objective is to provide a statement of financial position


useful for useful for predicting, comparing and evaluating enterprise earning power. This
statement should provide information concerning enterprise transactions and other events that are
part of incomplete earning cycles. Current values should also be reported when they differ
significantly from historical costs. Assets and liabilities should be grouped and segregated by
relative uncertainty of amount and timing of prospective realization or liquidation.

8. Uncompleted Transactions: An objective is to provide a statement of periodic earnings


useful for predicting, comparing and evaluating enterprise earning power. The net result of
completed earnings cycles and enterprise activities resulting in recognizable progress toward

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completion of incomplete cycles should be reported. Changes in values reflected in successive
statements in financial position should be reported, but not separately since they differ in terms
of their certainty of realization.

9. Expected Information: Another objective is to provide a statement of financial activities


useful for predicting, comparing and evaluating enterprise earning power. This statement should
report mainly on factual aspects of enterprise transactions having or expected to have significant
cash consequences. This statement should report data that require minimal judgment and
interpretation by the preparer.

10. Forecasts: An objective of financial statements is to provide information useful for the
predictive process. Financial forecast should be provided when they will enhance the reliability
of users’ predictions.

11. Governmental: An objective of financial statements for governmental and not-for-profit


organizations is to provide information useful for evaluating the effectiveness of the management
of resources in achieving the organization goals. Performance measures should be quantified in
terms of identified goals.
12. Social Concerns: An objective of financial statements is to report on those activities of
enterprises that affect society which can be determined and described or measured and which are
important to the role of the enterprise in its social events.

The Conceptual Framework of Accounting


The conceptual framework is a body of interrelated objectives and fundamentals. The objectives
identify the goals and purposes of financial reporting and the fundamentals are the underlying
concepts that help achieve those objectives. Those concepts provide guidance in selecting the
transactions, events and circumstances to be accounted for, how they should be recognized and
measured and how they should be summarized and reported. To date, the FASB has issued seven
Concepts Statements1 (Concepts Statement No. 6, Elements of Financial Statements) covering
the following subjects:
Objectives of financial reporting by business enterprises and nonprofit organizations
Qualitative characteristics of useful accounting information
Elements of financial statements (that is, the definitions of assets, liabilities, revenues and so
forth)
Criteria for recognizing and measuring those elements
Use of cash flow and present value information in accounting measurements.
Source: FASB August 2001

Why is a Framework needed?

Components of and need for a Conceptual Framework


Corporate status captures both the legal entity and the limit of liability principles. were
established by the Victorian laws and case law.

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Advantages/Disadvantages of a Conceptual Framework
A conceptual framework would provide accountants and the users of accounting information
with a standard set of rules, principles and procedures that would work in the way that a recipe
for Yorkshire Pudding works or in the way that a procedure in an engineering workshop works.
For example, the conceptual framework of accounting would provide the following features:
 there would be less of a patchwork quilt feel to accounting information
 issues can be ranked
 there would be scope for less political interference
 we would be able to see the overall picture of accounting and accounting information
 maybe we would be able to satisfy the needs of all user groups?
 there might be a need for multiple conceptual frameworks?
 whilst a conceptual framework might not make accounting standard setting and
implementation easier, it would add a set of guidelines and procedures that would make
those processes more certain
Source: From the web site of the University of Exeter School of Business and Economics

Who Benefits from a Conceptual Framework?


The Accounting Standards setters would be the most direct beneficiary of a conceptual
framework. The framework provides standards setters with both a foundation for setting
standards and concepts to use as tools for resolving accounting and reporting questions.
The framework provides a basic reasoning on which to consider the merits of alternatives.
Although it does not provide all the answers, the framework narrows the range of alternatives to
be considered by eliminating some that are inconsistent with it. It thereby contributes to greater
efficiency in the standard setting process by avoiding the necessity of having to re-debate
fundamental issues such as "what is an asset?" time and time again.
In addition, the framework contributes to greater efficiency in communications, both internal and
external. By providing a common terminology and frame of reference, it greatly facilitates any
debate about specific technical issues. It also greatly facilitates communications between the
standards setters and their constituents.

A framework should also reduce political pressures in making accounting judgments. The
framework is used to guide the development of accounting standards that are intended to
facilitate the provision of evenhanded, or neutral, financial and related information. Neutral
information enables users of that information to make informed investment and credit decisions.
Consequently, neutral information serves the public interest by helping to promote the efficient
allocation of scarce resources in the economy and society.

