Accounting and Economic Decisions

Sharad Bhattacharya

Faculty, AIMK

Purpose of an economic entity

To do business is to create an economic entity with the purpose of
Wealth creation Wealth management, and Wealth distribution

Objective of an enterprise To create the best possible values and share them in the equitable manner among all the stakeholders

Understanding Business Organisations

What do business organisations do?
e.g., Infosys Technologies, BHEL, Zee Telefilms, Amazon.com

Types of business organisations

Merchandising or trading Manufacturing Service

Business organisations are cash machines

Promoter
Implementation of a business idea developed by an entrepreneur requires capital. An entrepreneur usually forms a limited liability company (also called joint stock company) to implement the business plan. Individuals who float the company are called promoters of the company. The term promoter refers to individuals or other entities (e.g. an existing company) which devise a plan and take preliminary steps to form the company.

Limited Liability Company

Limited liability companies in India are governed by the Companies Act, 1956. The liability of the owners (promoters and other shareholders) is limited to their commitment to contribute to the capital of the company.

Limited Liability Company: Juridical Person In the eye of law, a company is a juridical person.
It has an identity separate from investors in the company. It can enter into contracts and can sue and be sued in its own name using the common seal. A common seal is the official stamp or "signature" of an association.

A company acts through its Board of Directors.

Directors are elected by shareholders who provide equity capital.

The most important right of an equity holder is the voting right.

Under the Indian Companies Act, one share has one vote.

Capital
Capital provided to a company belongs to the company.
Use of the capital is decided by the company.

Investors provide capital to a company in exchange of claim on economic resources (assets) of the company.
Capital provided to a company is classified into equity and debt.

Debt Capital
In the case of debt capital (also called loan fund) the company has an obligation to repay the capital and usually to pay a regular return (interest) on capital.
In the case the company defaults in its commitment, investors can take legal recourse to sell the assets and recover their investment, to the extent possible.

The debt holders have no other right on the companys economic resources.

Equity Capital
In the case of equity capital, the company has no obligation to repay the capital or to provide a return on capital.
The Companies Act, 1956 does prohibit return of contributed equity capital.

Net profit belongs to the providers of equity capital.

However, the company has unconditional discretion on the distribution of net profit to equity holders.

An investor in equity capital has the right to transfer her share in the company to another investor without obtaining consent of the company.

Equity Capital (cont.)

In a situation of winding up of a company, first all liabilities (including debt capital) are settled from the sale proceeds of assets and the balance amount is distributed to investors in equity capital. Therefore, it is said that investors in equity have residual claim on assets. Law considers investors in equity as deemed owners.
They exercise their ownership rights through the Board of Directors.

Preference Shares
Preference share-holders have a preferential claim on the assets of the company and on its profit.
They are entitled for a pre-determined dividend if the company earns profit. Their claim is superior to the claim of equity shareholders but subordinate to the claim of creditors. The Companies Act classifies preference shares as equity. Under IFRS, preference shares are classified as debt or equity depending on the terms of the issue. Redeemable preference shares are classified as debt.

Perpetual Succession
Perpetual succession is the continuation of a companys existence despite the death, bankruptcy, insanity, change in membership or an exit from the business of any owner or member, or any transfer of shares.
A company ceases to exist only when it is liquidated through a legal process. Except in rare situations, a company cannot refuse to register the transfer in its record.

Return on investment in the equity capital of a company is the total of dividend and capital appreciation.

Why Accounting?
Accounting forms the basis for measuring the performance of an enterprise The performance determines which stakeholder gets what share of the business Accounting also ensures equitable distribution of wealth generated, based on each persons contribution to the business Few examples: Taxman gets his share of the profits (currently 30% in India), which are determined based on prudent accounting practices Employees are typically rewarded based on their individual performance as well as the performance of the enterprise Minority shareholders get equal treatment compared to majority owners (equal dividend distribution) Debt holders are paid their due for contributing debt capital to the business (interest payment and principal repayment)
Key to understanding accounting principles is to view an enterprise as a separate legal entity, and all stakeholders as those contributing capital, labour or resources.

What is Accounting
Accounting is the language of business Accounting provides information for making decisions Accounting is an information system Accounting and economic decisions Why should managers and other decisionmakers know accounting?

Major Branches of Accounting

Financial Accounting For external users Historical information Standardised format Laws and conventions Summarised Income statement; Balance sheet; Cash flow statement; Accounting policies
Management Accounting For internal users Future-oriented Flexible format Context-specific More detailed Product cost statement; Standard costs; Budgets; Variances; Performance reports

The Accounting Information System

Inputs Processing Outputs
Financial statements and reports

Users
Investors, lenders, managers

Business Accounting transactions principles and events and procedures

Users of Accounting Information

Investors Lenders Security analysts and advisers Managers Employees and trade unions Suppliers and other trade creditors Customers Government and regulatory agencies The public

Use of Information in Financial Statements Users of financial statements use the information to analyse the financial position and performance of the firm over a number of years (say, over the past six years) and to compare the financial position and performance of a firm relative to its peers for a particular year or over a number of years.
Therefore, companies are required to use accounting principles and methods consistently from year to year and also to apply generally accepted accounting principles (GAAP) in the preparation and presentation of financial statements to ensure comparability.

