SYMBIOSIS INSTITUTE OF INTERNATIONAL BUSINESS (SIIB)

is a constituent of SYMBIOSIS INTERNATIONAL (DEEMED UNIVERSITY)

(Estd. Under section 3 of the UGC act, 1956 I Re-accredited by NAAC with ‘A++’ grade I Awarded category – I by UGC)
 Contents

Introduction to Finance and Accounting

Chapter Title Page No

1. Instructions 3

2. Financial System – An Introduction 4

3. Introductory Financial Concepts 26

4. Accounting Concepts – An Introduction 31

 Instructions

Students are required to go through the study material provided.

On the first day of induction, you will be required to compulsorily give a quiz based on the topics
given in the study material.

The marks of the quiz will be part of your grades for the subjects in the first semester.

Kindly go through the material carefully.

 Chapter 2
FINANCIAL SYSTEM – AN INTRODUCTION

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlinked institutions, agents, practices, markets, transactions, claims, and liabilities
in the economy. The financial system is concerned about money, credit and finance - the three
terms are intimately related yet are somewhat different from each other. Indian financial system
consists of a variety of institutions, markets, instruments and financial regulators related in a
systematic manner – provides the principal means by which savings are transformed into investments.
Financial system deals with financial assets.
Financial assets: They represent claims against the future income and wealth of others. Financial
liabilities, the counterparts of financial assets, represent promises to pay some portion of
prospective income and wealth to others. The important financial assets and liabilities in our
economy are money, demand deposit, short-term debt, intermediate-term debt, long-term debt, and
equity stock.
Financial market: A financial market is a market for creation and exchange of financial assets. In
financial market trading of financial assets take place, facilitating transfer of economic resources
from lenders to ultimate borrowers. There are varieties of financial instruments that are created
and traded on these markets. The financial markets can be classified in several ways viz. Primary
market and Secondary market, Capital Market and money market, etc. These two markets are
interdependent and inseparable segments.

Financial Institutions or Financial Intermediaries: These are business firms that produce
specialized financial products like loans, insurance, pensions, etc. They act as mobilisers and
depositors of savings and provide various financial services to the community. There are many
types of financial intermediaries that coexist in any economy. They are broadly classified as
banking intermediaries and non-banking intermediaries. There are also regulatory institutions to
provide policy framework and to supervise/ monitor the operations of the players in the financial
markets.
Payment System
Depository financial intermediaries such as banks are the pivot of the payment system. Credit card
companies play a supplementary role.

Pooling of Funds
• Financial markets and intermediaries facilitate the pooling of the household savings for
financing business. Transfer funds from those who have surplus to those who need funds to
invest
• Transfer funds in such a way as to redistribute the unavoidable risk
• To facilitate the transfer efficiently, we need a sound financial system
Transfer of Resources
The financial system facilitates the efficient life-cycle allocations of household consumption, the efficient
allocation of physical capital to its most productive use, and the efficient separation of ownership from
management.

Risk Management
A well-developed financial system offers a variety of instruments that enable economic agents to pool,
price, and exchange risk. The three basic methods of managing risk are: hedging, diversification, and
insurance.

Price Information for Decentralized Decision Making

Interest rates and security prices are used by households in their consumption-saving-investment
decisions and by firms in their investment and financing decisions
The purpose of financial system in any economy is to gather and allocate funds in the most
efficient manner. This involves flow of funds from surplus to deficit economic units. Financial
Markets in which funds are transferred from people who have an excess of available funds to
people who have a shortage

Financial markets play a very pivotal role in allocating resources in the economy by performing three
important functions as they:

Facilitate Price Discovery

The continual interaction among numerous buyers and sellers who participate in financial markets helps
in establishing the prices of financial assets.

Provide Liquidity

Thanks to the liquidity provided by financial markets, it is possible for companies (and other entities) to
raise long-term funds from investors with short-term horizons

Reduce the Costs of Transacting

Financial markets considerably reduce the following costs of transacting

• Search cost
• Information cost
Financial Markets is a place where buyers and sellers of securities can enter into transactions to
purchase and sell ordinary shares, Government Securities, debentures, preference shares, etc.
Further, it performs an important role of enabling corporates, entrepreneurs to raise resources for their
companies and business ventures through public issues. Transfer of resources from those having
idle resources (investors) to others who have a need for them (corporates) is most efficiently
achieved through the securities market. They provide channel for reallocation of savings to
investments and entrepreneurship. Savings are linked to investments by a variety of intermediaries,
through a range of financial products, called ‘Securities’. One can invest in Shares, Government
Securities, Derivative products, Units of Mutual Funds etc., are some of the securities investors in the
securities market can invest in.

The financial market essentially has three categories of participants, namely, the issuers of securities,
investors in securities and the intermediaries, such as merchant bankers, brokers etc. While the
corporate and government raise resources from the securities market to meet their obligations, it is
households that invest their savings in the securities market.

Participants in the Financial Market: The financial market essentially has three categories of
participants, namely, the issuers of securities, investors in securities and the intermediaries, such as
merchant bankers, brokers etc. While the corporate and government raise resources from the
securities market to meet their obligations, it is households that invest their savings in the
securities market.

The securities market has two interdependent segments: the primary (new issues) market and the
secondary market. The primary market provides the channel for sale of new securities while the
secondary market deals in securities previously issued.

There are different ways of classifying financial markets. The important bases for classification are:
type of financial claims, maturity of claims, new issues versus outstanding issues, timing of delivery,
and nature of organizational structure.

Financial markets can be classified by the type of financial claims. i.e. Debt Markets and Equity
Markets. Debt markets enable corporations and governments to borrow to finance their activities.
Determination of interest rates takes place in this market. It is the financial market for fixed claim and
the equity market is the financial market for residual claims (equity instruments)

Equity Markets is a place where buyers and sellers of securities can enter into transactions to
purchase and sell ordinary shares, preference shares. Further, it performs an important role of
enabling corporates, entrepreneurs to raise resources for their companies and business ventures
through public issues. Transfer of resources from those having idle resources (investors) to others
who have a need for them (corporates) is most efficiently achieved through the securities market.

Debt instrument represents a contract whereby one party lends money to another on pre- determined
terms with regards to rate and periodicity of interest, repayment of principal amount by the borrower
to the lender. In Indian securities markets, the term ‘bond’ is used for debt instruments issued by
the Central and State governments and public sector organizations and the term ‘debenture’ is used for
instruments issued by private corporate sector.

Features of debt instruments: Each debt instrument has three features: Maturity, coupon and
principal.
Maturity: Maturity of a bond refers to the date, on which the bond matures, which is the date on
which the borrower has agreed to repay the principal.

Term-to-Maturity refers to the number of years remaining for the bond to mature. The Term-to-
Maturity changes every day, from date of issue of the bond until its maturity. The term to
maturity of a bond can be calculated on any date, as the distance between such a date and the date
of maturity. It is also called the term or the tenure of the bond.

Coupon: Coupon refers to the periodic interest payments that are made by the borrower (who is also
the issuer of the bond) to the lender (the subscriber of the bond). Coupon rate is the rate at which
interest is paid, and is usually represented as a percentage of the par value of a bond.

Principal: Principal is the amount that has been borrowed, and is also called the par value or face value
of the bond. The coupon is the product of the principal and the coupon rate. The name of the bond
itself conveys the key features of a bond. For example, a GS CG2008 11.40% bond refers to a
Central Government bond maturing in the year 2008 and paying a coupon of 11.40%. Since Central
Government bonds have a face value of Rs.100 and normally pay coupon semi- annually, this bond
will pay Rs. 5.70 as six- monthly coupon, until maturity.

Interest is the amount paid by the borrower (the company) to the lender (the debenture-holder) for
borrowing the amount for a specific period of time. The interest may be paid annual, semi- annually,
quarterly or monthly and is paid usually on the face value (the value printed on the bond
certificate) of the bond.

There are three main segments in the debt markets in India, viz., (1) Government Securities, (2)
Public Sector Units (PSU) bonds, and (3) Corporate securities. The market f r Government
Securities comprises the Centre, State and State-sponsored securities. In the recent past, local

bodies such as municipalities have also begun to tap the debt markets fo funds. Some of the PSU
bonds are tax free, while most bonds including government securities are not tax-free. Corporate
bond markets comprise of commercial paper and bonds. These bonds typically are structured to suit
the requirements of investors and the issuing corporate, and include a variety of tailor- made features
with respect to interest payments and redemption.
Given the large size of the trades, Debt market is predominantly a wholesale market, with
dominant institutional investor participation. The investors in the debt markets are mainly banks,
financial institutions, mutual funds, provident funds, insurance companies and corporates.

Most Bond/Debenture issues are rated by specialized credit rating agencies. Credit rating agencies in
India are CRISIL CARE, ICRA and Fitch. The yield on a bond varies inversely with its credit (safety)
rating. The safer the instrument, the lower is the rate of interest offered.

You may subscribe to issues made by the government/corporates in the primary market.
Alternatively, you may purchase the same from the secondary market through the stock exchanges.

A second way is to classify financial markets by the maturity of claims. A money market is a
financial market for debt securities with maturities of less than one year (short-term). The New York
money market is the world’s largest. The money market facilitates short term financing and assures
the liquidity of short term financial assets. The money market is significant for indicating changes
in short term interest rates, monetary policy and availability of short term credit and is a main place
for central bank activities.

The focus of money market is on providing a means by which the participants, individuals,
institutions and Government are able to rapidly adjust their actual liquidity position. It is a
medium through which holders of temporary cash surpluses meet the requirements of those with
temporary cash deficits. Hence an institution with temporary excess of investible funds is able to invest
in the money market for a short period of time and get return on them. Similarly individuals,
institutions and government with temporary problem of liquidity can raise funds in the money market
for a short period of time. Money market meets the working capital requirements of industry, trade
and commerce.

The money market assures borrowers that they can obtain short term funds quickly and it assures
lenders that they can convert their short term financial assets into cash. Reserve Bank of India, The
Central bank, which is responsible for regulating and controlling the money supply in economy,
conducts most of its operations through money market. The risk of capital losses and risk of default
are minimum in the money market. Capital losses re minimized because the money market
instruments are short term in nature and change in interest rates does not affect their prices very
much as the assured maturity is discounted over a short period of time. The risk of default or credit risk
is low because money market instruments are mostly the liabilities of the government, central bank and
commercial banks.
The money market comprise specialised sub markets and it consists of central bank, commercial
banks, cooperative banks, discount houses, acceptance houses, bill market, bullion market and in some
cases even insurance companies. The central bank occupies a pivotal position in money market. Its
function is not only that of monitoring of the monetary system but also of a promotional and
development banker.
Money Market provides various kinds of instruments that suit the needs of various investors viz. call
money, Repos, Treasury Bills and commercial bills.

Capital markets are the financial markets for long-term debt and corporate stocks. The New York
Stock Exchange, Bombay Stock Exchange (BSE), National Stock exchange (NSE) are the examples
of a capital market. Traditionally cut off between short term and long term has been one year –
though this dividing line is arbitrary but widely accepted. The primary purpose of capital market is
to direct t e flow of savings into long term investments. The demand for long term funds is from
individuals, institutions, government, local authorities and corporate sector and are met through the
issue of shares, debentures and bonds. Apart from raising funds directly from savers, the deficit units
obtain long term funds from financial institutions. On the supply side are individuals (household
sector), institutions, banks and financial institutions.

Capital market plays a vital role in the financial system. Savings and investment are important for
economic development and growth of an economy, which depends upon the rate of long term
investment and capital formation in a country. The capital market plays a vital role in mobilizing the

savings and making them available to the enterprising investors. An active capital market, through
its price mechanism, allocates the scarce financial resources to the most productive uses at a low
cost. Usually the cost of capital is comparatively low for the large and efficient companies as
their securities are subject to lesser risk and their shares command a premium in the market
whereas the companies with poor performance may have to issue securities at a discount to raise
additional funds.
Third way to classify financial markets is based on whether the claims represent new issues or
outstanding issues. Primary markets are the markets in which newly issued securities are sold for the
first time. Secondary markets are where securities are resold after initial issue in the primary market.
Primary Market: The primary market provides the channel for sale of new securities. Primary
market provides opportunity to issuers of securities; Government as well as corporates, to raise
resources to meet their requirements of investment and/or discharge some obligation. They may issue
the securities at face value, or at a discount/premium and these securities may take a variety of forms
such as equity, debt etc. They may issue the securities in domestic market and/or international
market.

Primarily, issues can be classified as a Public, Rights or Preferential issues (also known as
private placements). While public and rights issues involve a detailed procedure, private placements
or preferential issues are relatively simpler. The classification of issues is illustrated below:

Initial Public Offering (IPO) is when an unlisted compa makes either a fresh issue of securities
or an offer for sale of its existing securities or both for the first time to the public. This paves way for
listing and trading of the issuer’s securities.

A follow on public offering (Further Issue) is when an already listed company makes either a fresh
issue of securities to the public or an offer for sale to the public, through an offer document.

Rights Issue is when a listed company which proposes to issue fresh securities to its existing
shareholders as on a record date. The rights are normally offered in a particular ratio to the
number of securities held prior to the issue. This route is best suited for companies who would like

to raise capital without diluting stake of its existing shareholders.

A Preferential issue is an issue of shares or of convertible securities by listed companies to a select

group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a
public issue. This is a faster way for a company to raise equity capital. The issuer company has to
comply with the Companies Act and the requirements contained in preferential allotment in SEBI
guidelines which inter-alia include pricing, disclosures in notice etc.

