Business and Accounting Basics

Forms of Business Organization

Sole Proprietorship
In sole proprietorship, a single individual carries on a business. He keeps all the profits the business earns.
The sole proprietor’s liability is unlimited, i.e. if the business doesn’t do well, he is personally liable for
paying off the debts. The proprietorship form is usually appropriate when the business is small or very
small and is not expected to grow much. There is no specific law to regulate proprietorships.

Partnership
A partnership has a minimum of two and a maximum of 100 persons trading together as one firm. There
is no upper limit for professional practices. The partners share the firm’s profits and losses equally, unless
they agree otherwise. Each partner has unlimited liability for all the debts and obligations of the firm and
is further responsible for the liabilities in the firm of his fellow partner or partners. This is because
partnership is a mutual agency, i.e. every partner is an agent of the other partners. The Indian Partnership
Act regulates partnership businesses. The regulation is minimal; even registration with the government is
not a must. The partnership agreement can be oral or written.

Company
A company is a legal entity unlike a sole proprietorship or partnership. Under the law, it has most of the
rights of a natural person. For example, a company can buy, sell, lend and borrow. The Companies Act
2013 governs the functioning of companies. Companies must, among other things, prepare audited
financial statements. A one-person company has a single shareholder with limited liability. A private limited
company must have a minimum of two shareholders and can have up to 200 shareholders. Private
companies’ shares are not available to the public. They have “Private Limited” as part of their names (e.g.
FANUC India Private Limited). A public limited company must have a minimum of seven shareholders;
there is no maximum. Public companies’ shares are available to the public. In addition, they may be listed
for trading on a stock exchange. Public companies have “Limited” as part of their names (e.g. Hindustan
Unilever Limited). The shareholders of a company undertake to contribute an agreed amount to the
company’s capital. This limits the liability of the members to pay the company’s debts. Even if the company
can’t meet its debts, it can’t ask for an amount above the agreed amount. Since a company’s shareholders
are usually strangers, they wouldn’t like to assume unlimited liability for the other shareholders. Limited
liability is now so common that business would be unthinkable without it. The law requires the shareholders
to contribute the amount agreed to by them. If the company’s assets fall short of its liabilities, the
shareholders have no legal obligation to make good the deficiency.

Forming a company is more complicated than forming a proprietorship or partnership business. The
founders (known as ‘promoters’ in India) of a proposed company must register it with the Registrar of
Companies in the state in which the company’s registered office is to be located. They must submit the
memorandum of association which should include the name of the company, its objects, a statement of the
limited liability of its members, the amount of share capital, and how the share capital is divided into shares.
The company must also submit the articles of association which cover internal matters, such as meetings,
voting, and issue of new shares. Once the legal formalities for formation of a company have been complied
with, the Registrar issues a certificate of incorporation , bringing the company into existence as a separate
legal entity.

The corporate organization structure consists of the shareholders, board of directors, and corporate
officers. The shareholders appoint the board of directors to manage the company. Corporate officers assist
the board of directors in carrying out its responsibilities to the shareholders.

At the apex of the corporate organization are its shareholders who are the owners of a company. The capital
of a company is divided into units of ownership called shares. The shares of a public company are freely
transferable from one person to another. Individual shareholders generally own small numbers of shares,
while institutional shareholders, such as banks, insurance companies, and mutual funds, may hold a
substantial portion of the share capital. The shareholders appoint the company’s directors and determine
their remuneration. They delegate the authority to manage the company to the board of directors. The
shareholders appoint an individual auditor or an audit firm as the external auditor.