The framework helps the capital markets and other markets to function more efficiently in the
same way. The use of an agreed upon framework reduces the influence of personal biases on
standard setting decisions. Without the guidance provided by an agreed upon conceptual
framework, standard setting would be quite different, as it necessarily would have to be based on
the personal frameworks of individual members of the Board. As Charles Horngren, former APB
member, former FASAC member and former FAF trustee, once noted,
"As our professional careers unfold, each of us develops a technical conceptual framework.
Some individual frameworks are sharply defined and firmly held; others are vague and weakly
held; still others are vague and firmly held."
He added that:

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"At one time or another, most of us have felt the discomfort of listening to somebody attempting
to buttress a preconceived conclusion by building a convoluted chain of shaky reasoning. Indeed,
perhaps on occasion we have voiced such thinking ourselves … My experience as a member of
the APB taught me many lessons. A major one was that most of us have a natural tendency and
an incredible talent for processing new facts in such a way that our prior conclusions remain
intact."

In an environment in which standard setting is based on the personal conceptual frameworks of


individual standard setters, agreement on specific standard setting issues will only occur when a
sufficient number of those personal frameworks intersect.
However, even those agreements may prove to be transitory because, as the membership of the
body changes over time, the mix of individual conceptual frameworks will change as well. As a
result, that standard setting body may reach significantly different conclusions about similar, or
even identical, issues than it did earlier, resulting in standards not being consistent with one
another and past decisions not being indicative of future ones. Standard setting therefore
becomes more or less ad hoc.
Moreover, without a framework, rational debate cannot occur because positions about the
appropriate accounting treatment for a given transaction can neither be defended nor refuted, the
appropriate treatment is simply "in the eye of the beholder."

The credibility of financial reporting is enhanced when objectives and concepts are used to
provide direction and structure to financial accounting and reporting. The framework helps by
leading to the development of standards that are not only internally consistent but also consistent
with each other. As a result, both preparers and users of financial statements benefit from
financial statements that are based on a body of standards that is more internally consistent and
less ad hoc.
The framework further helps users of financial reporting information to better understand that
information and its limitations. It also provides a frame of reference for understanding the
resulting standards. That frame of reference is useful to preparers who apply those standards and
to auditors who examine the resulting reports, as well as to students who study accounting and
the faculty who teach it.
Source: FASB August 2001, as amended

Is Accounting a Science or an Art?


In simple words, science establishes relationship of cause and effect whereas the art is the
application of knowledge comprising of some accepted theories, principles and rules. Since
accounting does not establish cause and effect relationship it only provides us with the procedure
by which objectives of accounting can be achieved, therefore accounting is an art and not a
science. Accounting is an art of recording financial transactions in a set of books; classifying in
desired categories and summarizing the information for presentation in a suitable manner to the
concerned persons for their benefit.

Scope of Accounting
The need of a system of accounting was felt by man early in the history of trade and commerce.
The art of book-keeping is as old as the art of trading itself. This art of keeping records passed
through many phases since its inception. With the development of commerce, it has attained a

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position of great importance. Indeed, it can be truly said that accounting has become the
foundation on which the whole fabric of modem commerce rests.

Though there is no legal obligation on an ordinary trader to keep the records, every business
house finds it essential and convenient to keep the systematic records so as to know where
exactly it stands. Moreover, it is legally binding on some forms of business, such as joint stock
companies, to prepare periodically, statements in proper forms showing the position of the
business. A proper and satisfactory method of accounting is an essential part of any business
house for the following reasons :
(1) If no records are kept, it will be difficult to find out accurate net profit. Under such
circumstances, tax authorities may overestimate the profits and thus a trader will suffer for not
having kept the business records.
(2) In absence of proper business records, the trader will find it difficult to submit the true
position to the court in case he becomes insolvent.
(3) Keeping of proper records helps the trader in framing future business plans & policies.
(4) It will be difficult to ascertain and fix the price of business to be sold or disposed off, if no
records are kept.
(5) Finally, in spite of the best memory it is beyond the capacity of a trader to remember all the
business dealings with back references.

DEFINITIONS
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Business
Any legal activity undertaken for the purpose of earning profit.

Accounting
Accounting is an art of recording, analyzing, classifying, summarizing and interpreting the
transactions of a business enterprise in a systematic way.

Proprietor
The owner of a business is called proprietor. He invests in the business. He is entitled to receive
profit or to bear loss arising from business.

Capital
Capital is the amount invested by the proprietor to commence and manage the affairs of a
business.

Assets
Assets are the economic resources retained by a business and from which future economic
benefits are expected.

Examples: Land, Building, Plant, Machinery, Cash, Equipment, Stock (inventory), Pre-paid
Expenses, Debtors (Accounts Receivables), Furniture, Fixtures, Office Supplies, Bills
Receivables, Notes Receivables etc.

Liabilities
The present obligations of an enterprise, the settlement of which is expected to result in outflow
of economic resources.

Examples: Creditors (Accounts Payables), Expenses Payables, Incomes Received in Advance,


Bills Payable, Notes Payable etc.