Difference between public issue and private placement: When an issue is not made to only a select
set of people but is open to the general public and any other investor at large, it is a public issue. But
if the issue is made to a select set of people, it is called private placement. As per Companies Act,
1956, an issue becomes public if it results in allotment to 50 persons or more. This means an issue
can be privately placed where an allotment is made to less than 50 persons.
Initial Public Offer (IPO): An Initial Public Offer (IPO) is the selling of securities to the public in the
primary market. It is when an unlisted company makes either a fresh issue of securities or an offer for
sale of its existing securities or both for the first time to the public. This paves way for listing and
trading of the issuer’s securities. The sale of securities can be either through book building or through
normal public issue.

Secondary market: Secondary market refers to a market where securities are traded after being
initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of
the trading is done in the secondary market. Secondary market comprises of equity markets and the
debt markets.

Role of the Secondary Market: For the general investor, the secondary market provides an
efficient platform for trading of his securities. For the management of the company, Secondary
equity markets serve as a monitoring and control conduit—by facilitating value-enhancing control
activities, enabling implementation of incentive-based management contracts, and aggregating
information (via price discovery) that guides management decisions.
Difference between the Primary Market and the Secondary Market
In the primary market, securities are offered to public for subscription for the purpose of raising
capital or fund. Secondary market is an equity trading venue in which already existing/pre-issued
securities are traded among investors. Secondary market could be either auction or dealer market.
While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer
market.

Fourth way to classify financial markets is by the timing of delivery. A cash or spot market is one
where the payment and delivery occurs immediately. Most of the trades in government securities
in OTC market in India are spot trades. The organized markets do not provide facility for spot trades.
Closest to the spot market is the cash market where settlement takes place after some time. Trades
taking place over a trading cycle are settled together after certain time. E.g. if an organized market
follows T+2 settlement cycle, the transaction has taken place on Monday will be settled after 2 days.

Markets where securities are traded for future delivery and payments are known as deferred
delivery markets. Derivative products are traded in this market. Derivatives are claims whose value
depends on what happens to the value of the underlying asset. The underlying asset can be a
commodity, index, share foreign exchange or anything. The basic financial derivative products are
Forward or Futures and options. Their values depend on what happens to the prices of other assets,
say IBM stock, and Japanese yen. hence, the value of a derivative security is derived from the value of
an underlying real asset. Derivative contracts may be traded on an exchange or they may be sold
directly over the counter by the issuer. Forward markets or futures market where the delivery occurs
at a predetermined time in future.

Forwards: A forward contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts, such as futures of
the Nifty index.
Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the
underlying at a stated date and at a stated price. While a buyer of an option pays the premium and
buys the right to exercise his option, the writer of an option is the one who receives the option
premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types - Calls and Puts options:

‘Calls’ give the buyer the right but not the obligation to buy a given quantity of the underlying asset,
at a given price on or before a given future dates.
‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a
given price on or before a given future date. Presently, at NSE futures and options are traded on the
Nifty, CNX IT, BANK Nifty and 116 single stocks.

Warrants: Options generally have lives of up to one year. The majority of options traded on
exchanges have maximum maturity of nine months. Longer dated options are called Warrants and
are generally traded over-the counter.

At the time of buying an option contract, the buyer has t pay premium. The premium is the price
for acquiring the right to buy or sell. It is price paid by the option buyer to the option seller for
acquiring the right to buy or sell. Option premiums are always paid up front.

Commodity Exchange: A Commodity Exchange is an association, or a company of any other body

corporate organizing futures trading in commodities. In a wider sense, it is taken to include any
organized market place where trade is routed through one mechanism, allowing effective
competition among buyers and among sellers – this would include auction-type exchanges, but not
wholesale markets, where trade is localized, but effectively takes place through many non- related
individual transactions between different permutations of buyers and sellers.

Commodity: FCRA Forward Contracts (Regulation) Act, 1952 defines “goods” as “every kind of
movable property other than actionable claims, money and securities”. Futures’ trading is
organized in such goods or commodities as are permitted by the Central Government. At present, all
goods and products of agricultural (including plantation), mineral and fossil origin are allowed for
futures trading under the auspices of the commodity exchanges recognized under the FCRA.
Commodity derivatives market: Commodity derivatives market trade contracts for which the
underlying asset is commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed,
cotton, etc. or precious metals like gold, silver, etc.

Difference between Commodity and Financial derivatives: The basic concept of a derivative
contract remains the same whether the underlying happens to be a commodity or a financial asset.
However there are some features which are very peculiar to commodity derivative markets. In the
case of financial derivatives, most of these contracts are cash settled. Even in the case of physical
settlement, financial assets are not bulky and do not need special facility for storage. Due to the
bulky nature of the underlying assets, physical settlement in commodity derivatives creates the
need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far
as financial underlyings are concerned. However in the case of commodities, the quality of the
asset underlying a contract can vary at times.

Fourth way to classify financial markets is by the nature of its organizational structure i.e.
exchange traded market and Over the Counter (OTC) market. In exchange traded markets like the
share market operated by licensed exchanges, all the procedures are standardized and exchange
acts as counter party for every trade, thus counter party risk is centralized. Operations are regulated
by regulator (like SEBI in India) and the exchange’s self-regulatory organization. Exchanges specify
limits on positions and leverages.

OTC markets run by investment institutions and banks and conducted by traders via telephones, and
counter party risk is decentralized with individual institutions. Regulation is through national legal
system, banking supervision and market surveillance. No formal centralized limits on individual
positions, leverage or margining.

We can as well classify financial markets in several other ways: Wholesale and Retail market, in
wholesale markets the size and volume of transaction is huge also quotes are competitive. In retail
markets size and volume of transactions is small and quotes differ according to size of transaction.

Private placement markets and Public markets in private placement markets, transactions are worked
out directly between two parties and structured in any manner that appeals to them. Bank loans
and private placements of debt with insurance companies are examples of private placement market
transactions. In public markets, standardized contracts are traded on organized exchanges. Securities
that are issued in public markets, such as common stock and corporate bonds, are ultimately held
by a large number of individuals. Private market securities are more tailor-made but less liquid,
whereas public market securities are more liquid but subject to greater standardization.

Financial Intermediaries:
Financial Intermediaries that stands between the lender-savers and borrower-spenders and help
transfer funds from one to another. Financial intermediaries are business organizations that
receive funds in one form and repackage them for the use of those who need funds. Through
financial intermediation, resources are allocated more effectively, and the real output of the
economy is thereby increased.

Financial intermediaries are firms that provide services and products that customers may not be able
to get more efficiently by themselves in financial markets. E.g. Mutual Funds. The major financial
intermediaries in India are commercial banks, developmental financial institutions, insurance
companies, mutual funds, non-banking financial companies, and merchant banks.
Financial intermediaries seem to offer several advantages like return with diversification, lower
transaction cost, economies of scale, confidentiality, and signaling benefit.

Important products offered by Financial Intermediaries include Savings / Current Accounts, Loans,
Mortgages, Mutual Fund Schemes, Insurance Contracts, etc. There are many types of financial
intermediaries that coexist in any economy. These intermediaries essentially purchase financial
claims with one set of characteristics from deficit units and sell financial claims with different
characteristics to surplus units.

Deposit institutions offer savings, current and time deposit facilities and use the funds to provide
consumer, business and mortgage loans. The deposits collected are highly liquid and can be
withdrawn with no or short notice. The deposits up to Rs.1 lakh are generally covered by deposit
insurance. They participate in the payment mechanism of the economy and their deposit liabilities
constitute major part of nation’s money supply. Commercial Banks Scheduled/Private, Cooperative

Banks, Regional Rural Banks come under this category of institutions.

Banks: The banking system of India consists of the Reserve Bank of India, commercial banks and
cooperative banks. It is characterized by excessive concentration of business in a small number of
big banks. All these banks accept deposits and give loans.
Commercial banks liabilities include several types of deposits and non-deposit funds as well as
equity capital provided by the owners. They accept savings, current and time deposits of varied
maturities. Non deposit liabilities include borrowings and a wide array of instruments such as
interse bank borrowings, repo transactions etc. these firms are highly leveraged firms. The ratio of
outsider’s liability to share holders’ funds in commercial banks is the highest in the financial
sector.
Their assets are wide varieties of loans viz. consumer, commercial and real estate loans, business loans
being the major asset in bank balance sheets. Banks are also major investors of government and
industrial securities. I most of the countries money available with the banking system is subject to
regulation. Regulations prescribe for the investment in high quality papers such as government
securities and highly rated corporate papers. Credit or default risk is the major risk factor of
commercial banks.
Commercial Ban are of the following types scheduled, nonscheduled. Indian, foreign, public sector,
private sector and regional rural banks. The share of nonscheduled banks has declined and it has
become nil now. The commercial banking activity is mainly constituted by the Scheduled
Commercial Banks (SCBs). Among the SCBs Indian scheduled banks (excluding regional rural
banks) belonging to both public and private sector account for more than 90% of business. The
proportion of time deposit to total deposits has significantly increased accounting for 55 – 60% of
total deposits. Banks have diversified into many areas such as merchant banking, mutual funds,
venture capital, equipment leasing, hire purchase credit, housing finance, credit cards, securities
trading, etc.

Contractual Savings Institutions: They obtained funds under long term contractual arrangements
and invest funds in capital market instruments, government securities and real estate. They
receive steady flow of funds from contractual commitments and liquidity is not a problem in the
management of these institutions. Insurance Companies: Life Insurance / Non- Life Insurance Cos.
And Pension Funds come under this category. These companies collect premium by issuing
policies and the premium collected after the payment of expenses are invested largely in short
term money market instruments and to a small extent in long term capital market instruments.

Non-Banking Financial Institutions: Some institutions are not direct intermediaries in the
financial markets. These institutions do the loan business but their resources are not directly
obtained from the savers. They are generally set up by the government to provide financial
assistance for specific purposes, sectors and regions thereby meet the credit needs of certain
borrowers. Institutions like IDFC, IFC, NHB, and NABARD in India are examples.

Other Institutions: There are several types of financial intermediaries operate in an economy.
Examples of them are Mutual Funds, Housing Finance Companies, Non-Banking financial companies
(NBFCs).
A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956
and is engaged in the business of loans and advances, acquisition of shares/stock/bonds/
debentures/securities issued by Government or local authority or other securities of like marketable
nature, leasing, hire-purchase, insurance business, chit business but does not include any institution
whose principal business is that of agriculture activity, industrial activity, sale/purchase/construction
of immovable property.
NBFCs are similar to banking institutions as they collect deposits from small investors and
generally lend for commercial purposes. They generally engage themselves in the activities like
leasing, hire purchase, factoring, venture capital financing.

NBFCs are doing functions akin to that of banks; however there are a few differences:
a) a NBFC cannot accept demand deposits;
b) it is not a part of the payment and settlement system and as such cannot issue cheese to its
customers; and
c) Deposit insurance facility of DICGC is not available for NBFC depositors unlike in case of
banks.

In terms of Section 45-IA of the RBI Act, 1934, it is mandatory that every NBFC should be
registered with RBI to commence or carry on any business of non-banking financial institution as
defined in clause (a) of Section 45 I of the RBI Act, 1934. However, to obviate dual elation, certain
category of NBFCs which are regulated by other regulators are exempted from the requirement of
registration with RBI viz. Venture Capital Fund/Merchant Banking companies/Stock broking
companies registered with SEBI, Insurance Company holding a valid Certificate of Registration
issued by IRDA, Niche companies as notified under Section 620A of the Companies Act, 1956,
Chit companies as defined in clause (b) of Section 2 of the Chit Funds Act, 1982 or Housing
Finance Companies regulated by National Housing Bank.
The NBFCs that are registered with RBI are:
a) equipment leasing company;
b) hire-purchase company;
c) loan company; and
d) investment company.

With effect from December 6, 2006 the above NBFCs registered with RBI have been reclassified as
a) Asset Finance Company (AFC)
b) Investment Company (IC) (iii)Loan Company (LC)

AFC would be defined as any company which is a financial institution carrying on as its principal
business the financing of physical assets supporting productive / economic activity, such as
automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments,
moving on own power and general purpose industrial achines. Principal business for this purpose is

defined as aggregate of financing real/physical assets supporting economic activity and income
arising therefrom is not less than 60% of its total assets and total income respectively.

Some of the important intermediaries operating in the financial markets include;

• Banks : Commercial Banks Scheduled/ Private, Cooperative Banks, Regional Rural Banks
• NBFCs
• Developmental Financial Institutions – SFC, SIDC, SIDBI
• Insurance Companies : Life Insurance / Non Life Insurance Cos.
• Pension Funds
• Post Office Savings Bank
• NABARD
• National Housing Bank
• Mutual Funds
• Investment Bankers
• Financial Advisers
 • Portfolio Managers
• St ck Exchanges
• Merchant Bankers
• Underwriters
• Registars
• Depositories
• Custodians
• Venture Capital Firms
• Information Services
Though the markets are different, there may be a few intermediaries offering their services in more
than one market e.g. Underwriter. However, the services offered by them vary from one market to
another.
Over the years, the roles of domestic and the international financial institutions (IFIs) have been
changing. For many of the IFIs, recent projects in the Europe and Central Asia (ECA) region are
heavily concentrated in the financial sector. The World Bank’s private arm, the International
Finance Corporation (IFC), along with the European Bank for Reconstruction and Development

(EBRD) and Asian Development Bank (ADB), have prioritized private sector development,
notably in the areas of finance, energy, and small and medium sized enterprises (SMEs). The projects
often decentralize lending by filtering IFI assistance through financial intermediaries (FIs), which
then distribute funds to various projects, companies, or other banks.