Types of Companies – Statutory, Chartered, OPC, Government, Private, Public, Listed, Unlisted etc

Important terms discussed – Shares, Securities Premium, Directors vs Shareholders, Primary markets,
Secondary markets, types of investors (angels, VCs, PE etc), Corporate Governance

Limited Liability Partnership

A limited liability partnership (LLP) , created by the Limited Liability Partnership Act 2008, is a hybrid
between a company and a partnership. It is a separate legal entity with perpetual existence, similar to a
company. Only individuals can be partners in a partnership, but an LLP can have individuals or corporate
bodies as partners. An LLP must have at least two partners; there is no upper limit. Every partner of an
LLP is an agent of the LLP, but is generally not bound by anything done by the other partners. An LLP
may designate one or more partners as managing or executive partner for compliance with legal
requirements. The LLP form is especially suitable for professional services firms.
Accounting

Accounting is often called the language of business. The function of a language is to facilitate
communication among individuals in a society. Accounting is the common language used to communicate
financial information in the world of business. Accounting is a principal means of communicating financial
information to owners, lenders, managers, and many others who have an interest in an enterprise. It is not
an end in itself. Accounting is an information development and communication function that supports
economic decision-making.

MEANING OF ACCOUNTING

transactions and
Accounting is an art of events
Recording
and interpreting
Classifying and which are of
results thereof
Summarising,
in terms of money financial
character

PROCEDURAL ASPECTS OF ACCOUNTING

• Generating the financial information
• Using the financial information
 •Investors
•Employees
•Recording •Lenders
Generating •Classifying Using the •Suppliers/Cr
the •Summarising
financial editors
financial •Analysing •Customers
information •Interpreting information •Govt and
•Communicating other
agencies
•Public

Accounting information is useful in making a number of decisions that affect the income or wealth of
individuals and organizations. Accounting reports, or general purpose financial reports , are designed to
meet the common information needs of most decision-makers. The information given in a language can
be useful only to persons who understand that language. For example, if a restaurant’s menu is in Italian, a
customer should know enough Italian to be able to make sense of the items and their ingredients. In the
same way, decision-makers should understand the language of accounting and its intricacies. Accounting is
an indispensable part of their life.

ACCOUNTING CYCLE
Accounting cycle is a complete sequence beginning with the recording of transactions and
ending with preparation of final accounts i.e., finding out net profit and financial position of
a business organization

• Journalizing
• Posting in Ledger
• Balancing of ledgers
• Trial Balance
• Income Statement
• Balance Sheet
OBJECTIVES OF ACCOUNTING

Objectives of
accounting

Systematic Ascertainment Communicating

Ascertainment
recording of of financial information to
of results
transactions position various users

Book Keeping; Manufacturing,

Financial
Journal; Ledger Trading and Balance Sheet
Reports
and TB P&L Account

FUNCTIONS OF ACCOUNTING
o Measurement
o Forecasting
o Decision-making
o Comparison & Evaluation
o Control
o Government Regulation and Taxation

DISTINCTION BETWEEN BOOK KEEPING AND ACCOUNTING

S. No Book-keeping Accounting
1. Process concerned with recording of Process concerned with recording and
transactions summarizing of transactions
2. Forms a base for accounting Considered as a language of the
business
3. Financial statements are not a part of Financial statements prepared on the
this process basis of book keeping records
4. Managerial decisions cannot be taken Management takes decisions on the
basis of these records
5. There is no sub field of book keeping Has several sub fields
6. Financial position and results not Financial position and results
ascertained ascertained

SUB FIELDS OR BRANCHES OF ACCOUNTING

o Financial Accounting
o Management Accounting
o Cost Accounting
o Social Responsibility Accounting
o Human Resource Accounting

ADVANTAGES OF ACCOUNTING
• Facilitates
Ø to comply with legal requirements
Ø to ascertain net result of operations
Ø to ascertain financial position
Ø the users to take decisions
Ø a comparative study
Ø control over assets
Ø settlement of tax liability
Ø the ascertainment of the value of business
Ø raising loan
• Acts as a legal evidence

LIMITATIONS OF ACCOUNTING
• Ignores qualitative elements
• Not free from bias
• Use of estimates
• Historical costs – Ignores price level changes
• Window dressing

Entity – An entity means an economic unit which performs business or economic activity

Transaction
A business transaction is an exchange where each participant receives or sacrifices value
It involves exchange of goods and services on cash or credit
Activities involving transfer of money or money’s worth

Events are end results of transactions

Conceptual Framework

The Framework deals with:

(a) the objective of financial statements;
(b) the qualitative characteristics that determine the usefulness of information in financial statements;
(c) the definition, recognition and measurement of the elements from which financial statements are
constructed; and

Contents of Framework
Users and their information needs
The objective of financial statements
Underlying assumptions
Qualitative Characteristics of Financial Statements
Elements of Financial Statements

Objective of Financial Statements

The objective of financial statements is to provide information about the financial position, performance
and cash flows of an entity that is useful to a wide range of users in making economic decisions.