Expense
Decrease in economic benefits during an accounting period is called expense OR Expired Cost is
called expense OR outflow of resources which is of recurring nature is called Expense.

Examples: Salaries, Wages, Interest, Stationery Consumed, Advertisement, Discount Allowed,


Commission, Freight, Depreciation etc.

Revenue
Revenue is the gross inflow of economic benefits during the period arising in the course of
ordinary activities of an enterprise.
For Example Sales.
Purchases Goods which are bought for resale purpose are called Purchases.
Inventory (Stock)
Goods or merchandise on hand, i.e. goods remaining unsold are called Stock. It is our current
asset.

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Business Entity Concept
The Business and its Owner are two separate entities. Always think from the business point of
view.

Difference between Equity & Liability


Equity is the claim of owner against the assets of the business whereas liability is the claim of
third party against assets of the business.

Drawings
Goods or cash taken by the proprietor from business for personal use.

Discount
The rebate or allowance in original price is called discount.

(a) Trade Discount


The discount given by the seller at the spot is called Trade Discount and it is not recorded
in the books of accounts.

(b) Cash Discount


It is the discount given by a creditor to a debtor; it given in case of credit transaction to
collect the amount early. It is recorded in the books of accounts.

Debtor (Accounts Receivable)


The person who owes money to the business.

Creditor (Accounts Payable)


The person to whom something is owed by business.
Journal
Journal is the book of original entry in which all transactions are recorded in a
Chronological order.
Balance Sheet
Balance Sheet is a financial statement which shows the financial position of a given
business entity at a specific date.
Accounting Equation
A fundamental characteristic of every Balance Sheet is that total amount of assets is equal
to the total amount of liabilities & owner’s equity.

Assets = Liabilities + Owner’s Equity

Account (Ledger Account)


A summarized record of transactions relating to a particular item of business activities..

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Example: Cash Account, Debtors Account, Machinery Account etc.

(a) Personal Accounts


These accounts show the transactions with suppliers, customers, bankers, owner etc.

(b) Real Accounts


These are the accounts of assets & properties such as land, building, cash etc.

(c) Nominal accounts


These are the accounts of incomes, expenses, gains and losses such as wages, salaries, interest,
commission, discount account etc.

Double Entry System


Every Transaction has two aspects, i.e. Debit aspect & Credit aspect.

Rules of Debit and Credit


Dr.

+
Assets & Expenses Dr.
-

Cr.

Cr.

+
Incomes, Liabilities & Capital Cr.
-

Dr.

Generally Accepted Accounted Principles (GAAPs)

Generally accepted accounting principles, or GAAP for short, are the accounting rules used to
prepare and standardize the reporting of financial statements, such as balance sheets, income
statements and cash flow statements, for publicly traded companies and many private companies
in the United States. GAAP-based income is measured so that the information provided on
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financial statements is useful to those making economic decisions about a company, such as
potential investors and creditors.

GAAP is implemented through measurement principles and disclosure principles. Measurement


principles recognize and determine the timing and basis of items that enter the accounting cycle
and impact the financial statements, such as the period in which transactions will be recorded.
Disclosure principles determine what specific numbers and other information are essential to be
presented in financial statements. Basically, GAAP is concerned with:
 the measurement of economic activity;
 the time when such measurements are to be made and recorded;
 the disclosures surrounding this activity; and
 the preparation and presentation of summarized economic information in financial
statements.
Why GAAP?
Without GAAP, companies would be free to decide for themselves what financial information to
report and how to report it, making things quite difficult for investors and creditors who have a
stake in that company. Because financial statements prepared under GAAP are intended to reflect
an economic reality, GAAP makes a company's financials comparable and understandable so that
investors, creditors and others can make rational investment, credit and other financial decisions.
In order to be useful and helpful to users, GAAP requires information on financial statements to
be relevant, reliable, comparable and consistent.

Accounting Conventions

Accounting Conventions (or assumptions) are the basic rules of accounting which have become
acceptable procedures over time. They are the basic rules of accounting. 

Accounting standards are laws for members of the professional bodies to follow. Together they
form  a  set  of rules   which  allow   accounting   records  and  reports   to  be prepared   in a  similar
fashion,   regardless   of   the   type   of   business   or   the   form   of   ownership.   The   more   important
conventions are:

The   Business   entity   convention  is   the   basic   principle   that   the   personal   transactions   of   the
owner(s) should be kept separate from those of the business. The business is always viewed as a
separate entity, regardless of whether the firm is a sole trader, a partnership or a company.

The historical cost convention  is a rule which states that all transactions are recorded at their
original value and adjustments are not made for inflation. This means that assets are not valued
at what they could be sold for at the present time. All items stay in the accounting records at their
historical or original price. This method is quite objective, as it relies on document evidence such
as invoices and receipts. 