Stock Exchange

The Securities Contract (Regulation) Act, 1956 [SCRA] defines ‘Stock Exchange’ as anybody of
individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or
controlling the business of buying, selling or dealing in securities. Stock exchange could be a
regional stock exchange whose area of operation/jurisdiction is specified at the time of its
recognition or national exchanges, which are permitted to ha e nationwide trading since inception.
NSE was incorporated as a national stock exchange.
Intermediary Market Role

Stock Exchange Capital Market Secondary Market to securities

Investment Bankers Capital & Credit Corporate advisory services, Issue of securities
Market
Underwriters Capital & Subscribe to unsubscribed portion of securities
Money Market
Registrars, Depositories, Capital Market Issue securities to the investors on behalf of the company
Custodians and handle share transfer activity
Primary Dealers Satellite Money Market Market making in government securities
Dealers
Forex Dealers Forex Market Ensure exchange in currencies

Financial Regulators: Fourth co ponent of financial system is law and regulations. As a maker
and enforcer of laws in a society, the government has the responsibility for regulating the financial
system. Financial system constantly deals with other people’s property so it is responsibility of
financial system to make sure that the wealth of people is protected, that the financial contracts are
honoured by counterparties so that the events of default are minimized, that small investors given
services that they have been promised, that investors are made aware of their rights and so on. This

role is performed by the specialized institutions known as financial regulators. In India there are
three major regulatory arms of the Government of India are the Reserve Bank of India (RBI) , the
Securities and Exchange Board of India (SEBI) and the Insurance Regulatory and Development
Authority.

Reserve Bank of India (RBI) :

The RBI is the central bank of the economy and guides, monitors, regulates, controls and promotes
the financial system in the country. The main functions of the RBI are:
• Formulation and conduct of monetary policy, which refers to the use of techniques of
monetary control at the disposal of the central bank
• Promoting the country’s banking and financial structure, thereby helping savings
mobilization and proper allocation of funds to desired sectors
• Maintaining stable payment system for smooth financial transaction.
• To act as banker to the government by providing all banking services like deposit
acceptance, withdrawals, transfer of funds and management of public debt. RBI also acts as
bankers’ bank by providing credit facility to commercial as well as cooperative banks in times
of need.
• To develop a sound banking system in the country, RBI has powers to supervise and
control the banking institutions.
• Monopoly of issuing currency notes (other than one rupee notes and coins and coins of
 smaller denominations) against the security of gold coins and gold bullion and foreign
securities.
• Management of rupee exchange rate and foreign exchange reserves

Securities Exchange Board of India (SEBI)

The absence of conditions of perfect competition in the securities market makes the role of the
Regulator extremely important. The regulator ensures that the mar t participants behave in a
desired manner so that securitie market continues to be a major source of finance for corporate and
government and the interest of investors are protected. The responsibility for regulating the securities
market is shared by Department of Economic Affairs (DEA), Department of Company Affairs (DCA),
Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI).

Role of SEBI: The Securities and Exchange Board of India (SEBI) is the regulatory authority in India
established under Section 3 of SEBI Act, 1992. SEBI Act, 1992 provides for establishment of
Securities and Exchange Board of India (SEBI) with statutory powers for (a) protecting the interests
of investors in securities (b) promoting the development of the securities market and (c) regulating the
securities market. Its regulatory jurisdiction extends over corporates in the issuance of capital and
transfer of securities, in addition to all intermediaries and persons associated with securities market.
SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In
particular, it has powers for:
• Regulating the business in stock exchanges and any other securities markets
• Registering and regulating the working of stock brokers, sub–brokers etc.
• Promoting and regulating self-regulatory organizations
• Prohibiting fraudulent and unfair trade practices
• Calling for information from, undertaking inspection, conducting inquiries and audits of the
stock exchanges, intermediaries, self – regulatory organizations, mutual funds and other
persons associated with the securities market.
The Insurance Regulatory and Development Authority (IRDA):
IRDA is a national agency of the Government of India, based in Hyderabad. It was formed by an act
of Indian Parliament known as IRDA Act 1999, which was amended in 2002 to incorporate some
emerging requirements. Mission of IRDA as stated in the act is "to protect the interests of the
policyholders, to regulate, promote and ensure orderly growth of the insurance industry and for
matters connected therewith or incidental thereto.
The law of India has following expectations from IRDA...
 a) To protect the interest of and secure fair treatment to policyholders.
b) To bring about speedy and orderly growth of the insurance industry (including annuity and
superannuation payments), for the benefit of the common man, and to provide long term
funds for accelerating growth of the economy.
c) To set, promote, monitor and enforce high standards of integrity, financial soundness, fair
dealing and competence of those it regulates.

d) To ensure that insurance customers receive precise, clear a d correct information about
products and services and make them aware of their responsibilities and duties in this
regard.
e) To ensure speedy settlement of genuine claims, to prevent insurance frauds and other
malpractices and put in place effective grievance redressal machinery.
f) To promote fairness, transparency and orderly conduct in financial markets dealing with
insurance and build a reliable management information system to enforce high standards of
financial soundness amongst market players.
g) To take action where such standards are inadequate or ineffectively enforced.
h) To bring about optimum amount of self-regulation in day to day working of the industry
consistent with the requirements of prudential regulation.

Duties, Powers and Functions of IRDA

Section 14 of IRDA Act, 1999 lays down the duties, powers and functions of IRDA
1. Subject to the provisions of this Act and any other law for the time being in force, the
Authority shall hav th duty to regulate, promote and ensure orderly growth of the insurance
business and re-insurance business.

2. Without prejudice to the generality of the provisions contained in sub-section (1), the powers and
functions of the Authority shall include,
a) issue to the applicant a certificate of registration, renew, modify, withdraw, suspend or
cancel such registration;
b) protection of the interests of the policy holders in matters concerning assigning of
policy, nomination by policy holders, insurable interest, settlement of insurance claim,
surrender value of policy and other terms and conditions of contracts of insurance;
c) specifying requisite qualifications, code of conduct and practical training for
intermediary or insurance intermediaries and agents;
 d) specifying the code of conduct for surveyors and loss assessors;

e) promoting efficiency in the conduct of insurance business;

f) promoting and regulating professional organizations connected with the insurance and re-
insurance business;
g) levying fees and other charges for carrying out the purposes of this Act;

h) calling for information from, undertaking inspection of, conducting enquiries and
investigations including audit of the insurers, intermediaries, insurance intermediaries and
other organizations connected with the insurance business;

i) control and regulation of the rates, advantages, terms and conditions that may be offered
by insurers in respect of general insurance business not s controlled and regulated by the
Tariff Advisory Committee under section 64U of the Insurance Act, 1938 (4 of 1938);

j) specifying the form and manner in which books of account shall be maintained and
statement of accounts shall be rendered by insurers and other insurance intermediaries;

k) regulating investment of funds by insurance companies;

l) regulating maintenance of margin of solvency;

m) adjudication of disputes between insurers and intermediaries or insurance

intermediaries;

n) supervising the functioning of the Tariff Advisory Committee;

o) specifying the percentage of premium income of the insurer to finance schemes for
promoting and regulating professional organizations referred to in clause (f);

p) specifying the percentage of life insurance business and general insurance business to be
undertaken by the insurer in the rural or social sector; and

q) exercising such other powers as may be prescribed from time to time,

Mutual Funds: These are funds operated by an investment company which raises money from the
public and invests in a group of assets (shares, debentures etc.), in accordance with a stated set of
objectives. It is a substitute for those who are unable to invest directly in equities or debt because of
 resource, time or knowledge constraints. Benefits include professional money management, buying
in small amounts and diversification. Mutual fund units are issued and redeemed by the Fund
Management Company based on the fund's net asset value (NAV), which is determined at the end of
each trading session. NAV is calculated as the value of all the shares held by the fund, minus
expenses, divided by the number of units issued. Mutual Funds are usually long term investment

vehicle though there some categories of mutual funds, such as money market mutual funds which
are short term instruments

Securities Exchange Board of India (SEBI) is the re latory body for all the mutual funds. All the
mutual funds must get registered with SEBI.

Benefits of investing in Mutual Funds: There are several benefits from investing in a Mutual Fund:
1. Small investments: Mutual funds help you to reap the benefit of returns by a portfolio spread across a
wide spectrum of companies with small investments.

2. Professional Fund Management: Professionals having considerable expertise, experience and

resources manage the pool of money collected by a mutual fund. They thoroughly analyze the
markets and economy to pick good investment opportunities.

3. Spreading Risk: An investor with limited funds might b able to invest in only one or two
stocks/bonds, thus increasing his or her risk. However, a mutual fund will spread its risk by investing a
number of sound stocks or bonds. A fund normally invests in companies across a wide range of
industries, so the risk is diversified.

4. Transparency: Mutual Funds regularly provide investors with information on the value of their
investments. Mutual Funds also provide complete portfolio disclosure of the investments made by
various schemes and also the proportion invested in each asset type. Choice: The large amount of
Mutual Funds offer the investor a wide variety to choose from. An investor can pick up a scheme
depending upon his risk/ return profile.

5. Regulations: All the mutual funds are registered with SEBI and they function within the provisions
of strict regulation designed to protect the interests of the investor.
Net Asset Value: NAV or Net Asset Value of the fund is the cumulative market value of the assets
of the fund net of its liabilities. NAV per unit is simply the net value of assets divided by the number
of units outstanding. Buying and selling into funds is done on the basis of NAV- related prices.
The NAV of a mutual fund are required to be published in newspapers. The NAV of an open end

scheme should be disclosed on a daily basis and the NAV of a close end scheme should be disclosed
at least on a weekly basis

Entry/Exit Load: A Load is a charge, which the mutual fund may collect on entry and/or exit from
a fund. A load is levied to cover the up-front cost incurred by the mutual fund for sellingthe fund. It
also covers one time processing costs. Some funds do not charge any entry or exit load. These funds
are referred to as ‘No Load Fund’. Funds usually charge an entry load ranging between 1.00% and
2.00%. Exit loads vary between 0.25% and 2.00%.

For e.g. Let us assume an investor invests Rs. 10,000/- and the current NAV is Rs.13/-. If the entry
load levied is 1.00%, the price at which the investor invests is Rs.13.13 per unit. The investor
receives 10000/13.13 = 761.6146 units. (Note that units are allotted to an investor based on the
amount invested and not on the basis of no. of units purchased). Let us now assume that the same
investor decides to redeem his 761.6146 units. Let us also assume that the NAV is Rs.15/- and the
exit load is 0.50%. Therefore the redemption price per unit works out to Rs. 14.925. The investor
therefore receives 761.6146 x 14.925 = Rs.11367.10.
Risks involved in investing in Mutual Funds
Mutual Funds do not provide assured returns. Their returns are linked to their performance. They
invest in shares, debentures, bonds etc. All these investments involve an element of risk. The unit value
may vary depending upon the performance of the company and if a company defaults in payment of
interest/principal on their debentures/bonds the performance of the fund may get affected. Besides
incase there is a sudden downturn in an industry or the government comes up with new a regulation
which affects a particular industry or company the fund can again be adversely affected. All these
factors influence the performance of Mutual Funds.
Some of the Risk to which Mutual Funds are exposed to is given below:

Market risk: If the overall stock or bond markets fall on account of overall economic factors, the
value of stock or bond holdings i the fund's portfolio can drop, thereby impacting the fund
performance.
Non-market risk: Bad news about an individual company can pull down its stock price, which can
negatively affect fund holdings. This risk can be reduced by having a diversified portfolio that
consists of a wide variety of stocks drawn from different industries.
Interest rate risk: Bond prices and interest rates move in opposite directions. When interest rates
rise, bond prices fall and this decline in underlying securities affects the fund negatively.
Credit risk: Bonds are debt obligations. So when the funds invest in corporate bonds, they run the
risk of the corporate defaulting on their interest and principal payment obligations and when that risk
crystallizes, it leads to a fall in the value of the bond causing the NAV of the fund to take a beating.
Different types of Mutual funds:
Mutual funds are classified in the following manner:
(a) On the basis of Objective Equity Funds/ Growth Funds: Funds that invest in equity shares
are called equity funds. They carry the principal objective of capital appreciation of the investment
over the medium to long-term. They are best suited for investors who are seeking capital
appreciation. There are different types of equity funds such as Diversified funds, Sector specific
funds and Index based funds.
Diversified funds: These funds invest in companies spread across sectors. These funds are
generally meant for risk-averse investors who want a diversified portfolio across sectors.

Sector funds: These funds invest primarily in equity shares of companies in a particular business
sector or industry. These funds are targeted at investors who are bullish or fancy the prospects of a
particular sector.

Index funds: These funds invest in the same pattern as popular market indices like S&P CNX Nifty
or CNX Midcap 200. The money collected from the investors is invested only in the stocks,
which represent the index. For e.g. a Nifty index fund will invest only in the Nifty 50 stocks. The
objective of such funds is not to beat the market but to give a return equivalent to the market returns.

Tax Saving Funds: These funds offer tax benefits to investors under the Income Tax Act.
Opportunities provided under this scheme are in the form of tax rebates under the Income Tax act.

Debt/Income Funds: These funds invest predominantly in high-rated fixed-income-bearing

instruments like bonds, debentures, government securities, commercial paper and other money
market instruments. They are best suited for the medium to long-term investors who are averse to risk
and seek capital preservation. They provide a regular income to the investor.
Liquid Funds/Money Market Funds: These funds invest in highly liquid money market
instruments. The period of investment could be as short as a day. They provide easy liquidity. They
have emerged as an alternative for savings and short-term fixed deposit accounts with
comparatively higher returns. These funds are ideal for corporate, institutional investors and
business houses that invest their funds for very short periods.

