Basic Accounting Principles and Budgeting Fundamentals

CHAPTER 7:
Basic Accounting Principles

and Budgeting Fundamentals
7.1 Introduction to Accounting
7.2 Classification of Accounts
7.3 Accounting Concepts
7.4 Financial Statements
7.5 Budgeting and Budgetary Control
7.1 Introduction to Accounting
Accounting, as an information system is the process of identifying,
measuring and communicating the economic information of an organization
to its users who need the information for decision making. It identifies
transactions and events of a specific entity. A transaction is an exchange or
deal in which each participant receives or sacrifices value (e.g. purchase of
raw material). An event (whether internal or external) is a happening of
consequence to an entity (e.g. use of raw material for production). An entity
means an economic unit that performs economic activities.
American Institute of Certified Public Accountants (AICPA) which defines
accounting as "the art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events, which
are, in part at least, of a financial character and interpreting the results
thereof". There are various terminology used in the accounting which are
being explained as under:
1) Assets: An asset may be defined as anything of use in the future
operations of the enterprise & belonging to the enterprise. E.g., land,
building, machinery, cash etc.
2) Equity: In broader sense, the term equity refers to total claims against the
enterprise. It is further divided into two categories.
i. Owner's Claim – Capital
ii. Outsider's Claim – Liability
Capital: The excess of assets over liabilities of the enterprise. It is the
difference between the total assets & the total liabilities of the enterprise.
Liability: Amount owed by the enterprise to the outsiders i.e. to all others
except the owner. e.g.,: trade creditor, bank overdraft, loan etc.
3) Revenue: It is a monetary value of the products or services sold to the
customers during the period. It results from sales, services & sources like
interest, dividend & commission.
4) Expense/Cost: Expenditure incurred by the enterprise to earn revenue is
termed as expense or cost. The difference between expense & asset is that the
benefit of the former is consumed by the business in the present whereas in
the latter case benefit will be available for future activities of the business.
e.g., Raw material, consumables & salaries etc.
5) Drawings: Money or value of goods belonging to business used by the
owner for his personal use.
6) Owner: The person who invests his money or money's worth & bears
the risk of the business.
7) Debtors: A person from whom amounts are payable for goods sold or
services rendered or in respect of a contractual obligation. It is also known
as debtor, trade debtor, accounts receivable.
8) Creditors: It is an amount to be paid by the enterprise on account of
goods purchased or services rendered or in respect of contractual
obligations. e.g., trade creditor, accounts payable.
7.2 Classification of Accounts
The classification of accounts and rules of debit and credit based on such
classification are given below:
Accounts
Personal Impersonal
Real Nominal
1. Personal Accounts:
Accounts recording transactions relating to individuals or firms or company
are known as personal accounts.
2. Real Accounts:
The accounts recording transactions relating to tangible things (which can be
touched, purchased and sold) such as goods, cash, building, machinery etc.
Whereas the accounts recording transactions relating to intangible things
(which do not have physical shape) such as goodwill, patents and copy rights,
trade marks etc.
3. Nominal Accounts:
The accounts recording transactions relating to the losses, gains, expenses and
incomes.
Branches of Accounting
The changing business scenario over the centuries gave rise to specialized
branches of accounting which could cater to the changing requirements. The
branches of accounting are;
i. Financial accounting – is the accounting system concerned only with the
financial state of affairs and financial results of operations.
ii. Cost accounting – is concerned with the accumulation and assignment of
historical costs to units of product and department, primarily for the
purpose of valuation of stock and measurement of profits.
iii. Management accounting – is the presentation of accounting information in
such a way as to assist management in the creation of policy and the day-
to-day operation of an undertaking. It is an accounting which provides
necessary information to the management for discharging its functions.
7.3 Accounting Concepts
To understand the kinds of decisions and informed judgments that can be
made from the financial statements, it is appropriate to understand some of
the broad concepts and principles of accounting that have become generally
accepted for financial accounting and reporting purposes.
The term ‘concept’ is used to denote accounting postulates, i.e., basic
assumptions or conditions upon the arrangement of which the accounting
super-structure is based.
These concepts and principles can be related to the basic model of the flow of
data from transactions to financial statements illustrated earlier and shown
here:
Accounting entity
Assets = Liabilities + Owners’ equity Going concern

(accounting equation) (continuity)
Procedures for sorting, classifying, and

presenting (bookkeeping).
Transactions Selection of alternative methods of reflecting Financial
the effects of certain transactions statements
(accounting).
- Unit of measurement - Accounting period - Consistency

- Cost principle - Matching revenue and expense - Full disclosure
- Objectivity - Revenue recognized at time of sale - Materiality
- Accrual/Mercantile concept - Conservatism
The basic model of the flow of data from transactions to financial statements
7.4 Financial Statements
Financial statements are the product of the financial accounting process. An
entity's financial statements are the end product of a process that starts with
transactions between the entity and other organizations and individuals.
Transactions are economic interchanges between entities: for example, a
sale ∕ purchase, or a receipt of cash by a borrower and the payment of cash
by a lender. The flow from transactions to financial statements can be
illustrated as follows:
The flow from transactions to financial statements
Procedures for sorting, classifying, and

presenting (bookkeeping).
Financial
Transactions Selection of alternative methods of statements
reflecting the effects of certain transactions
(accounting).
Transactions are summarized in accounts, and accounts are further