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There are some exceptions to this rule, for example with land. Unlike most assets which lose
value over time, land normally appreciates in value and may be revalued in some circumstances.

The going concern assumption conceives that a business will continue as a ‘going concern’ for
an indefinite period. By following this rule, accountants can report long­term assets in a balance
sheet. Otherwise they would all have to be written off as costs in their year of purchase. The
going concern rule also allows accountants  to cater for transactions  which overlap over two
consecutive years, as is the case with many credit transactions.

The matching principle endeavours to calculate a profit or loss figure for a accounting period by
matching revenue for that period with the expenses over the same period of time. There are two
basic   methods   of   applying   this   matching   principle.   (1)   Cash   accounting,   where   profit   is
calculated  by matching revenue received with expenses  paid. (2) The accrual method where
profit is determined by matching revenue earned with expenses incurred.

The consistency principle  requires that the accounting methods used are applied consistently
from   one   accounting   period   to   the   next.   By   applying   the   same   accounting   techniques,
comparisons of performance can be made over time.

Verifiability  is the concept that evidence should be available whenever possible to verify or
check the details of financial transactions. Business documents such as invoices, receipts and
cheques are the tools of verifiability.

Conservatism   (prudence).  Accounting,   in   some   cases,   involves   a   degree   of   estimation.   It   is


generally accepted that when trying to predict the future, it is better to err on the safe side. There
is a tendency to allow for all possible losses whilst at the same time only recognize gains if
reasonably certain that they will occur. The concept is summarized by the well known phrase
'anticipate no profit and provide for all possible losses'. Thus, undue optimism can never be part
of the make up of an accountant! The danger is that if an optimistic view of profits is given then
dividends may be paid out of profits that have not been earned.

Materiality.  All   significant   items   must   be   reported   in   accounting   reports.   This   allows   for
immaterial amounts to be omitted. The test of whether items are material is whether or not their
omission   would   influence   financial   decision­making.   For   example,   materiality   leads   to   the

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omission  of cents  in accounting  reports  as  they  have an insignificant  effect  on the  users  of
accounting information.

The Realization concept helps the accountant to determine the point at that he feels that a
transaction is certain enough for the profit to be made on it to be calculated and taken to the
profit and loss account. Realization occurs when a sale is made to a customer. The basic rule is
that revenue is created at the moment a sale is made, and not when the account is later settled by
cheque or by cash. Thus, profit can be taken to the profit and loss account on sales made, even
though the money has not been collected. The sale is deemed to be made when the goods are
delivered, and thus profit cannot be taken to the profit and loss account on orders received and
not yet filled. An exception to this rule would be a long term contract that involves payments on
account before completion of the work.

The money measurement concept states that only those transactions that are true financial
transactions may be accounted for. That is, only those transactions that may be expressed in
money values (whatever the currency) are of interest to the accountant.

The objectivity concept requires an accountant to draw up any account, and further analysis, only
on the basis of objective and factual information. Thus, this concept attempts to ensure that if, for
example, 100 accountants were to draw up a set of accounts for one business, there would be 100
identical accounting statements prepared. Everyone would be obtaining and using only facts. The
problem here is that there are many aspects of accounting ensuring that objectivity cannot be
universally applicable in the preparation of accounts. For example, with fixed assets: the cost of
a van must be known at its purchase: say Rs.30,000. However, how long will this van be in
service? I say five years, my colleague could say 10 years. If I prepare the accounts using the
straight line method of depreciation calculation, I would provide Rs.30,000 ÷ 5 = Rs.6,000 each
year for depreciation; my colleague would charge Rs.30,000 ÷ 10 = Rs.3,000 each year for
depreciation; and both of us could be correct! The problem is that with an issue such as
depreciation we are not always able to be objective.

The Substance over form


To ensure that the financial statements reflects the complete, relevant and accurate picture of the
transactions and events, it is important to appreciate and adhere to this concept called Substance
Over Form
When an entity practice the Substance Over Form, it means that the financial statements reflect
the financial reality of the entity (Substance) rather than the legal form of the transactions and
events(Form) which underlie them. To put it very simply: if it is a goat but it was disguised in a
legal form to look like a dog, Substance Over Form would prevail to reinstate that it is a goat and
not a dog!
To be able to differentiate Substance Over Form, we need to be vigilant, have very good inner
knowledge of the company’s operation and takes a more investigative in-depth approach so as to
seek further evidence or proof. This is because normally these types of events or transactions are

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often quite complex. These events or transactions happen just around the accounting year ended.
(balance sheet date)

MAJOR FINANCIAL STATEMENTS

The basic financial statements of an enterprise include the 1) balance sheet (or statement of
financial position), 2) income statement, 3) cash flow statement, and 4) statement of changes in
owners' equity or stockholders' equity. The balance sheet lists all the assets, liabilities, and
stockholders' equity (for a corporation) of an entity as of a specific date. The balance sheet is
essentially a financial snapshot of the entity. The income statement presents a summary of the
revenues, gains, expenses, losses, and net income or net loss of an entity for a specific period.
This statement is similar to a moving picture of the entity's operations during this period of time.
The cash flow statement summarizes an entity's cash receipts and cash payments relating to its
operating, investing, and financing activities during a particular period. A statement of changes in
owners' equity or stockholders' equity reconciles the beginning of the period equity of an
enterprise with its ending balance.