Gilt Funds: These funds invest in Central and State Government securities. Since they are
Government backed bonds they give a secured return and also ensure safety of the principal
amount. They are best suited for the medium to long-term investors who are averse to risk.

Balanced Funds: These funds invest both in equity shares and fixed-income-bearing instruments
(debt) in some proportion. They provide a steady return and reduce the volatility of the fund while
providing some upside for capital appreciation. They are ideal for medium to long-term investors
who are willing to take moderate risks.
b) On the basis of Flexibility Open-ended Funds
These funds do not have a fixed date of redemption. Generally they are open for subscription and
redemption throughout the year. Their prices are linked to the daily net asset value (NAV). From the
investors' perspective, they are much more liquid than closed-ended funds.
Close-ended Funds
These funds are open initially for entry during the Initial Public Offering (IPO) and thereafter
closed for entry as well as exit. These funds have a fixed date of redemption. One of the
characteristics of the close-ended schemes is that they are generally traded at a discount to NAV; but
the discount narrows as maturity nears. These funds are open for subscription only once and can be
redeemed only on the fixed date of redemption. The units of these funds are listed on stock
exchanges (with certain exceptions), are tradable and the subscribers to the fund would be able to exit
from the fund at any time through the secondary market.
 Chapter 3
INTRODUCTORY FINANCE CONCEPTS

3.1 Different Types of Capital in a Limited Company

Nominal, Authorised or Registered capital

This is the sum stated in the memorandum of association of a company limited by shares as the
capital of the company with which it is registered. It is the maximum amount which the company is
authorised to raise by issuing shares. This is the capital on which it had paid the prescribed fee at the
time of registration, hence also called Registered capital. As and when this is increased, fees for
such increase will have to be paid to the Registrar in accordance with the provisions in the
Companies’ Act. This is divided into shares of uniform denominations. The amount of nominal
capital is fixed on the basis of the projections of fund requirements of the company for its business
activities.

Issued capital: It is part of the authorised or nominal capital which the company issues for the time
being for public subscription and allotment. This is computed at face value or nominal value.

Subscribed capital: It is that portion of the issued capital at face value which has been subscribed or
taken up by the subscribers of shares in the company. It is clear that the entire issued capital may or
may not be subscribed.

Called up capital: It is that portion of the subscribed capital which has been called up or demanded
on the shares by the company e.g., where Rs.5 has been called up on each of 100000 shares of a
nominal value of Rs.10/- each, the called up capital is Rs.5lacs.

Uncalled capital: It is the total amount not yet called up or demanded by the company on the
shares subscribed, which the shareholders are liable to pay as and when called up, e.g., in the
above case, uncalled capital is Rs.5lacs.

Paid-up capital: It is that part of the total called up amount which is actually paid by the
shareholders e.g., out of Rs.5lacs, called up, only 4.5lacs get paid by the subscribers, the paid up
capital is Rs.4.5 lacs.
Unpaid capital: It is the total of the called up capital remaining unpaid, determined by the difference
between the called up capital and paid-up capital.
Reserve capital: It is that part of the uncalled capital of a company which the company has decided
by special resolution not to call excepting in the event of the company being wound up and thereafter
that portion of the share capital shall not be capable of being called up except in that event and for
that purpose only.

Merits and demerits of “limited companies”

Merits:
a) It is a well-structured form of organisation;
b) It is a perpetual entity and change in the management does not affect the continuity of the
entity, unlike in the case of partnership firms;
c) The level of acceptability in the market of a limited company is quite high with widely held
public limited companies commanding the highest degree of acceptability. Hence they have
wider access to resources starting from a private limited company with the widely held public
limited company having the maximum resources;
d) The shareholders have limited liability and they are not held personally responsible for any
loss of the company. Their liability is limited to the value of their share investment in the
company.

Demerits:
a) The formation of a limited company is far more complex with requirement of registration and
other legal formalities to be gone through;
b) The companies are subject to a number of statutes, like The Companies’ Act, The Income-
Tax Act for compulsory audit, SEBI rules and guidelines for raising equity from the public as
in the case of widely held companies, legal clearance for mergers and acquisitions etc. and
their administration is far more complex than that of partnership firms;
c) In case of large public limited companies, the ownership is not exclusive, but shared with a
lot of other investors;
d) Private limited companies are comparable with partnership firms from the point of view of
control and administration and their shareholders do not enjoy “limited liability” on the
losses of the company, at least in the case of bank borrowing. The banks, in order to tie the
owners up, obtain the personal guarantees of the owners as collateral security for loans given
by them;
 Chapter 4
ACCOUNTING CONCEPTS: AN INTRODUCTION

4.1 Finance & Accounts Functions & Business Enterprises

Functions of Accounts Department that does Financial Accounting

a) Maintenance of Accounts strictly in accordance with the Accounting Principles, following

Accounting Rules as per prescribed Accounting system and observing Accounting standards as
well GAAP depending upon the country of operations.

b) Control over amounts receivable, amounts payable, bank accounts, cash o hand etc.

c) Preparation of budgets, both revenue and capital, with the objectives of allocation of resources,
control and monitoring of expenses

d) Compliance with payment of Advance Tax as per the Rules and Regulations in this behalf

e) Thorough understanding of Income Tax Rules and Regulations with a view to minimize tax
payable by the enterprise
f) Maintenance of Financial Management Information System (popularly known as MIS) that is a
review of performance of key financial parameters vis-à-vis the estimates – this is an important
tool in taking corrective action in time and hence forms an integral part of decision-making
process
g) Being responsible for the process of “Audits” of various kinds – Internal Audit, Statutory Audit,
Tax Audit etc.
 Differences among proprietorship and partnership firms on one hand and limited companies on the
other hand in respect of Financial Accounting process/system

Parameter Sole proprietorship firms Partnership firms Limited companies

Accounting system – No compulsion. The firm can No compulsion under The Under the provisions of The
Accrual or Cash choose either of them but Partnership Act. The firm can Companies’ Act, it is compulsory
once decided, will have to choose either of them but to adopt the Accrual basis of
stick with it once decided, will have to Accounting. No choice
stick with it

Cash transactions and credit If cash system is adopted, If cash system is adopted, The enterprise has to account for
transactions credit transactions will be credit transactions will be both cash and credit transactions
ignored ignored

Final audited s No specific formats No specific formats Specific formats as per Schedule
tatements – VI of the Companies’ Act
presentation in specific
formats

Components of P&L Trading and Profit & Loss Trading and Pr fit & Loss Profit & Loss and Profit &
Statement components components Loss Appropriation
components

Retained profit in Transferred to the capital of Transferred to the capital Transferred to Reserves &
business the owner thereby increasing accounts of the owners surplus as share capital of the
the investment of the owner thereby increasing their owners cannot be altered by
(Profit After Tax as reduced
in the firm. investment in the firm retained profits in business
by profit withdrawn from
business or distributed in the
form of dividend)

Distribution of 100% profit Done Done Cannot be done. Dividend is

to the owners’ capital only after transferring certain
minimum amount to the General
Reserve that depends upon the
percentage of Dividend on
Capital Share capital

Statutory audit of Accounts Not compulsory. Tax audit Not compulsory. Tax audit Compulsory under the provisions
compulsory in case turnover compulsory in case turnover of the Companies’ Act, besides
is beyond is beyond Tax audit

Depreciation on fixed Not compulsory in the books Not compulsory in the books Compulsory in terms of the
assets other than land of accounts – claimed in the of accounts – claimed in the Companies’ Act – Schedule
Income Tax returns Income Tax returns XIV and the rates are different
from The Income Tax
provisions
Difference between finance function and accounts function

Financial Accounting Functions Corresponding Finance Functions

Maintenance of Accounts – strict compliance with Financial planning and Resources mobilization.
statutory provisions as per ICAI guidelines, Adequate resources in time and in a cost-
Accounting Standards, GAAP (India) provisions, effective ways. More of market orientation than
Income Tax Act provisions etc. statute-orientation

Responsible for budgets – both revenue and capital Cash management – stand-by arrangements, both in
case of excess and deficit

Tax compliance and tax planning besides audit Responsible for treasury management –
largely, liquidity management, risk
management and investment management

Management Information System & Reports for Strategic Financial Management initiatives like
Finance expansion, diversification etc.

Finance and accounts functions may be integrated in an organisation. This means that one
department handles both. In most of the small and medium size units in India, the functions will be
integrated. A business enterprise will require a full-fledged finance department only when the
functions listed above are predominant functions impacting business in a big way. If the finance
functions are not predominant functions, Accounts department looks after Finance also. Constant
requirement of funds, surplus for investment etc, could be some of the factors influencing the need
for a full-fledged Finance department.
 Accounting

1 Introduction the preparation of reports to shareholders, tax

2 Historical background authorities and others outside the company,
3 The regulation of accounting using aggregated data from the database (see
4 The use of accounting in managerial FINANCIAL ACCOUNTING). The term 'manage­
decision making rial accounting' concerns the use of account­
5 Accounting in an international setting ing data internally, within a company, to help
6 The accounting discipline in the twenty­ with management and decision making and to
first century improve profitability.
Techniques developed to meet financial
accounting requirements include the prepara­
Overview
tion of shareholder reports for groups of
Accounting is a discipline that seeks to companies under the same economic control
provide information about a business entity. (see C.\)NSOLIDATED ACCOUNTING) and segmen­
Such information is useful to those who are tal reporting, which concerns the breakdown
interested in making decisions that may affect of aggregated information in annual reports in
the entity or one's relationship with the entity. order to help predict future performance.
This entry aims to provide a background to Inflation accounting addresses the short­
the accounting discipline that will enable the comings of traditional financial accounting
reader to fit the role of accounting into the measurement methods in a context where
broader arena of business and economic monetary values are not fixed (see ASSET
activity. It serves as an introduction to both VALUATION, DEPRECIATION AND PROVISIONS; IN­
managerial and financial accounting areas FLATION ACCOUNTING) while the objectives of
and related topics such as auditing and sets 'creative accounting' are generally to improve
the stage for other entries which go into reported earnings or to enhance a company's
greater detail. However, no brief description debt/equity ratio (see CREATIVE ACCOUNTING).
of accounting can be expected to capture Cash flow accounting, an alternative ap­
comprehensively the changing faces of the proach to analysing transactions, concerns the
discipline over time or the impact of account­ preparation of the cash flow statement, which
irig on all business decisions, current and all major companies include in their annual
prospective. external reporting package (see CASH FLOW
ACCOUNTING). The external reports of large

1 Introduction companies are subjected to auditing in order

to reassure shareholders and other users of
The term accounting conjures up a variety of their validity (see STATUTORY AUDIT). People
images, ranging perhaps from that of a Dick­ who read published accounts have developed
ensian clerk painstakingly recording an indi­ special tools for extracting key information
vidual transaction, to that of the annual (see FINANCIAL STATEMENT ANALYSIS) and the
financial statements of a major multinational accounts are also used as the basis for corpo­
corporation, running to many pages of com­ rate taxation (see TAX-\TION. CORPORATE).
plex data. Both of these notions are valid. even Financial accounting does not comprise a
if the clerk now uses the latest computer given set of techniques that are undisputed
technology, but how do they fit together? and used uniformly throughout the world
The term 'financial accounting' concerns The legal, economic and social context of
the whole of the area of the capture of accounting has an important influence on
financial data concerning a company's trans­ how it is formulated and. consequently, the
actions. its organization into a database and measurements and objectives of accounting
 Accounting

are often different in different countries (see, periodic summary of an entity's wealth at a
for example, ACCOUNTING IN CENTRAL AND given date and its performance over a period.
EASTERN EUROPE; ACCOUNTING IN JAPAN; AC­ The records kept were mostly of cash trans­
COUNTING IN THE USA). The area of accounting actions, but the need to go beyond cash events
harmonization concerns various initiatives to obtain more useful information was evident
that have been taken to reduce these differ­ even in the earliest days.
ences (see ACCOUNTING HARMONIZATION). The need for accounting grew slowly in
Managerial accounting is distinguished the pre-industrial era. Land owners had a
from financial accounting in many ways: for need to assess their wealth status from time
example, it is intended purely for confidential to time: as the operations of property were
use internal to the company, and it is not turned over to non-owners for management,
mandated by any legal or quasi-legal rules. the now 'absentee' owners' needs for infor­
The justification for management accounting mation provided by accounting increased,
is only that it is useful in managing the partly as a check on the performance of
company, and its techniques therefore tend managers. Throughout this period, the focus
to travel more easily than those used in of accounting was on changes in the wealth
financial accounting. owned by the entity (a business or an
The origins of managerial accounting are in individual estate). Income for a period was
costing, which is designed to provide informa­ viewed as the change in wealth between two
tion about the costs of individual product in dates, with accounting providing the measure
order to control profitability and encourage of wealth at the two dates, as well as
efficiency (see COSTING). The information pro­ sufficient information about wealth changes
vided by these techniques can be used in to facilitate an understanding of the particu­
decision making, using models such as cost­ lar factors that contributed to the net change,
volume-profit (CVP) analysis (see cosT-VO­ or income, for the period.
LUME-PROFIT RELATIONSHIPS). In recent years, Prior to the Industrial Revolution, many
there has been a revision of costing ideas with business activities were localized, which facili­
a technique known as activity-based costing, tated the measurement of values of resources
which aims to reflect modern production periodically. Furthermore, technology as we
methods more faithfully (see AcnvrTY-BASED know it today was minimal, and the resources
COSTING). Cost information also feeds into comprising an entity's wealth were, therefore,
systems for monitoring overall unit profit­ relatively simple to value. Even business activ­
ability, as in the practice of budgetary control ities involved in world trade were structured in
(see BUDGETARY CONTROL). Companies estab­ a manner that created few problems of valua­
lish 'budgets', or target costs and sales, for tion. Joint venture arrangements were com­
short periods ahead, and then feed actual mon, and these were organized around limited
performance data (often from the financial activities within finite time intervals. The
accounting database) into comparative re­ accounting notions of the day served users'
ports. The compilation of such reports should needs well under these circumstances.
reflect the organization needs of the company The Industrial Revolution created new
(see ACCOUNTING AND ORGANIZATIONS). challenges for accounting. The annual 'reck­
oning', or valuation of resources was no
2 Historical backgrounci longer sufficient. Business operations became
more complex and information was needed to
The roots of accounting go back many cen­ facilitate those operations more frequently
turies, to biblical times and earlier. Modern than on an annual basis. Manufacturing activ­
accounting, however, is generally perceived to ities grew, and accounting was expected to
date back to about 1494, to the inclusion of a provide information to assist in controlling
chapter on double-entry book-keeping in an costs, on the one hand, and in pricing pro­
Italian mathematics book (see PACIOLI. L ). The ducts, on the other. Out of these needs grew
focus was on record keeping to facilitate a cost accounting (now generally referred to as
managerial accounting) notions. Gradually, the focus of accounting shifted to the cost of resources,
rather than their value.