Underlying Assumptions
Accrual
Going Concern

Elements of Financial Statements

Asset
An asset is a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.

Liability
A liability is a present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits.

Equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Income
Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating
to contributions from equity participants.

Expenses
Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating
to distributions to equity participants.
Accounting Concepts

Accounting concepts are the fundamental assumptions based on which financial statements
of a business entity are prepared.

The following are the important accounting concepts:

Basic
Income Assets
Accounting
Measurement Valuation
procedures
Seperate Entity
Periodicity Going Concern
Dual Aspect
Matching Cost Concept
Money Measurement

Full Disclosure
Accrual Realisation Concept
Materiality
Prudence /
Substance over form
Consistency Conservatism

• Accounting entity
ü Business and Owner of the business are treated separately
ü Accounting is done for the business and not for the owner
ü It is done from business point of view and not from the owners point of view
ü Applicable to all forms of business organisations
ü This is the reason why capital is considered along with the liabilities

• Dual Aspect
ü Double entry concept
ü Every debit should have a corresponding credit and vice versa

• Money Measurement
ü Accounting is concerned about and records only those transactions which can be
valued in terms of money

• Full disclosure
ü Financial statements must disclose all the relevant and reliable information which may
be useful to its users
ü Disclosure should be full, fair and adequate

• Materiality
 ü Exception to the full disclosure principle
ü Any insignificant item which will not be relevant to the users’ need, need not be
disclosed

• Consistency
ü Accounting policies should be followed consistently from year to year

• Periodicity
ü Also called time period concept or periodicity concept
ü Financial statements are prepared for a particular period called accounting period
ü Financial position as well as performance is found out as on and for that period

• Matching
ü Expenses incurred in an accounting period should be matched with revenues
recognized in that period. (eg – revenue and COGS)

• Accrual
ü Basis of accounting – Cash and Accrual basis
ü Also called mercantile system – Under this, income and expenses are recorded in the
period in which they accrue, whether paid or not, received or not

• Prudence
ü Do not anticipate income but provide for all losses
ü Accordingly, expected future losses are provided and accounted for but future gains
or profits are not

• Going Concern
ü Assumption of continuity
ü An enterprise is viewed as going concern, continuing its operations for the foreseeable
future
ü Enterprise has no intention of liquidation or scaling down its operations

• Cost Concept
ü All assets are recorded at historical or acquisition cost

• Realisation Concept
ü Any change in the value of the asset is to be recorded only when the business realizes
it.
Accounting Principles

Accounting, the language of business, facilitates communication of financial information. Like any
language, accounting has rules. These include assumptions, principles, standards and conventions.

The conventions, assumptions, concepts and rules which define accepted accounting practice constitute
generally accepted accounting principles (GAAP). GAAP represents the fundamental positions that
have been generally agreed upon, often tacitly and ambiguously, by accountants and encompasses
contemporary permissible accounting practice. GAAP assures us of the reliability and comparability of
accounting information.

The following conventions or assumptions underlie accounting measurement in GAAP:

• Reporting entity,
• Going concern,
• Periodicity and
• Money measurement

Accounting Standards (AS)

Accounting standard is a selected set of accounting policies or broad guidelines regarding the principles
and methods to be chosen during the course of accounting and financial reporting.

They are written policy documents issued by expert accounting body or by government or other regulatory
body covering the aspects of recognition, treatment, measurement, presentation and disclosure of
accounting transactions and events in the financial statements.

Accounting standards in India are issued by Accounting Standards Board (ASB) of ICAI.