For an item to be recognized in the financial statements, it should meet several fundamental
recognition criteria: 1) Meet the definition of an element of financial statements; 2) Subject to
reliable standards of measurement; 3) Potentially pertinent in user decisions; 4) Verifiable; and 5)
Representative of the subject's true standing.

Items currently reported in financial statements are measured by different attributes (for example,
historical cost, current cost, current market value, net reliable value, and present value of future
cash flows). While historical cost has traditionally been the major attribute assigned to assets and
liabilities, the Financial Accounting Standards Board expects to continue to use different
attributes.

Notes to financial statements are informative disclosures appended to financial statements. They
provide information concerning such matters as depreciation and inventory methods used, details
of long-term debt, pensions, leases, income taxes, contingent liabilities, method of consolidation,
and other matters. Notes are considered an integral part of the financial statements. Schedules
and parenthetical disclosures are also used to present information not provided elsewhere in the
financial statements.

Each financial statement has a heading, which gives the name of the entity, the name of the
statement, and the date or time covered by the statement. The information provided in financial
statements is primarily financial in nature and expressed in units of money. The information
relates to an individual business enterprise. The information often is the product of
approximations and estimates, rather than exact measurements. The financial statements
typically reflect the financial effects of transactions and events that have already happened (i.e.,
historical).

15
Financial statements presenting financial data for two or more periods are called comparative
statements. Comparative financial statements usually give similar reports for the current period
and for one or more preceding periods. They provide analysts with significant information about
trends and relationships over two or more years. Comparative statements are considerably more
significant than are single-year statements. Comparative statements emphasize the fact that
financial statements for a single accounting period are only one part of the continuous history of
the company.

Interim financial statements are reports for periods of less than a year. The purpose of interim
financial statements is to improve the timeliness of accounting information. Some companies
issue comprehensive financial statements while others issue summary statements. Each interim
period should be viewed primarily as an integral part of an annual period and should generally
continue to use the generally accepted accounting principles (GAAP) that were used in the
preparation of the company's latest annual report. Financial statements are often audited by
independent accountants for the purpose of increasing user confidence in their reliability.

Every financial statement is prepared on the basis of several accounting assumptions: that all
transactions can be expressed or measured in dollars; that the enterprise will continue in business
indefinitely; and that statements will be prepared at regular intervals. These assumptions provide
the foundation for the structure of financial accounting theory and practice, and explain why
financial information is presented in a given manner. Financial statements also must be prepared
in accordance with generally accepted accounting principles, and must include an explanation of
the company's accounting procedures and policies. Pervasive accounting principles include the
recording of assets and liabilities at cost, the recognition of revenue when it is realized and when
a transaction has taken place (generally at the point of sale), and the recognition of expenses
according to the matching principle (costs to revenues). The convention of conservatism requires
that uncertainties and risks related to a company be reflected in its accounting reports. The
convention of materiality requires that anything that would be of interest to an informed investor
should be fully disclosed in the financial statements.

Accounting procedures are those rules and practices that are associated with the operations of an
accounting system and that lead to the development of financial statements. Accounting
procedures include the methods, practices, and techniques used to carry out accounting
objectives and to implement accounting principles. Accounting policies are those accounting
principles followed by a specific entity. Information about the accounting policies adopted by a
reporting enterprise is essential for financial statement users and should be disclosed in the
financial statements. Accounting principles and their method of application in the following
areas are considered particularly important: 1) a selection from existing alternatives; 2) areas that
are peculiar to a particular industry in which the company operates; and 3) unusual and
innovative applications of GAAP. Significant accounting policies are usually disclosed as the
initial note or as a summary preceding the notes to the financial statements.