Coincident with the growth in industrial activity came the increasing need for capital by business
entities. The corporate form of business organization flourished and capital providers became
increasingly diverse, ceasing to have any other association with the entity. There was growing
recognition that the ac- counting discipline was uniquely suited to provide information for capital
investment decisions, just as it had provided information to assist managers. Alongside this changing
perception of accounting, a need arose for assurance that the information generated by the
accounting discipline was fair and objective and that it could be relied upon for its intended
purposes. Thus, the auditing profession grew in prominence, its mission being to assure users of
audited financial information that the information represented the transactions and events of the
entity fairly.
This brief summary brings the development of accounting up to the early 1900s. By this time, the
accounting discipline had shown itself to be adaptable and had proved capable of providing information
to meet the changing and growing needs of diverse user groups. While much of the change evolved
in continental Europe, the greatest progress in the development of the accounting discipline was in
the UK, at least until the early 1900s. The effects of these developments were felt across the Atlantic
Ocean, where a growing US economy was generating an ever-increasing need for accounting
information.

Twentieth-century developments

As awareness of financial reports and the accounting discipline grew, demand for ac- counting-
trained personnel grew. While in the UK this demand was met largely through an apprenticeship
system, in the USA, accounting studies became a part of university training in economics and later
evolved into a discipline separate from, but related to, economics. The growing focus of business
on periodic income, rather than on periodic wealth measurements, provided certain economists
with a fertile new field of study to develop - the study of accountancy.
Increasingly, the study of accounting grew apart from economics and gradually evolved into the
discipline we know today. Various tensions existed, principally between two schools of thought:
those who argued that changes in wealth (value changes) were more relevant and meaningful for
accounting in- formation; and those who argued that accoun tability for invested costs and
measurement of revenue inflows and cost outflows were of prime importance.

During the 1920s, the proponents of accounting for value changes seemed to grow in prominence
and asset re-measurements were common. However, the stock market crash of 1929 and the
worldwide depression that followed seemed to impair the credibility of those favouring the
measurement of changes in value. As a result, the focus on historical cost grew. Some considered this
focus to be the most appropriate means of deriving information required to assess management
account- ability; others favoured it because it was seen to be a notion that was integral to the
determination of income - that is, the difference between the revenues earned (and gains) and the
costs and expenses (and losses) related to the earning activities.

The focus on historical cost was consolidated in 1936 with the publication of An Introduction to
Corporate Accounting Standards, by William A. Paton and A.C. Littleton. While both authors were
educated as economists, Paton favoured valuations and re- measurements (see PATON. w A.), but
Littleton did not. Littleton's views dominated the book and it became the cornerstone of influence in
accounting education over the next half century. The separation of accounting from economics had
become complete, even though calls frequently arose for accounting reports to do a better job of
reflecting the economic reality of business operations, a notion that re-emerged in the l990s as
dissatisfaction with the perceived lack of relevance of historical cost information grew.
 Accounting

investment decisions. The continued pressure

3 The regulation of accounting for ever more disclosure in the USA con­
trasted significantly with pressures in most
Regulation in the United States of America
other parts of the world. Other societies were
As the twentieth century evolved, business less open and relied on a limited number of
became increasingly complex and the ac­ capital providers to supply increasing capital
counting discipline expanded to meet increas­ needs; widespread demand for additional
ingly diverse needs for financial information. financial disclosures simply did not arise.
In the USA, governmental intervention in the When the AICPA assumed responsibility
affairs of the market economy also became for writing accounting standards in the USA
more pervasive. By the late 1930s it was clear in the late 1930s, the work was assigned to a
that the emerging accounting profession had committee, the individual members of which
to step up its self-regulatory activities or it had high-level responsibilities in the practice
would become dominated by governmental of public accounting. Only token representa­
bureaucrats. While Federal securities laws tion was afforded to academics or those with
passed in the early 1930s empowered a new responsible accounting roles in US industry.
agency, the Securities and Exchange Commis­ Over time, the influence of public practi­
sion (SEC), to establish sound accounting tioners manifested itself in increasingly de­
standards, the accounting profession per­ tailed standards. Pressures on practitioners
suaded this agency to permit it, through the would develop to permit acceptance of an
American Institute of Certified Public Ac­ innovative accounting notion. Such pressure
countants (AICPA), to establish such stan­ was countered by attempts to write standards
dards. The SEC retained the power to amend detailed enough to thwart at least those
or veto the standards emanating from the potential innovations that could be perceived
private sector. at the time. The process persisted into the
For the next thirty-five years in the USA, 1990s, with the result that accounting stan­
accounting standards evolved in the private dards in the USA are a mass of detailed rules
sector, often with the encouragement and lacking in internal consistency and leading to
some direction from the SEC, but only occa­ the notion of 'practice by the rule book'.
sionally with direct intervention. Surprisingly, The development of increasingly detailed
the standards evolved largely in an ad hoc rules began to be countered in the l 960s by
manner and consistency among standards was pressure from the preparers of financial state­
more accidental than intended. While the ments in industry. While it was their financial
earlier work of Paton and Littleton continued statements that were being regulated when
to provide some fundamental guidance, its new standards were issued, this group felt that
almost total reliance on historical cost infor­ it had been allowed too little participation in
mation often created nomalies for financial the regulatory process. In addition, the pace of
statement users - the information provided change in the evolution of accounting stan­
was highly reliable, but it was not relevant dards was felt to be far too rapid. Preparers
because it failed to reflect the economic effects really wanted much greater flexibility in stan­
of ongoing market changes. dards than the standard-setting bodies were
During this period, one phenomenon of permitting, and they wanted to retain the
note was the greatly expanded disclosures status quo for longer periods than had pre­
made by US companies in the footnotes to viously been permissible. Their attitude could
their financial statements. The SEC was con­ be expressed as follows: 'we don't want to
ceived in an atmosphere calling for more change our present practices, but if we have to,
complete disclosure, with the objective being give us plenty of time to adapt to the change
to assure investors and potential investors that before it becomes a requirement'.
US stock and bond markets were fair in the In an atmosphere of increasing business
sense that information made available to complexity, rapid technological d:.3.nge that
investors was an adequate basis for their facilitated innovations in business thinking
 Accountmg

(and thus in accounting) and growing sophis­ of proposed new auditing initiatives. As litiga­
tication among those responsible for prepar­ tion against auditors expanded, valid new
ing financial statements, the accounting auditing initiatives were often characterized
standard-setting process was altered signifi­ as self-serving protectionist devices for the
cantly. A new private sector board, the Finan­ auditors.
cial Accounting Standards Board (FASB), By the 1990s, both accounting standards
was created as an independent private sector and auditing standards were very different
agency, taking control of the standard-setting from those of fifty years earlier. The account­
process away from the AICPA. Standard ing profession had reacted to the changing
setting in the USA became a more open complexities of the business environment.
process, one that reflected the diverse views While disagreements arose over the pace of
that users of financial statements had devel­ change in standards, which developed in
oped. Initially, majority influence appeared to response to the needs generated by the evol­
reside with the public accounting profession, ving business community, an objective obser­
but by the I 990s the centre of influence had ver would have to conclude that the leaders of
shifted more to the preparers of financial the accounting profession in the USA had
statements. made reasonable efforts to meet the challenges
The output of the FASB was primarily an posed by the changing environment. .
extension of the work of the AICPA in the At this point in the evolution of accounting
accounting standard-setting arena. If any­ practice, two central conflicts warrant addi­
thing, the standards became even more tional attention. The first concerns the differ­
detailed and several were accompanied by ences between accounting information
relatively elaborate guides to their applica­ generated for internal use in managing the
tion. Standards still took substantial time to business and information made available to
develop, with the result that in some cases investors and creditors to assist them in their
they were issued a long time after the issue decision making. The second conflict con­
under consideration had become a major cerns the great diversity of accounting stan­
problem. The focus of the FASB continued dards across country borders and the
to be on evolving a single acceptable ac­ detrimental effects of this condition at a time
counting approach, thus limiting the flex­ of increased cross-border trade and unprece­
ibility of preparers of financial statements. dented developments in communications and
Even so, variations in practice remained technology. Each of these two matters is
significant and financial statements of differ­ considered below.
ent companies were generally not as compar­
able as an unsophisticated user might
4 The use of accounting in managerial
consider them to be.
Coincident with the evolution of account­
decision making
ingstandards wasthedevelopment of auditing For a number of reasons, the study of account­
standards - standards to guide the activities ing at the university level became popular in
and attitudes of auditors. These efforts were the USA after the 1940s. The result is that
relatively more fruitful and less controversial virtually all large companies, as well as many
than those in the accounting standards arena. 'middle market' companies, have accounting
Auditing standards affect a more homoge­ expertise available internally and no longer
neous population - the body of external need to rely on their outside auditors to
auditors - while accounting standards affect provide such expertise. Of greater significance,
both preparers of financial statements and however, is the use of such expertise within the
their auditors, two groups whose interests and entity to assist in the management of the
objectives sometimes differ, as well as a whole business. In many companies, the focus of
range of users. Even so, the development of accounting activities moved from those
auditing standards often led to controversy. needed to meet regulatory reporting require­
Tensions arose over the cost/benefit trade-off ments to those that are increasingly significant
 Accounting

in the management of the company. The financial reporting system. This focus pro­
accounting process at many companies vides an opportunity for preparers of finan­
evolved into a total information system, with cial information to present, on an
the system supplying data of a qualitative experimental basis, information useful in
nature that is not limited to information which their internal decision making that is not
is a by-product of the double-entry accounting required to be reported or disclosed by exist­
system. ing regulatory requirements. While preparers
These developments also had an impact on are understandably reluctant to disclose pro­
accounting standard setters. Preparers (indus­ prietary information, there seems to be little
try insiders) frequently commented that FASB doubt that companies' internal accounting
proposals would be costly to implement and processes generate information that would
would produce information that would be assist a variety of users of financial informa­
useless in running the business. Such argu­ .tion in their decision making.
ments focused attention on the distinctions History suggests that accounting adapts
between the information needs of managing a well to the needs of those who consume the
business and information needs of creditors, results of accounting activity in a constantly
investors and prospective creditors and inves­ changing business and financial environment.
tors. The central focus of the FASB and its Dissatisfaction with the information :,gener­
predecessors on the needs of investors and ated by accounting processes that served
creditors biased their resulting standards and business in the latter half of the twentieth
created a significant basis for conflict with the century is likely to lead to innovations in, and
preparers of financial statements. Resolution extensions to, accounting information in or­
of that conflict will be a central issue in the first der to serve the needs of users in the twenty­
part of the twenty-first century. first century.
In the 1990s, users have become increas­
ingly aware that financial reports have either 5 Accounting in an international
lost some of their usefulness for decision­
setting
making purposes or never had the degree of
usefulness many asserted they had. The cen­ While accounting techniques and mechanisms
tury-long reliance on historical cost infofll).a­ are not constrained by national boundaries,
tion has led to the recognition that, for many the differences that exist in legal systems,
companies, such information has little rele­ financing arrangements and social and busi­
vance for decision making. Balance sheet ness customs from country to country have led
carrying amounts are seen to bear little rele­ to a remarkable diversity in accounting prac­
vance to values in use and valuable resources tices. While the adaptability of accounting to
often go unreported. There is a growing the needs of users of financial information is a
recognition that quantified information in positive attribute, it has led to considerable
financial statements tells only part of thestory differences in financial information among
and that other information, sometimes re­ the world's leading economies.
ferred to as 'soft information', is needed to Early efforts to cope with diversity in
evaluate the prospects, risks and uncertainties accounting practices that evolved among the
of a business. world's major trading cou tries culminated in
Separate studies have been undertaken by the creation in 1973 of the International
_the AICPA, the Financial Executives Re­ Accounting Standards Committee (IASC).
search Foundation and the Association for Based in London, the IASC has as memben
Investment Management and Research (for­ over one hundred professional accounting
merly the Financial Analysts Federation) to bodies from approximately eighty countries.
explore how financial reports might be made It operates primarily through a board of
more relevant to the needs of users. One fourteen representatives - thirteen countries
important focus is on key information that and the International Federation of Financial
is not an integral part of the standard Analysts - and a small secretariat based in
 Accountmg
London. During its first fifteen years, the a more integral part of the EU. Many types of
IASC issued some twenty-seven international barriers have fallen and a great deal of product
accounting standards. Most were character­ standardization has been achieved. These
ized by the acceptability of two or more developments have greatly assisted EU ac­
alternatives. Even so, most standards also counting representatives as they have
eliminated one or more practices found in struggled to remove alternative accounting
certain countries. The work of the IASC practices that generate uneconomic, and often
during its early years established a foundation misleading, financial information.
for harmonizing standards. While not yet fully Beginning in 1988, the IASC moved to
effective, this work nevertheless provides a reduce markedly the range of acceptable alter­
basis for further progress in dealing with natives among its existing standards. Repre­
cross-border accounting diversity. sentatives of various countries on the IASC
The condition of diversity did not lead to board demonstrated a new willingness to seek
many significant problems until late in the compromise and agreed that some long-stand­
twentieth century. While international trade ing practices could no longer be justified in the
has existed for hundreds of years and certainly face of rational arguments raised by others.
increased in volume during the twentieth (3) As the centrally planned economies of
century, it was only the developments at the eastern Europe and the former USSR evolve
end of the century that Jed to renewed interest into ones based on private owne rship, their
in international differences in accounting. accounting policies change, too, providing
Most of this interest was directed at increasing data that helps effect the economic changes.
the harmonization of accounting and auditing Western investors need reliable financial data
standards among countries. Harmonization pertaining to joint venture operations, as well
efforts naturally generate conflict, as one or as free-standing investment opportunities, if
more countries face a need to make changes, they are to make sound investment decisions.
often significant ones, in long-standing ac­ Financial information based on western no­
counting practices. tions of accrual accounting enables these
Several developments external to the ac­ countries to incorporate the investment effects
counting profession have provided momen­ into their financial statements and to evolve
tum to harmonization efforts. appropriate pricing policies as their econo­
( l) Advances in technology and communica­ mies become more market-sensitive.
tions have helped facilitate significant exten­ (4) Cross-border trade initiatives have in­
sions of cross-border financing. Possible creased and there has been a gradual reduc­
financing sources once considered too remote tion of cross-border trading barriers. For
to investigate have become readily accessible. example, talks held during the early 1990s
As demands for funds from new sources grew, under the General Agreement on Tariffs and
lenders focused on financial information Trade (GATT) and the completed North
compiled on bases different from those in American Free Trade Agreement (NATTA)
their own countries. Informed lending deci­ focused considerable attention on free trade.
sions require understanding of different ac­ Paralleling this development, there has been a
counting approaches as well as some effort to fall in the number of acceptable accounting
convert information received to a more famil­ alternatives, reducing the possibility of mis­
iar format. understandings and misinterpretations in the
(2) The ongoing unification of Europe has reading of financial statements. Accounting
generated considerable momentum for coop­ best serves the needs of trading enterprises
eration and few doubt that the European when differences in financial information be­
Union (EU) will become an increasingly tween countries are minimized.
powerful economic force in decades to come. (5) The International Organization of Secu­
The progress achieved thus far flows from rities Commissioners (IOSCO) has become an
decisions by many countries to forgo certain increasingly significant force in the interna­
long-standing national objectives and become tional accounting arena. The IOSCO is com-
 Accounting