Objective of AS
To harmonize the diverse accounting policies and practices

Advantages of AS
ü Reduction in variations in accounting policies applied by different enterprises
ü Facilitates inter firm comparison

Limitations of AS
Ø Restrictions in choice of alternative treatment
Ø Rigidity
Ø Cannot override any statute

Accounting Policies
Accounting policies refer to specific accounting principles and methods of applying those principles
followed by an enterprise in the preparation of financial statements.

Ø Accounting principles, and

Ø Methods of applying those principles

Such principles and concepts are discussed earlier.

There is no single list of accounting policies which are applicable to all entities in all circumstances.

Examples of different accounting policies include:

Ø Method of depreciation, depletion and amortization
 Ø Valuation of inventories
Ø Treatment of goodwill
Ø Valuation of investments
Ø Valuation of fixed assets

Selection of Accounting policies

Accounting policies are to be selected based on
ü Prudence
ü Substance over form
ü Materiality

Change in Accounting policy

A change in accounting policy should be followed only in the following circumstances:
ü Required to comply with a statute or an accounting standard
ü Change would result in more appropriate presentation of financial statements

INSTITUTIONS THAT REGULATE ACCOUNTING

MCA

SEBI IASB

NFRA IFAC
Indian
Accounting

Reserve
ICAI Bank of
India

IT Dept C&AG

• The Ministry of Corporate Affairs (MCA) , Government of India administers the Companies
Act 2013. The Act lays down the form and content of financial reports of companies. The MCA
articulates the government’s view on financial reporting and accounting requirements.
• The government prescribes accounting and auditing standards in consultation with the National
Financial Reporting Authority (NFRA) . The fifteen-member NFRA recommends accounting
and auditing standards and enforces compliance.
• The Securities and Exchange Board of India (SEBI) regulates companies listed in stock
exchanges in India. It prescribes the type and amount of information provided in company
prospectuses for issue of securities. SEBI introduced cash flow statements, quarterly financial
results, and consolidated financial statements.
 • The Institute of Chartered Accountants of India (ICAI) , constituted under the Chartered
Accountants Act 1949, regulates chartered accountants (CAs). Its recommendations on accounting
and auditing have a significant persuasive influence on practice.
• The Ministry of Finance , Government of India administers the tax laws through the CBDT and
the CBEC. Tax rules and accounting principles have different objectives but they have
similarities. Tax treatment is an important influence on accounting.
• The Reserve Bank of India (RBI) regulates the functioning of banks and finance
companies. The RBI specifies accounting and reporting requirements for them. Lately,
the RBI has been requiring banks to increase provisions for bad loans.
• The Insurance Regulatory and Development Authority of India (IRDAI) regulates the
functioning of the insurance business in India and lays down accounting and disclosure rules for
insurance companies.
• The Comptroller and Auditor-General of India (CAG) audits the accounts of the Government
of India, State governments, government organizations and public sector enterprises and reports
to Parliament. The CAG appoints the auditors of government companies.
• The International Accounting Standards Board (IASB) develops a single set of accounting
standards for businesses around the world. The IASB issues International Financial Reporting
Standards (IFRS) and International Accounting Standards (IAS) , commonly known as IFRS. The
IASB works with national regulators to achieve worldwide convergence. The International
Federation of Accountants (IFAC) works in areas such as education, ethics, and auditing. The
International Organization of Securities Commissions (IOSCO) is an association of national
securities regulators. IOSCO is influential in improving accounting regulation in securities markets
around the world.

AS, Ind AS and IFRS

AS – Old Accounting Standards followed in India

Ind AS – New accounting standards, closer to IFRS (Converged)
IFRS (International Financial Reporting Standards) – Global GAAP issued by IASB

Ind AS and IFRS

The MCA’s notifications on Ind AS contains some “carve-outs” from international standards.
“Convergence” enables the Indian authorities to carve out exceptions to IFRS when they are applied in
India. In contrast, “adoption” would require accepting IFRS without changes. The government intends to
follow IFRS with modifications. As a result, financial statements prepared in accordance with Ind AS will
not be IFRS-compliant . This would lead to some problems in comparing them with IFRS financial
statements.
Convergence with IFRS is likely to bring about major changes in Indian financial reporting. IFRS follows
the fair value measurement basis, whereas Indian standards largely follow historical cost. Indian companies
may face significant problems in their transition to IFRS because of the absence of active markets for some
assets in India. Also, companies must improve their documentation of management decisions and
judgments on financial reporting. In this book you will learn about Ind AS and IFRS.