ELEMENTS OF FINANCIAL STATEMENTS

The Financial Accounting Standards Board (FASB) has defined the following elements of
financial statements of business enterprises: assets, liabilities, equity, revenues, expenses, gains,
losses, investment by owners, distribution to owners, and comprehensive income. According to
FASB, the elements of financial statements are the building blocks with which financial

16
statements are constructed—the broad classes of items that financial statements comprise. These
FASB definitions, articulated in its "Elements of Financial Statements of Business Enterprises,"
are as follows:

 Assets are probable future economic benefits obtained or controlled by a particular entity
as a result of past transactions or events.
 Comprehensive income is the change in equity (net assets) of an entity during a period
from transactions and other events and circumstances from non-owner sources. It
includes all changes in equity during a period except those resulting from investments by
owners and distributions to owners.
 Distributions to owners are decreases in net assets of a particular enterprise resulting
from transferring assets, rendering services, or incurring liabilities to owners.
Distributions to owners decrease ownership interest or equity in an enterprise.
 Equity is the residual interest in the assets of an entity that remains after deducting its
liabilities. In a business entity, equity is the ownership interest.
 Expenses are outflows or other uses of assets or incurring of liabilities during a period
from delivering or producing goods or rendering services, or carrying out other activities
that constitute the entity's ongoing major or central operation.
 Gains are increases in equity (net assets) from peripheral or incidental transactions of an
entity and from all other transactions and other events and circumstances affecting the
entity during a period except those that result from revenues or investments by owner.
 Investments by owners are increases in net assets of a particular enterprise resulting from
transfers to it from other entities of something of value to obtain or increase ownership
interest (or equity) in it.
 Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in
the future as a result of past transactions or events.
 Losses are decreases in equity (net assets) from peripheral or incidental transactions of an
entity and from all other transactions and other events and circumstances affecting the
entity during a period except those that result from expenses or distributions to owners.
 Revenues are inflows or other enhancements of assets of an entity or settlement of its
liabilities (or a combination of both) during a period from delivering or producing goods,
rendering services, or other activities that constitute the entity's ongoing major or central
operations.

Business Activities – Operating, Investing & Financing

Operating Activities: Operating Activities are principal revenue-producing of an enterprise and


other activities that are not investing or financing activities.

Investing Activities: Investing Activities are concerned with the acquisition and disposal of
long-term assets and other investments not included in cash equivalents.

Financing Activities: Financing activities are result in changes in the size and composition of
the equity capital and borrowings of the enterprise.

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Questions of Accounting Equation
Question 1
From the following transactions, prepare Accounting Equation.

1. Mr. A invested Rs.500,000 to commence business.


2. He deposited Rs.50,000 in his bank.
3. He immediately bought Land of Rs.100,000.
4. He purchased furniture of Rs.30,000 and payment was made through cheque.
5. He bought goods worth Rs.150,000 (Rs.100,000 paid in cash and signed a note for the
remainder).
6. Paid Commission Rs.1000 and salary Rs.10,000.
7. Mr. A withdrew Rs. 10,000 for personal use.
8. Repair Charges of Rs.500 were paid for building.
9. Advertisement Charges of Rs.50000 were incurred and paid in cash.
10. Goods costing Rs.50,000 were sold for Rs.70,000.

Question 2
From the following transactions, prepare Accounting Equation.
1. Commenced the business by investing Rs.500,000.
2. Purchased a piece of land for Rs. 300,000.
3. Purchased Machinery for Rs.50,000.
4. Purchased Office Equipment for RS. 50,000, paying Rs. 20,000 in cash and incurring a
liability for Rs. 30,000.
5. Sold a piece of land for Rs. 55,000, collectible within four months.
6. Received Rs.40,000 as a partial collection of the Rs. 55,000 accounts receivables.
7. Paid Rs. 10,000 to accounts payables.

Question 3
From the following data develops the Accounting Equation as on 31st March.

1. Initial investment by owners, Rs.100,000 cash.


2. Acquisition of inventory for Rs.75,000 cash.
3. Acquisition of inventory for Rs.135,000 on open account.

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4. Merchandise carried in inventory at a cost of Rs.100,000 was sold on open account for
Rs.120,000.
5. Cash collections of accounts receivable, Rs.30,000.
6. Cash payments of accounts payable, Rs.8,000.
7. Paid office rent in advance Rs.15,000
8. Received commission in advance Rs.5,000.
9. Deposited Rs.10,000 in bank.
10. Withdrew cash Rs.5,000 and merchandise of Rs.2,000 for personal use.