prised of representatives of either the securi­ policy to urge the various countries it repre­
ties commissions of various countries (for sents to require non-domestic companies to
example, the US Securities and Exchange reconcile their financial information with
Commission) or the stock markets of coun­ IASC accounting standards when filing with
tries that do not have a separate regulatory local regulators. Such a development would be
commission in the securities arena. a major advance in the harmonization of
Securities commissioners have a natural financial information across borders.
interest in reducing the range of acceptable
alternatives among accounting standards. The 6 The accounting discipline in the
existence of alternatives makes the accurate
analysis of financial information from various
twenty-first century
countries difficult and therefore interferes Throughout its 500-year or so history, the
with the evaluation of such information as a accounting discipline has demonstrated its
basis for permitting the trading of securities of capacity for adapting to changes in a society's
a non-domestic company. customs and business practices. Practices de­
The USA currently has the most stringent veloped in local environments to meet local
financial reporting requirements of any coun­ needs, often with no knowledge that similar
try. The SEC requires a non-domestic com­ needs were evolving:. elsewhere. As societies
pany that files financial information to and cultures evolved v..·ith multiple differences
support the sale of securities in US markets in foci and objectives. accounting grew by
either to recast the information in accorda ce reflecting the needs and objectives of its
with US generally accepted accounting prin­ varying contexts. For example, accounting in
ciples (GAAP) or to reconcile the information the USA is characterized by the expansive
to what it would be if it were prepared in capital market and bottom line, earnings-per­
accordance with US GAAP. Most other share-driven influences, while German ac­
countries accept filings of non-domestic fi­ counting is dominated by a prescriptive legal
nancial information without a restatement or framework, driven by income tax law and
reconciliation, but securities regulators in characterized by the preservation of capital.
such countries appear increasingly concerned Anyexpectation that such divergent forces will
that the local investors have an inadequate blend readily into a single accounting frame­
basis to assess alternative investment oppor­ work in the short term is na"ive and unrealistic.
tunities. On the other hand, the divergent forces may
By 1995 the IOSCO was working closely well become more integrated as societies and
with the International Federation of Accoun­ cultures adapt to a more closely integrated
tants (a sister organization of the IASC) to world heavily influenced by ongoing advances
achieve a more uniform set of internationally in communications and technology.
acceptable auditing standards, as well as with Generally speaking, developments in ac­
the IASC on its efforts to achieve a set of more counting have grown out of the reactions of
harmonized accounting standards. In mid- accounting professionals to new transaction
1995, the IOSCO and the IASC reached forms, contracts or instruments and have been
agreement on an agenda of those accounting largely local in nature. Such developments are
standards issues needing further attention. likely to continue in this fasi:iion into the
The IASC has targeted completion of work ·twenty-first century. Accounting is, and will
on these issues for 1999, with the hope (and remain, a utilitarian discipline shaped in large
expectation) that by the year 2000 the IOSCO measure by the needs of interested parties.
will find the then-completed set of IASC Even so, the twenty-first century is likely to see
standards sufficient to be the basis for finan­ far greater initiatives in the international
cial reporting by multinational companies in arena than have occurred to date. It is likely
international capital markets. The expectation that some international body will act as a
is that when the new IASC standards are of catalyst for further developments. guiding t':J.e
acceptable quality the IOSCO will adopt a accounting profession through changing cir-
 Accounting

cumstances. However, it remains to be seen the provision of capital as efficient as possible,

whether the catalyst for international initia­ with a consequent reduction in financing
tives will be a private sector standard-setting costs. Accounting will be caught up in these
body such as the IASC or the International pressures and will face the challenge of moving
Federation of Accountants or a body such as toward an internationally accepted package of
the United Nations, the European Commis­ accounting principles that will avoid the need
sion, the Organization for Economic and for constant restatements and/or reconcilia­
Cultural Development or even the IOSCO. tions of financial information. Currently, re­
International accounting harmonization statements and reconciliations are required to
will not be easy to achieve and change will facilitate the operation of the capital markets.
not be effected quickly. Time is needed to lt is probable that multinational companies
permit those who will be affected by changing will move to embrace IASC international
policies to become comfortable with new standards in some fashion during the first
procedures. Resistance to change always exists two decades of the twenty-first century. For a
and even when conditions are likely to effect time, these companies are likely to prepare
changes as pervasive as those contemplated by their basic financial statements in accordance
the proposed revisions to existing IASC stan­ with the accounting standards generally ac­
dards, the time-periods over which the cepted in their home countri s. Financial
changes can be expected to be implemented statements that satisfy the requirements of
are substantial. For example, should the IASC international standards will be prepared o·n a
at some future time revise its existing standard supplementary basis or a reconciliation from
on accounting for inventories to eliminate the national standards to IASC standards will be
acceptability of last in, first out (LIFO) as a prepared. At a later stage, multinationals are
costing assumption, this revision would prob­ likely to prepare their basic financial state­
ably not be accepted by many of the world's ments in accordance with international stan­
leading economic powers for a significant dards as securities regulators around the
number of years. A need for research into the world move to embrace these standards as a
tax-revenue implications of such a change means of increasing the efficiency of their
would arise and a balancing of competing capital-raising process. Economic incentives
interests would be necessary at various levels, will increase with the growing ease of access to
both in the government and private sectors. In international capital markets; this phenom­
the USA, for example, cooperation between enon will mean that multinational companies
the FASB, the SEC and the Department of the will probably be the leaders in implementing
Treasury would be necessary and the time international accounting standards..
required for the various processes to evolve Accounting has met the challenge of
could be substantial. Similar types of coop­ change for hundreds of years and as the
eration would be necessary in other countries. twentieth century winds down, the discipline
Each change contemplated would face numer­ shows ongoing evidence of its ability to adapt
ous hurdles and require sometimes lengthy to the changing needs of the world's financial
time-periods to resolve. and commercial structures.
The overriding phenomenon, in terms of ARTHUR R. WYATT
the future of accounting, is that business UNIVERSITY OF ILLINOIS AT
customs and practices are changing con­ URBANA-CHAMPAIGN
stantly in many places around the world.
Trade patterns are becoming more complex
Further reading
and international among countries. The need
for capital will continue to grow and capital Beaver, .H. (1981) Financial Reporting: An
markets will soon know no national bound­ Accounting Revolution, Englewood Cliffs, NJ:
aries. Accounting serves the needs of those Prentice Hall. (Classic text analysing the use of
who supply capital and those who employ it financial accounts and the evolution of annual
statements.)
and there will be increasing pressure to make
FINANCE AND SMALL BUSINESSES

Financial Accounting

a) The role of financial reporting

b) The conceptual framework underlying financial accounting
c) The financial accounting information system
d) Preparation of financial statements
e) Some issues in financial accounting

Overview

The beginnings of accounting, which precede even the first use of figures, date from before the time of recorded
history. The first attempts at modern corporate accounting, however, are usually traced to the late Middle Ages.
It was in northern Italy of the fourteenth and fifteenth centuries that the kind of accounting known as double-
entry book-keeping first saw the light of day. The first work to deal with these procedures, the Summa de
arithmetica geometr ia pr opo rtioni & proportionalita, was a treatise on mathematics written in Italian by a
Franciscan monk, Luca Pacioli, and printed in 1494. One of the book's chapters provided a full description of
the new accounting method 'invented ' by the merchants and bankers of Genoa, Venice and Florence and made
accessible to a wider audience by Pacioli.

Double-entry accounting, used throughout the world, is not a fixed set of techniques, but rather a system that
is continually being perfected and adapted to the needs of firms and their economic environments . Some
authors, such as the German economist Werner Sombart, would see it as a major factor in the development of
capitalism. Without question, double-entry book-keeping is still the primary information system available to
firms. Today, it is possible to define accounting as a system of introducing and communicating information
about the firm. This system can be divided into two main sub-systems. The first provides information used
within a firm itself for internal management. For this rea- son, it is called management accounting. The second
sub-system, which is the subject of the present entry, provides information for external use by a firm’s economic
and social partners. It is called general accounting, or, more frequently, financial accounting.

What is financial accounting used for? What constitutes its theoretical underpinnings and the logic behind it?
How does it work? What do the main documents associated with it look like? What are its limitations and
possible future developments? These are the main questions which will be dealt with below.

The role of financial reporting

The role of accounting has evolved signific-antly over the course of time. None the less, it can be examined and
illustrated by analogy with the master-servant relationship of another era. Whenever servants were given a task
or mission to complete for their masters, they were required to give a full account of precisely how the task or
mission had been carried out. Modem-day accounting may be regarded as just one of the means by which
servants can render an account to their masters, and through which the latter can verify that the task or mission
has been carried out in the service of their own interests.