summarized in the financial statements. In this sense, transactions can be
seen as the bricks that build the financial statements.
The financial statements of an entity show the following for the reporting
period:
Financial position at the end of the period.
Earnings for the period.
Cash flows during the period.
Investments by and distributions to owners during the period.
The financial statements that satisfy these requirements are, respectively, the:
Balance sheet (or statement of financial position).
Income statement (or statement of earnings).
Statement of cash flows.
Statement of changes in owners' equity (statement of changes in retained
earnings).
7.5 Budgeting and Budgetary Control
Budget is a financial and /or quantitative statement, prepared and approved prior
to a defined period of time of the policy to be pursued during that period for the
purpose of attaining a given objective. It may include income, expenditure and
employment of capital.
Features:
1. Financial and/or quantitative statement.
2. Futuristic – prepared and approved prior to a defined period of time.
3. Goal oriented – for the purpose of attaining a given objective.
4. Components – income, expenditure and employment of capital.
Capital refers to the fixed assets of an organization (like factories, hospitals,
schools, and their major equipment fit into this category such as tangible property,
including durable goods, equipment, buildings, installations, land).
A capital budget is therefore an outline of planed expenditures on fixed assets,
and capital budgeting is the whole process of analyzing projects and deciding
whether they should be included in the capital budget.
Budgets may be classified on the following bases:
1. Time Period: a. Long-term Budget &
b. Short-term Budget
2. Conditions: a. Basic Budget and
b. Current Budget
3. Capacity: a. Fixed Budget and
b. Flexible Budget
4. Coverage: a. Functional Budget and
b. Master/summary budget
A functional budget is one which is related to function of the business.
Functional budgets are prepared for each function and they are subsidiary to the
master budget of the business. The various types of functional budgets to be
prepared will vary according to the size and nature of the business. The various
commonly used functional budgets are:
1. Sales budget
2. Production budget
3. Plant utilization budget
4. Direct material usage budget
5. Direct material purchase budget
6. Direct labor (personnel) budget
7. Factory overhead budget
8. Production cost budget
9. Ending inventory budget
10. Cost of goods sold budget
11. Selling and distribution cost budget
12. Administration expenses budget
13. Research and development cost budget
14. Capital expenditure budget
15. Cash budget
16. Summary/master budget – budgeted income statement and
budgeted balance sheet.
The steps in the capital budgeting process are:
1. Determine the economic life of the project
2. Estimate their Incremental Cash Flows
3. Determine the discount rate
4. Calculate Net Present Value
5. Apply the appropriate criterion to arrive at an initial preference

6. Do Sensitivity and Scenario Analysis
7. Interpret the results of the basic analysis and make a decision
8. If you decide to acquire the use of an asset, evaluate: lease vs buy
9. Check to make sure you can afford your decision by putting it in the
organization's budget
10. Implement and verify your decision
Incremental cash flows will consist of the costs of investment and operating
the new office, costs that it would not have been incurred unless the project
was undertaken. It will also include the revenues derived from the business,
benefits that would not have been realized otherwise.
Annual cash flow, and not accounting profits or costs, are to be used.
Depreciation and the need for working capital are causes of major differences
between profits and cash flow.
Only incremental cash flows are relevant for evaluating investment projects.
And, only those cash flows that would result directly from a decision to accept
a project are considered.
Discount rates are estimates of an organization's cost of capital
Economic concepts for use in discounted cash flow analysis
• Do include: • Do not include:

– Incremental Cash inflows – Accounting profits
and outflows – Sunk costs
– External benefits/costs
– Opportunity costs
Capital Budget Decision Process
Cost of
Criterion
Capital
Initial
Determine NPV
Choice
Discount Rate
Discounted
Start cash-flow
analysis Sensitivity &
Scenario
Analysis
Determine
Relevant
Incremental
Cash Flows Lease or yes Do the
buy
Project?
assessts?
Accounting
Projections
no
(Income End:
Statement) decision
Budgetary Control is defined as the establishment of budgets, relating the
responsibilities of executives to the requirements of a policy, and the
continuous comparison of actual with budgeted results either to secure by
individual actions the objectives of that policy or to provide a base for its
revision.
Features:
a. Objectives: Determining the objectives to be achieved, over the budget
period, and the policy that might be adopted for the achievement of these ends.
b. Activities: Determining the variety of activities that should be undertaken
for achievement of the objectives.
c. Plans: Drawing up a plan or a scheme of operation in respect of each class
of activity, in physical as well as monetary terms for the full budget period and
its parts.
d. Performance Evaluation: Laying out a system of comparison of actual
performance with the relevant budget and determination of causes for the
discrepancies, if any.
e. Control Action: Ensuring that when the plans are not achieved, corrective
action are taken; and when corrective actions are not possible, ensuring that
the plans are revised and objective achieved.
Class Discussion 7:
Compare and contrast 'Accounting' and 'Engineering'
Why 'Financial Statements'?

Basic Accounting Principles and Budgeting Fundamentals

Uploaded by

Copyright:

Available Formats

Basic Accounting Principles and Budgeting Fundamentals

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Basic Accounting Principles and Budgeting Fundamentals

Uploaded by

Copyright:

Available Formats

CHAPTER 7:

Basic Accounting Principles

Assets = Liabilities + Owners’ equity Going concern

Procedures for sorting, classifying, and

- Unit of measurement - Accounting period - Consistency

Procedures for sorting, classifying, and

Transactions are summarized in accounts, and accounts are further

2. Estimate their Incremental Cash Flows

3. Determine the discount rate

4. Calculate Net Present Value

5. Apply the appropriate criterion to arrive at an initial preference

• Do include: • Do not include:

You might also like