Accounting Cycle
Journal Entries in Banking Companies Books
1. On receiving deposits from customer’s

Cash Account
Customer Deposit Account

------------------------------------------------------------------

2. On withdrawal by the customer

Deposits account-customer
Cash account
--------------------------------------------------------------

3. On Advancing Money to Borrower’s

Loan or advances
Cash account
----------------------------------------------------------
4. On receiving loan installments

Cash account
Loan or Advances account
--------------------------------------------------------

5. On paying interest on deposits.


Interest expense
Cash / Deposits Account-Customer
--------------------------------------------------------
6. On charging markup or Interest on Loan, Advances

Interest Accrued/Loan and advances


Interest Income
-------------------------------------------------------

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7. On charging fee/commission from customers or Borrowers

Cash/ deposit-Customer/Borrower
Service charges/Commission earned
-------------------------------------------------------
8. On Discounting Customer Bills/Notes

Bills/Note Receivable
Cash Account/Deposits Customer
Discount earned
-------------------------------------------------------

9. On Maturity of Bills/Notes

Cash account
Bills/Note receivable
--------------------------------------------------------
10. On receiving Bills/Notes for Collection

Bills/ Notes/ Cheques Receivable being Bills/Notes for collection Contra


Bills/Notes/Receivable being bills/Notes for collection Entry
--------------------------------------------------------

11. Accepting or endorsing or giving Guarantee

Acceptances, Endorsements, and other Obligations Contra


Liabilities for acceptances, endorsements and guarantees Entry
--------------------------------------------------------
12. Writing off Bad Loan/ non-Performing Loans & outstanding accrued interest

Bad Debts exp.


Loan/Advances
Accrued Interest
----------------------------------------------------

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Question 1
Mr. Amin started business on 1st Jan. 2007. His transactions during Jan. were as follows.
 He invested Rs.7,500 in cash and his own personal Computer of Rs.10,000.
 He purchased goods for cash Rs.2,500.
 He sold goods for cash Rs.3,500.
 He paid Rent Rs.1,000.
 He bought goods on credit from Mr. Zafar Rs.1,000.
 He sold goods on credit to Mr. Akram Rs.2,000
 He paid Salaries Rs.100
 He withdrew Rs.500 from business for personal use.
 He paid Mr. Zafar Rs.500
 He received from Mr. AKram Rs.1,500.
Required:
1. Analyse & classify the above transactions.
2. Prepare Journal Entries
3. Post journal entries to ledger accounts.
4. Prepare a trial Balance
5. Prepare an Income Statement for the month of Jan. 2007.
6. Prepare a Balance Sheet as at Jan. 31st 2007.
Question 2
Ali Imran started business on 1st May 2007.
His transactions for the month of May are as follows:
May 1. He invested Rs.45,000.
2. He purchased goods for cash Rs.5,000 and he also paid transport charges Rs.500.
3. Sold goods for cash Rs.10,000.
7. Paid salaries Rs.500.
9. Paid Rent Rs.1,700.
12. Wages paid Rs.100.
14. He withdrew Rs.500 for personal use.
15. Paid Electricity Rs.300.
17. Bought goods from Akhtar on credit Rs.4,000.
20. Sold goods to Fawad on credit Rs.8,000.
22. Returned goods to Akhtar Rs.200.
24. Received goods from Fawad Rs.100.

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25. Paid Akhtar Rs.3,700 in full settlement.
26. Received from Fawad Rs.7,800 in full settlement.
28. Bought computer from ABC on credit for Rs.80,000.
31. The closing stock is of Rs.200.
Required:
1. Analyze & classify the above transactions.
2. Pass Journal Entries
3. Prepare Ledger Accounts
4. Prepare Trial Balance
5. An Income Statement for the month of May 2007
6. Balance Sheet as at May 31st 2007

Question. 3
Following transactions relate to A’s Enterprises for the month of January:
Jan. 1 Mr. A invested Rs.500,000 to commence business.
2 He immediately bought Land of Rs.100,000.
3 He acquired a building on rent being Rs.12,000 per month.
4 He bought goods worth Rs.150,000, Rs.100,000 paid in cash and signed a note for the
remainder.
10 Some of the goods were found to be defective and were returned of Rs.20,000.
11 Goods of Rs.300,000 were sold on credit.
15 One of the customers of Rs.50,000 made an early payment, a cash discount of 10% was
allowed to him.
16 Cash collected from customers Rs.180,000.
17 Paid Commission Rs.1000 and salary Rs.10,000.
18 Mr. A withdrew Rs. 10,000 for personal use.
30 Repair Charges of Rs.500 were paid for building.
31 Advertisement Charges of Rs.50000 were incurred and paid.
Required:
1. Analyze the above transactions.
2. Prepare General Journal
3. Prepare Ledger Accounts
4. Prepare Trial Balance
5. Prepare Income Statement
6. Prepare balance Sheet

Question. 4
Following are the transactions of Mr. Adnan for the month of January 2007.
1. Mr. Adnan invested Rs.500,000 to commence business.
2. He immediately bought Building of Rs.100,000.
3. He bought goods worth Rs.150,000,
4. Some of the goods were found to be defective and were returned to supplier of Rs.20,000.
5. Goods of Rs.300,000 were sold on credit.
6. One of the customers of Rs.50,000 made an early payment, a cash discount of 5% was
allowed to him.
7. Cash collected from customers Rs.180,000.
8. Paid Commission Rs.1000 and salary Rs.10,000.