The stewardship and reporting relationship

At the end of the medieval period, the large
 financial accounting

cities of northern Italy (Florence, Genoa and administrations and, more generally, to the
Venice) experienced considerable good for­ public.
tune in the spheres of banking and finance. The financial statements that firms produce
Their bankers and merchants, directors of the should ultimately satisfy many and varied
multinationals of their day, operated through­ needs for information. More specifically these
out the Mediterranean basin and northern documents should enable:
Europe. In order to carry out transactions
investors to evaluate their directors' man­
requiring large sums of money and often
agement performance and to make dec­
taking place in distant lands, they formed
isions about buying and selling shares;
associations and called on the services of
2 creditors to estimate the firm's capacity to
agents and stewards. We can understand their
reimburse loans;
need to find an accounting method that would
3 employees to judge the firm's capacity to
allow them, first, to check on the way in which
pay wages and salaries and maintain its
the stewards completed the missions entrusted
level of employment;
to them and, second, to decide how profits
4 suppliers to evaluate the firm's capacity to
should be divided up with their associates. The
honour its commitments;
then recently created double-entry book-keep­
5 customers to evaluate the firm's capacity to
ing system proved to be an instrument that
deliver orders placed;
went a long way towards meeting merchants
6 governments to measure taxable profits
needs for greater control and more informat­
ion on which to base decisions. and gain access to information necessary
for producing national statistics.
Perfected over a period of five centuries,
double-entry book-keeping still plays this Most of these needs are normally satisfied by
dual role, albeit considerably amplified in the kind of information concerning the firm's
large contemporary firms. The latter are more economic and financial situation which is
often run by professional managers who act provided in the balance sheet and income
for the numerous and geographically dis­ statement (profit and loss account).
persed shareholders who have no real control To the extent that a firm's books (that is, its
over the way the firm functions.•Shareholders accounting records) are kept by its directors
in such companies hold only their shares, the (or by accountants employed by them), we
value of which varies from day to day on the might legitimately ask how objective and
financial markets, and from which they expect credible they are. This is one of the main
income through dividends and increases in reasons that accounting adheres to two basic
share value. One of financial accounting's norms: first, accounting procedures through­
goals is to help shareholders evaluate the out the world are governed by rules and
way the firm is managed and to make dec­ standards - although how strict these regulat­
isions concerning the purchase and sale of ions are will differ from one country to
shares. This type of accounting should, in another- and, second, a firm's books must be
particular, furnish information on both the examined by public accountants, or auditors.
firm's financial situation and itseconomic and
financial performance.
Accounting regulations
In some countries, there is a long tradition of
Many users and many uses
rules and regulations governing accountancy.
In modern economies, firms' responsibilities In France, for example. this tradition began
have expanded significantly. Firms must give with a ministerial decree issued under Colbert
account of their activities, not only to their in 1673. It was in the twentieth century,
investors and creditors, but also to their other however, that regulation and standardization
economic and social partners, including their of accounting procedures gained momentum.
employees, suppliers and customers. They As can be seen in the example of the two
must supply information to governments and countries discussed below, France and the
 Financial accounting

USA, national accounting institutions and the creasingly international dimension. The Inter­
areas in which accounting practices are regu­ national Accounting Standards Committee
lated can differ significantly. (IASC), a private organization founded in
In the USA, the accounting profession has, 1973 whose members include over a hundred
from the outset, played an important role in accountancy bodies from more than eighty
standardizing accounting procedures. Until different countries, issues standards used
1972, committees formed by the American throughout the world. The standards are not
Institute of Certified Public Accountants compulsory, but a growing number of coun­
(AICPA), the national professional organiz­ tries and multinational companies have
ation of practising certified accountants, set adopted them. Within Europe, the European
the standards for ethical behaviour in ac­ Union (EU) has issued several accounting
counting, known as the 'Generally Accepted directives on company law, which must be
Accounting Principles' (GAAP). After 1972 applied by EU member states. The fourth and
this task was taken over by the Financial seventh company law directives are the most
Accounting Standards Board (FASB), an in­ relevant to accounting. The fourth covers
dependent organization which has strong ties public and private companies in all EU coun­
to the profession. The FASB has no regulatory tries and refers to valuation rules, formats of
powers. The only body with official regulatory published financial statements and disclosure
powers over accounting practices in the USA requirements. The seventh concerns consol­
is the Securities and Exchange Commission idated statements.
(SEC), which regulates companies issuing
securities to the public and/or listed on the
Financial accounting and auditing
stock exchange. In practice, the SEC imple­
ments standards formulated by the FASB and Public accountants offer their services to the
the accounting profession. general public on a fee basis. There are
In France, the initiative for standardization professional qualifications which should
in accounting has come, not from the profes­ guarantee their expertise and integrity. Public
sion itself, but from a government body accountants are organized in professional
known as the Conseil National de la Comp­ bodies or institutes, the first of which were
tabilite (CNC, National Council on Account­ formed in Scotland in the nineteenth century.
ing). The CNC is made up of representatives Professional public accountants can perform
of government, administrative bodies, the a wide variety of services, ranging from
accounting profession, industry and unions, income tax to management consulting, and,
as well as a certain number of university in particular, they are considered competent
professors of accounting. It issues opinions to give opinions on financial statements,
and recommendations which may, in some which gives greater credibility to these docu­
cases, give rise to official texts promulgated by ments. Before proffering such an opinion, the
the government or voted on by parliament. public accountant will perform an audit, that
Thus, the role of the state in this area is far is, an in-depth examination of the firm's
greater in France than it is in the USA. accounts and financial statements. It is his
The areas covered by standardization and or her task to ensure that all such documents
government regulations are not the same in all conform to standardized practices a-nd
countries. In the USA, standardization ap­ accounting regulations.
plies exclusively to the presentation and con­ The auditor's final opinion is given after
tent of financial statements, as well as to their publication of the financial statements issued
underlying principles. In France, standardiz­ by the firm in its annual report. All firms are
ation and regulation extend to book-keeping eager to obtain an unqualified audit report,
per se: French firms must use an official chart which means that the auditor has approved
of accounts to organize their books. the preparation of the accounts without
Furthermore, at the end of the twentieth restriction. The value placed on the opinion
century, standardization is taking on an in- will depend on the reputation of the public
Financial accounting

accounting firm responsible for giving it. amount of wealth invested in the firm by
Opinions issued by one of the six largest public the firm's owners. Equity consists of own­
accounting firms in the world are particularly ers' contributions (paid-in capital) on the
prized. These firms, known as the 'Big Six', one hand, and profits placed at the firm's
include Arthur Andersen & Co., Coopers & disposal (retained earnings) on the other.
Lybrand, Deloitte & Touche, Ernst & Young, Owners' equity for proprietorships and
KPMG Peat Marwick and Price Waterhouse. partnerships is often designated as capital;
Although all six were originally Anglo-Amer­ for a corporation, we refer to stockholders'
ican, they now have offices throughout the or shareholders' equity.
world.
In light of the definition given for owners'
equity, the balance sheet will satisfy the fol­
·2 The conceptual framework lowing equation:
underlying financial accounting Owners' equity (OE)=
The main questions asked by a firm's eco­ Assets (A) - Liabilities (L)
nomic and social partners are linked to its
This basic equation is often presented in the
financial situation and to its economic and
following way:
financial performance. To aid in replying to
these questions, financial accountants pro­ Assets (A)=
duce a set of documents summarizing the Liabilities (L) + Owners' equity (OE)
firm's position. These include the balance
The left side of the equation (assets) represents
sheet, the income statement, the statement of
the stocks of resources that are under the
retained earnings and the cash flow statement.
control of the business; the right side (liabil­
The fundamental principles and concepts
ities and owners' equity) shows the sources
underlying financial accounting are related to
from which the business obtained these
the preparation of the balance sheet and the
resources and, at the same time, the claims
income statement.
against them.
The foregoing notions may differ in both
Basic accounting concepts their definition and content from one country
to another. For example, in some countries,
The balance sheet is one of the major state­
equipment leased by a firm will be treated as
ments produced by financial accounting.
'assets'. In other countries, such a classificat­
Since it describes a firm's financial situation
ion would be against the law. The disparity
at a given time, it is also called a statement of
points up the rather contingent nature of
financial position or a statement of financial
accounting standards and practices.
condition.
In addition to the balance sheet, financial
The balance sheet is made up of three main
accounting furnishes another important
components: assets, liabilities and owners'
document, the income statement (or profit
equity. These elements can be defined gener­
and loss account). As its name suggests, this
ally as follows.
document shows the firm's income, which is
1 Assets are e"unomic resources that are measured in terms of the difference between
expected to provide future cash inflow or the firm's revenues and expenses during a
help reduce future cash outflow (examples given financial accounting period:
include cash, i_nventories and equipment).
Income= Revenues - Expenses
2 Liabilities are a firm's economic obligations
to outsiders or claims against its assets by The income statement isconsistent with the
outsiders (for example, loans payable). balance sheet, and the notions of revenues and
3 Owners' equity is the residual interest in, or profits are linked to the concepts of liabilities,
the remaining claims against, business as­ assets and owners' equity. Revenues may be
sets after liabilities are deducted. It is the defined as increases in owners' equity arising
 Financial accounting

from increases in assets received in exchange than the financial year (known as interim
for the delivery of goods or services to custom­ periods) at the end of six months, three
ers. Expenses are decreases in owners' equity months or even one month; but the published
that arise because goods or services are deliv­ accounts period is almost always one year.
ered to customers. Revenues and expenses, The going concern, or continuity, principle
therefore, are nothing more than variations of rests on the assumption, made on the balance
owners' equity incurred in the course of the sheet date, that the firm as an entity will last
firm's business activity; income, measured as indefinitely and will not be forced out of
the difference between revenues and expenses, business by bankruptcy. The going concern
is an element of owners' equity. principle is the opposite of the immediate
The preparation of the balance sheet and liquidation concept and has practical conse­
income statement is based on a certain number quences. It is, in particular, a justification for
of hypotheses and conventions usually desig­ using historical cost to value assets.
nated by the expression 'fundamental prin­
ciples'. These principles were forged by the
earliest accounting practitioners. In the first Measurement principles
half of the twentieth century, they were set In financial accounting, the monetary prin­
forth explicitly by the first theoreticians of ciple dictates that we measure the value of
accounting and by various standardization goods in terms of money. Estimating this value
commissions. The fundamental principles, is traditionally based on two principles, the
which serve as basic points of reference for principle of historical cost and the principle of
formulating accounting standards, fall into conservatism.
the two broad categories of observation prin­ The monetary principle rests on the assump­
ciples and measurement principles. tion that the monetary unit used to measure
value is stable - using a monetary unit as a
measure of value has the advantage of allow­
Observation principles
ing us to group together the values of different
Observation principles define the spatial and types of goods. However, the assumption of
temporal framework within which financial stability clearly does not always correspond to
statements are developed. reality. Where inflation is rampant, as it is in
The entity principle embodies the necessity many countTies, the monetary unit will fall in
for precise delimitation of a reporting entity. value. Consequently, provisions must be made
Preparing the balance sheet presupposes that to account for changes in the monetary units
a firm's assets and liabilities can be clearly and to revalue assets.
identified, and that thefirm is a distinct entity The historical cost principle dictates that
distinguishable from other entities. The firm's assets are entered on the books at their
activity should not, for example, be confused historical cost and, later, when the balance
with that of its owners. sheet is drawn up, that their value in account­
The time period principle allows for the ing terms is determined bydeducting from the
division of the life of the firm into accounting historical cost the depreciation incurred from
periods, because, obviously, we cannot wait the date of entry until the balance sheet date.
until a firm goes out of business to pass The historical cost of an asset is the amount
judgement on its financial situation and in­ originally paid to acquire it (the purchase
come. A balance sheet and an income state­ price) or to produce it (the production cost).
ment are issued at the end of each accounting The accounting value calculated in this way is
period, which will often, but not necessarily, often very different from the current value of a
coincide with the calendar year. Firms whose given asset. In some countries, firms are
activity is seasonal may choose to close their allowed to substitute the current value for
accounts at the time of year when their the accounting value deducted from the his­
business is at its lowest ebb. Firms also prepare torical cost.
financial statements that cover shorter periods The conservatism, or prudence, principle
 Financial accounting

gives rise to a curious practice which consists

Towards a rational conceptual framework?
of opting invariably for the method of eval­
uation that gives the lowest figure. To cite an Developed over more than five centuries, the
example, in order to value stocks, we would fundamental accounting principles discussed
apply the lower-of-cost-or-market conven­ above can prove to be contradictory and ill­
tion: either the current market value or the suited to the needs of contemporary users of
historical cost - whichever is lower - is con­ accounting information made available by
servatively selected as the basis for the val­ firms. The application of the conservatism
uation of inventories on the balance sheet. principle, for example, will tend to restrict
The prudence principle causes underval­ the application of the historical cost principle.
uation, not only of assets, but also of incom When goods have depreciated significantly,
and owners' equity. Those who use and they are no longer valued at their historical
consult financial statements are sometimes cost, but at their current value. Moreover, it is
critical of it. Accountants consider the prud­ legitimate to ask if the combined application
ence principle to be a means of protecting of the historical cost and conservatism prin­
themselves against the optimism of company ciples is actually suitable for indicating the
directors, who exhibit a strong tendency to value of a firm's assets in an inflationary
choose methods of valuation resulting in the period or if it would not be wiser to use, for
highest possible figures. Conservatism is also example, the replacement value instead.
an obstacle to creative accounting, which is Problems connected with the fundamental
the manipulation of figures to create a more accounting principles exist because there are
favourable impression of a firm's financial many users and many uses of accounting
performance than might otherwise be the case information, and because the objectives of
(see CREATIVE ACCOUNTING). financial accounting are not well defined. In
All the principles discussed above are used the 1970s, certain institutions, such as the
almost universally. Their interpretation, how­ FASB, attempted to assign precise objectives
ever, may vary significantly from one country to financial accounting and to create a more
to another. Accounting practices in both Ger­ rational conceptual framework for it. The
man and Swiss firms, for example, are well FASB defined a conceptual framework as a
known for their strict application of the con­ constitution, a coherent system of interrelated
servatism principle. objectives and fundamentals that can lead to
consistent standards and that prescribes the
The accruals principle
nature, function and limits of financial
accounting and financial statements.
Measuring income is a difficult problem in According to the FASB's conceptual
accounting. Income measurement is founded framework, financial reporting should pro­
on the accruals principle, which is distinguish­ vide information which will enable present
able from the cash principle. The accruals and potential investors, creditors and other
principle recognizes revenues when they are users to make rational investment decisions.
earned and expenses when they are incurred. The concepts and principles of financial ac­
In contrast, the cash principle recognizes counting should respect this objective. Such
revenues when they are received and expenses an objective is coherent with the economic
when they are paid in cash. According to the characteristics of the USA.
accruals principle, revenues must be recog­ According to a UK discussion paper pub­
nized when goods and services are delivered to lished by the Accounting Standards Commit­
customers in exchange for cash or claims; if tee, known as The Corporate Report, the
cash is not received immediately, there should fundamental objective of corporate reports is
be reasonable certainty regarding payment. to communicate the economic measurement
Expenses are recognized in the income state­ of, and information about, the reporting
ment from the period in which their economic entity's resources and performance. Such
benefits are consumed or used up. communication is expected to be useful to
those having reasonable rights to such information. Consequently, financial reporting should
provide information not only to investors, but to a full range of users. This concept of financial
reporting differs markedly from that of the FASB.