Convergence of Accounting Practices

With the globalisation of capital markets, there are sincere and serious efforts to achieve convergence of accounting practices across the globe. More than 100 countries (including the European Union) have adopted International Financial Reporting Standards (IFRS) which are issued by the International Accounting Standards Board (IASB). India has decided to adopt IFRS from 1 April 2011. USA has prepared a road map to adopt IFRS from the year 2014. IFRS have emerged as the global standard.

Assumptions Underlying Accounting Measurement

Accounting Entity
Business is distinct from owner

Going Concern
Business is a continuing enterprise

Periodicity
Business activities divided into periods

Money Measurement
Money is a stable measurement unit

The accounting process

Economic activities

Accounting links decision makers with economic activities and with the results of their decisions.

Accounting information

Actions (decisions)

Decision makers

Basic Functions of an Accounting System

Interpret and record business transactions.
Payment

Car

Basic Functions of an Accounting System

Interpret and record business transactions.
Classify similar transactions into useful reports.

Summarize and communicate information to decision makers.

The Accounting Cycle

Journalize transactions.

Post entries to the ledger accounts.

Prepare trial balance.

Make end-ofyear adjustments.

Prepare after closing Journalize and post closing trial balance. entries.

Prepare financial statements.

Prepare adjusted trial balance.

The Basic Documents VOUCHER: where transactions are entered first. JOURNAL: where transactions are entered chronologically and denote which accounts will be affected. LEDGER: where transaction of a particular account are written and balanced. TRIAL BALANCE: Lists all accounts. It is the starting point for preparing other reports.

The Role of Accounting Records

Establishes accountability for assets and transactions. Keeps track of routine business activities.

Obtains detailed information about a particular transaction. Evaluates efficiency and performance within company. Maintains evidence of companys business activities.

Accounts
Account
An individual record of increases and decreases in an item that is likely to be of interest or importance

Ledger: set of all accounts Chart of accounts

Examples: Office equipment, Sales, Salaries expense, Purchases, Cash, Machinery, etc
What accounts does State Bank of India need?

The Double Entry System

The T account
Debit is left side of T account Credit is right side of T account

Debits = Credits

Assets
Assets are economic resources that are owned by the business and are expected to provide positive future cash flows.
An asset is recognised in the balance sheet only if its cost or value can be measured reliably. - Although many companies create value by managing intangibles, internally generated intangibles, other than software, are not recognised as assets in the balance sheet.
Examples: Cash, Accounts Receivable, Buildings, Land, Equipment, Patents, Goodwill, Copyrights Prepaid Expenses

Liability
Liabilities are debts that represent negative future cash flows for the enterprise.
Creditors, Accounts Payable, Expenses Payable(outstanding), Loans payable, Warranty obligations, Pensions payable, Income tax payable

Owners Equity
Owners equity represents the owners claim to the assets of the business.

Changes in Owners Equity

Owners Investments Business Earnings Payments to Owners
Business Losses

Examples: Share capital, Share premium, Revenues,

Expenses, Dividends, Retained profit

Double Entry AccountingThe Equality of Debits and Credits

Economic Resources = Claims

Debit balances

A = L + OE =
Credit balances

In the double-entry accounting system, every transaction is recorded by equal rupee amounts of debits and credits.

The Accounting Equation Revisited

The equation, Assets = Liabilities + Equity can be rewritten as Assets = Liabilities + Capital + Revenues Expenses Dividends which can be rewritten as Assets + Expenses + Dividends = Liabilities + Capital + Revenues

Debit and Credit Rules

Effect Assets, Expenses Liabilities, Equity, Revenues

Debit Credit

Credit Debit

EXPANDED BASIC EQUATION AND DEBIT/CREDIT RULES AND EFFECTS

Basic Equation

Assets

= Liabilities +

Stockholders Equity

Expanded Basic Equation

Assets Dr. + Cr. -

= Liabilities +
Dr. Cr. +

Common Shares Dr. Cr. +

Retained Earnings

+ Revenues
Dr. Cr. +

Dr. -

Cr. +

- Dividends - Expenses
Dr. + Cr. Dr. + Cr. -

Accounting Records
The Journal (or Day Book)
Chronological record

Ledger
Classification of transactions Posting T account and standard form

Trial Balance Do Debits = Credits ?

Trial balance is not an accounting record

Can I trust my trial balance?

Expenditure and Expense

Expenditure reduces asset or increases liabilities. If no asset is recognised from the expenditure, the amount of equity in the balance sheet reduces. Expenditure, which is not recognised as an asset, is an expense for the accounting period in which it is incurred. An asset is recognised from expenditure if it is probable that the expenditure will provide benefits in future and if the cost or value of the benefit (asset) can be measured reliably.

Will the benefits from the expenditure flow to

If no , Recognise the expenditure as an expense in the income statement for the current period .

subsequent period(s) ?

If yes , Whether the resulting asset meets the recognition criteria?

If no , Re cognise the expenditure as an expense in the income statement for the current period.

If yes, Recognise the asset in the balance sheet.

QUESTIONS ?

Additionally: Golden rules of Accounting