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9. Mr. Adnan withdrew Rs. 10,000 for personal use.
10. Repair Charges of Rs.500 were paid for building.
11. Advertisement Charges of Rs.50,000 were incurred and paid.
Additional Information:
Closing Inventory amounted to Rs.30,000.
Required:
1. Prepare General Journal
2. Prepare Ledger Accounts.
3. Prepare Trial Balance.
4. Prepare Income Statement for the month ended January, 2007.
5. Prepare Balance Sheet as on January 31st, 2007.

Question 5
Mr. Ali started his business on January 1st, 2007. Following are the transactions for the month of
January.
Jan. 1 He invested Rs.500,000 cash and brought his personal furniture of Rs.50,000.
Jan. 2 He deposited Rs.350,000 into his bank.
Jan. 5 He paid six months rent in advance of Rs.12,000 in cash.
Jan. 6 He bought goods of Rs.200,000 from G. Traders.
Jan. 8 He sold goods to Usman Rs.250,000.
Jan. 11 Some of the goods purchased from G. Trders were defective and were returned
accordingly of Rs. 5,000.
Jan. 15 Defective goods returned by Usman Rs.7,000.
Jan. 25 Paid Rs.50,000 by cheque to G. Traders for the goods purchased on jan.6, 2007.
Jan. 26 Received Rs. 25,000 from Usman.
Jan. 31 Paid salaries of Rs.5,000 by cheque.
Jan. 31 paid Insurance Expense for the month through cheque of Rs.6,000.
Required:
1. Prepare General Journal.
2. Prepare Ledger Accounts.
3. Prepare Trial Balance.
4. Prepare Income Statement for the month ended January 31st, 2007.
5. Prepare Balance Sheet as on January 31st, 2007.

Question 6

On November 1st, 2007, Karin Started her business. Following are the transactions for the month
of November
1. Karin deposited Rs.400,000 cash in a bank account in the name of business.
2. Purchased land for Rs.170,000 and building for Rs.360,000, paying Rs.130,000 by
cheque and signing a note payable of Rs.400,000.
3. Purchased six trucks of Rs. 72,000 each. A down payment of Rs.200,000 was made by
cheque and a note payable was issued for the balance of purchase price.
4. Purchased goods for Rs.240,000.
5. Goods costing Rs.120,000 were sold for Rs.150,000 to Ahmed. Collected Rs.50,000 in
cash immediately and Balance is to be paid within 30 days.
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6. Paid salaries to employees Rs.20,000.
7. Received a bill of Rs.15,000 for repairs to trucks from Ali Transportation Co.
8. Karin withdrew cash Rs.25,000 and took away goods of Rs.10,000 for personal use.

Required
1. Prepare General Journal
2. Prepare Ledger Accounts.
3. Prepare Trial Balance.
4. Prepare Income Statement for the month ended November 30, 2007.
5. Prepare Balance Sheet as on November 30th, 2007.

Question 7
Dr. Shahid opened a surgical clinic on May 1, 2007. The business transactions for May are
shown below:

May 1 Dr. Shahid invested Rs.1000,000 cash in the business.

May 4 Land and a building were purchased for Rs.500,000. Of this amount,
Rs.140,000 applied to the land, and Rs.360,000 to the building. A cash
payment of Rs.200,000 was made at the time of the purchase, and a
note payable was issued for the remaining balance.

May 9 Surgical Equipments were purchased for Rs.260,000 in cash.

May 16 Office fixtures and equipment were purchased for Rs.100,000. Dr. Shahid paid
Rs.40,000 at the time of purchase and agreed to pay the entire remaining balance in
15 days.

May 21 Office supplies expected to last several months were purchased for Rs.10,000 in cash.

May 24 Dr. Shahid billed clients Rs.50,000 for services rendered. Of this amount,
Rs.19,000 was received in cash, and balance was billed on account (due in 30
days).

May 27 A Rs.1600 invoice was received for several radio advertisements aired
in May. The entire amount is due on June 5.

May 28 Received a Rs.22,000 Payment on the balance of account receivable recorded May 24.

May 31 Paid employees Rs.5,600 for salaries earned in May.

A partial list of account titles used by Dr. Shahid includes:

Cash Notes
Account Receivable Accounts Payable
Office Supplies Capital Stock

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Surgical Equipment Surgical Services Revenue
Office Fixtures and Equipment Advertisement Expense
Land Salary Expense
Building

Instructions:
a) Prepare journal entries for each transaction.
b) Post each transaction to the appropriate ledger account.
c) Prepare a trial balance dated May, 31, 2007.
d) Prepare Income statement fir the month ended May, 31, 2007.
e) Prepare a Balance Sheet as on May, 31, 2007.

25