Other concept discussed – Convergence vs Adoption of IFRS

Accounting Equation

The accounting equation shows the relationship between the economic resources of a business and the
claims against those resources. At all times, the following relationship holds:

Economic resources = Claims

Economic resources are assets.

The claims consist of creditors’ claims, or liabilities , and owners’ claims, or equity . (Recall that a business
is separate from its owner for accounting purposes. So the owner too has a claim on the business.)

The accounting equation may now be modified as follows:

Assets = Liabilities + Equity

We can analyze any business transaction, regardless of its size and complexity, in terms of its effect on the
accounting equation. The balance sheet shows the position of assets, liabilities and equity.

Illustrations

20XX
Mar. 1 Suresh begins business with cash, ` 50,000.
2 Takes a loan from Manish, ` 20,000.
3 Buys a computer for cash, ` 58,000.
6 Buys supplies on credit, ` 6,000.
9 Sells software for cash, ` 12,000.
12 Pays for a part of the supplies bought on March 6, ` 2,000.
17 Uses supplies for personal purpose, ` 1,000.
23 Returns defective supplies for immediate refund, ` 1,900.
26 Pays salaries, ` 4,000, and office rent, ` 1,200.
29 Sells software on credit, ` 8,000.
30 Withdraws cash for personal use, ` 3,500.
31 Uses supplies for business purpose, ` 1,400.

Exhibit 2.1 presents the effect of these transactions on the accounting equation. The balances
that change appear in italics.
On January 1, 20XX, Manohar started QualPhoto Company. The following transactions took
place during the first month:

Jan. 1 Manohar invested ` 30,000 cash in the company’s share capital (shares of ` 10 each).
2 Bought supplies of photographic materials on credit, ` 9,000.
5 Bought photographic equipment for cash, ` 12,000.
7 Received fees for photographic services, ` 15,000.
13 Paid creditor for supplies, ` 5,000.
18 Manohar invested further ` 12,000 cash in the company’s share capital.
22 Billed customers for services, ` 19,000.
27 Paid office rent, ` 2,500, and electricity charges, ` 1,200.
30 Paid dividends, ` 4,000.
31 Prepared the monthly payroll to be paid on February 1, ` 11,500.

Required 1. Analyze the effect of these transactions on the accounting equation. 2. Prepare the
balance sheet and statement of profit and loss
Financial Statements

The balance sheet shows the financial position at a point in time.

The statement of profit and loss reports the financial performance for a period.
The statement of changes in equity explains how equity changed as a result of net profit, dividends, return
of capital and other transactions in a period.
The statement of cash flows summarizes the cash inflows and outflows resulting from operating, investing
and financing activities in a period.
Important Terms Discussed

• Components of financial statement

• Assets vs Expense
• Revenue vs Capital expenditure
• Current vs Non Current
• Depreciation
• Matching Concept
• Intangible Assets
• Patents, TM, Copyrights
• Goodwill, brand name
• Recognition of intangible assets
• GAAP
• Forms of business organization
• Companies
• Sole proprietorship
• Partnership
• LLP
• Private Co vs Public Company
• Share capital
• Shares
• Authorized vs Issued
• Primary market vs Secondary market
• MOA, AOA
• Separate entity concept
• Owner vs directors
• Provision vs Reserve
• Securities premium
• Current tax Assets

Source and Reference

NARAYANASWAMY , R.. FINANCIAL ACCOUNTING: A MANAGERIAL PERSPECTIVE (Kindle

Locations 2008-2013). PHI Learning.

Note – Students are required to bear in mind that this Study Notes is to be used in conjunction
with Class notes and Practice Problems (if applicable).