At the international level, the IASC produced a 'Framework for the preparation and presentation of
financial statements’, which
A profit-making sale of $500,000 on credit results in an increase in money owed, a decrease in
stock (corresponding to the cost of the $300,000 of goods sold) and an increase in owners' equity
equal to the amount of profit made on the sale ($200,000).
ASSETS = LIABILITIES + OWNERS EQUITY

Looks very similar to the FASB framework. By the mid-1990s, however, such attempts to develop
a rational conceptual framework continued to encounter numerous difficulties and remained
entirely exploratory in nature.

The financial accounting information system

The most original feature found in the financial accounting information system is undoubtedly its
use of a recording principle discovered by northern Italian merchants in the late Middle Ages,
namely the double-entry principle. This principle has been interpreted in many different ways. It is
especially interesting to examine it in relation to the basic balance sheet equation.

Double-entry principle
Applying the double-entry principle can be seen as rendering in accounting terms the impact of a
firm's transactions on the balance sheet. The following examples will illustrate how the principle
is applied.

(1)A $100,000 purchase of merchandise on credit will create both an asset (an inventory
item) and a debt (to a supplier):
ASSETS LIABILITIES + OWNERS' EQUITY
 Using these examples, we can set forth a general statement concerning the double-en- try
principle : any flow of funds affecting any part of the balance sheet (A, L or OE) is
necessarily followed by a reverse flow of the same amplitude affecting one or more other
parts of the balance sheet so that the basic equation A - ( L + OE) = 0 remains valid.
The three main components of the balance sheet (A, L, OE) - each of which may either
increase or decrease - present nine basic recording possibilities as shown in Table 1. The
lines of the table correspond to flows (decrease in assets, increase in liabilities, in- crease in
owners' equity) which, when consid- ered in isolation , would have the effect of changing the
implicit relation of the balance sheet into a negative equation (< 0). The columns are arranged
symmetrically to corre- spond to flows (increase in assets, decrease in liabilities, decrease in
owners' equity) which, when considered in isolation, would have the effect of changing the
implicit relationship of the balance sheet into a positive equation (> 0). Each box on the table
corresponds to a basic transaction recorded according to the double-entry principle.

Merchandise Account payable Table 1 Nine basic recording possibilities

+ 100,000 + 100,000
(2) A cash payment of $250,000 by a client
A- 't L• OE•

makes one asset (the right to receive money A.J l 5 7

from the clien t ) disappea r and anot her (A.J,A t) (A .J,L•) (A,,OE•)
(money) appear: Lt 4 2 9
ASSETS LIABIL- + OWNERS' (Lt,A t) (Lt,L.J) (Lt,OE.J)
ITIES EQUITY
Cash Receivables
OEt 6 8 3
+ 250.000 - 250,000 (OEt,A t) (OEt,L.J) (OEt,OE.J)
 Financial accounting

Asset accounts Liability accounts Owners' equity accounts

+ + +
Figure I Assigning positive and negative flows

Accounts and the conventions of debit and which falls under the definition of asset
credit account, is as follows:
A firm's transactions are recorded in units of Debit Cash Credit
memory called accounts. Taken as a whole
these memory units make up the general Increases in I Decreases
accounting ledger. cash in cash
Each line on the balance sheet corresponds Figure 2 Format of the cash account
to at least one account, allowing us to follow
changes in the figures recorded for a given line. We can now see how the transactions used
Traditionally, since the end of the Middle above to illustrate the double-entry principle
Ages, an account has been presented as a are recorded on a firm's books. For a $100,000
two-olumn table, rendered schematically as purchase on credit, the asset acrnunt 'mer-
a capital T. To the right is the debit column; to chandise' is increased (debited) and the liabil-
the left, the credit column. The words 'debit' ity account ('account payable') is decreased
and 'credit' are of Latin origin: debit means (creditd) as follows:
'he/she ought (to pay someone)'; credit means For a customer's cash payment of $250,000,
'he/she trusts (someone to pay him/her)' . The Merchandise account Note payables account
terms have lost their original meanings, how-
ever, and have become simply the names for 100,000 1 .................................1..100.000
the right- and left-hand columns of an
account. Figure 3 Recording a credit purchase
The schematic representation of accounts
enables us to analyse information within the the asset account ('cash') is increased (debited)
double-entry framework without using the and another asset account ('receivables') is
plu a.nd min signs. This can be done by decreased (credited) as follows:
ass1gnmg positive flows to one column and For a $500,000 sale of merchandise resulting
negative flows to the other - a convention Cash account Receivables account

I ......... ........
which has been practised since the Middle
Ages and is universally adhered to. The con- 250,000 250,000
vention varies according to whether the
Figure 4 Recording a cash receipt
account is an asset account, a liability account
or an ers' equity account (see Figure 1).
Pos1t1ve flows are placed in thedebit side of in a $200,000 profit on the original $300,000
an asset account, but on the credit side of a purchase price, a debit of $500,000 is made to
liability or owners' equity acr.ount. Negative 'receivables', a credit of $300,000 is made to
flows are recorded in the credit column of 'merchandise' and a debit of $200,000 is made
asset accounts, but in the debit column of to 'income', as shown in Figure 5. As we can
liability or owners' equity accounts. For see, for each entry, the overall total for debits
example, the format of the cash account, equals the overall total for credits.

Merchandise account Receivables account Income account

i. ..............
1 300,000 .........500,000 .. 1200.000
Figure 5 Recording a sale of merchandise
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53
54
55
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4 .4 Basic Accounting Terms

Asset The property of the business entity such as land, building, stocks etc.
Usually split into current assets, i.e., working capital assets and long-term
assets, i.e., fixed assets.

Balance Sheet A summary picture of what the business owns, i.e., assets and what it
owes, i.e., liabilities as on a particular date. Usually balance sheet is
prepared at the end of one year. However it can be prepared as at the end
of every month also.

Capital Normally means permanent or long-term funds of the business –

introduced by the owners of the enterprise and/or borrowed in the form of
long-term loans from banks and fi ncial institutions. In the case of a
limited company, the owners’ capital is called share capital. The
borrowings are called debt capital.

Cash flow This usually means a statement showing all cash inflow, i.e., cash receipts
and cash outflow, i.e., cash expenditure. The statement is prepared at least
for a period of one month with the objective of monitoring cash flows in
the business and managing liquidity.

Creditors Persons to whom the business enterprise owes money due to goods or
services supplied by them or for expenses.

Current asset Working capital assets which enable a business enterprise to achieve what
is known as sales revenue by the process of turn-over of the current assets.
Current assets constantly change form from cash back to cash through the
activity of the firm, i.e., trading or manufacturing or service.

Current liability Debt of the business enterprise which is to be settled within a period of 12
months. They are also called short-term liabilities or working capital
liabilities, like creditors, accrued expenses etc.

Debt Money owed to external agencies, like loans, creditors etc. This is
classified into short-term, medium-term/long-term etc. depending upon the
period of repayment as well as the purpose for which it has been incurred.
If it is for fixed asset, it is medium to long-term and if it is for working
capital, it is short-term.

Debtors The money that is owned by the business and owed to it by the customers
to whom it has sold goods or supplied services on credit basis.

57
Depreciation A charge against business income to enable a business enterprise to keep a
certain % of the value of a fixed asset every year with a view to replace it
at the required time. It is a book or non-cash expense but is recognised as
a business expense by the revenue authorities.

Dividend Return to a shareholder in a limited company on its equity investment paid

by the company out of its taxed profits every year and is often referred to
as profit distributed to share holders.

Equity Money brought in by the owners in the case of a limited company. It is

permanent investment in the company and is paid back to the owners only
upon liquidation of the company.

Fixed assets Long-term business assets, like land, building, machinery, vehicles etc.
which act as catalysts in the activity of the enterprise but do not form a
part of the finished goods of the manufacturing company or stocks in trade
in the case of a trading enterprise. They are subject to wear and tear and
hence require replacement after some time. Hence, the business enterprise
claims depreciation on the e assets and charges the amount to its revenue
income.

Gearing Same as leverage. A measure of external debt in relation to the capital of

the owners of the enterprise. The higher the gearing, the greater the risk
and vice-versa.

Inventory Comprises materials like raw materials, consumables/ machinery spares

and packing material, work-in-progress and finished goods. Together with
bills receivables, form bulk of current or working capital assets.

Insolvent A business enterprise is considered insolvent when it is not able to pay its
liabilities in full from the proceeds of its assets.

Liability Amount owed by the business enterprise to outside agencies, which have
provided resources either in the form of money, as in the case of bank over
draft or goods as in case of creditors or services as in the case of accrued
expenses.

Loss Excess of expenditure over income in a particular accounting period.

Net current Difference between current assets and current liabilities. This
Asset is called as Net working capital.

58
Net Fixed assets Gross fixed assets (purchase price) as diminished by depreciation
(cumulative).

Overdraft A credit facility by which a customer of the bank can draw up to a pre
determined limit against some tangible security like inventory or
receivables or mortgage.

Payables Also known as bills payables or money owed by the enterprise to various
creditors.

Profit An excess of sales revenue over expenditure.

Profit and loss A detailed and consolidated statement of all income and expenditure
Statement prepared at the end of a specific period, like month, quarter, half-year and
year. However, the revenue authorities are insistent on yearly statements
and the other statements are meant for management purposes.

Receivables Also known as sundry debtors or bills receivables or book debts.

Represent money owed to the enterprise by debtors.

Reserves or Accumulated profits retained in business over a period of time.

Retained This is net of profit distributed in he form of dividend.
Earnings

Returns Either purchase returns or sales returns representing goods returned on

purchases or sales due to defects which stand adjusted either in the
amounts due from us or due to us or by replenishment of stocks with
quality goods. Purchase return is also called return outward and sales
return is also called return inward.

Shareholders’ Share capital plus all kinds of reserves representing profit

Funds retained in business over a period of time.

Solvent Means that the business enterprise is able to meet its liabilities with all its
assets.

Working capital Gross working capital = Total current assets

Net working capital = Total current assets (-) total current liabilities.

Difference between cash and fund – Cash means “money” and does not include credit or kind.
Fund includes every thing like credit or kind. For example, a supplier supplies material on
credit for which payment is not made immediately. Till the payment is made by us, the supplier
has given us money’s worth of goods. Similarly services would also be provided. Thus fund

59
could mean, either “physical cash” or “credit” for supply of goods or services. Hence, at times,
the term “fund” also refers to money or money’s worth (OR) cash or kind.

Another example is in case capital is brought into an enterprise in a form, other than cash; say in
the form of land or building or machinery or vehicle. This is also fund but would not fall under
the category of cash.

Components of cash flow statement – Cash management is usually done on the basis of cash
inflow and cash outflow. The cash receipts and cash expenditure are reflected in a statement
called “cash flow statement”. This statement can be prepared at a predetermined frequency, say
every day, every week, every fortnight or every month. Usually it is not prepared at a frequency,
which is less than a month. It has revenue receipts, revenue expe diture, capital receipts and
capital expenditure unlike profit and loss account, which has only revenue items of income and
expenditure. The details of revenue receipts/revenue expenditure and cash receipts/cash
expenditure are given in the following points.

Medium and long - term liability – Any lia lity, which is not due within a period of 12 months
but due within a period of 5-7 years like debenture or term loan, is called a medium-term
liability. In case the liability is due be ond 7/10 years like deep discounted bond, then it is called
long–term liability.

Revenue Receipt – Receipt from operations unlike capital receipt like sale of a capital equipment
etc. Usually a period of 12 months is taken as the period in which revenue receipt should occur.

Revenue Expenditure – Expenditure for operations unlike capital expenditure like purchase of
machinery etc. Usually a period of 12 months is taken as the period in which revenue
expenditure should occur.

Concept of ‘Profit’ as distinct from ‘Income’ – If the revenue receipts are higher in value than
revenue expenditure, the business enterprise is said to be in ‘Profit’; otherwise it is in ‘loss’.
Income or revenue is the result of activity of the business enterprise, be it manufacturing, trading
or services, while profit is the measure of financial performance for the year of the business
enterprise. Profit is the end result of revenues for the year. While revenues occur throughout the
financial year (1st April to 31st March in India), profit is determined at the end of the year.

Capital Receipt – Receipt from owner in the form of capital or loans from lenders which need
not be repaid within 12 months. Generally all sources, which go in for purchase of capital assets,
are called capital receipts.

Capital Expenditure – Expenditure towards purchase of capital assets or repayment of an earlier

capital receipt.

Opportunity cost and opportunity gain – A phenomenon arising out of comparison between
returns on alternative investment opportunities available to an investor.

60
 For example an investor gets return of 13% p.a. in bank deposits, while he can get 18% in
shares, the opportunity cost of investing in bank deposits vis-à-vis the investment in shares is
18% - 13% = 5%. As against this, the investment in shares fetches an opportunity gain of
5% p.a. Thus opportunity cost and gain are relative terms and absolutely dynamic, as the
returns even in the case of same investment vary from time to time.
Opportunity cost or gain is a dynamic concept and not static one. Further it is a product of
time and holds good only for a short period. It is always determined for a pair of alternative
investment opportunities.

Pre-tax expenditure and post-tax allocation – All operating expenses like interest, wages salaries
etc. are pre-tax expenditure as they are met out of income of an organisation and not out of
profits. As opposed to this, profits distributed to owners of the com ny are out of taxed profits
and hence they are referred to as post tax allocation. For example, dividend is a post tax
allocation. This can be appreciated by keeping in mind three stages of income profit and profit
allocation in a business.

Stage 1 – income from operations and other income like dividend etc.

Stage 2 – determination of profit for a given period after setting off all the operating
expenditure – pre-tax expenditure, against income for the same period and payment of tax on
the same.

Stage 3 – Distribution of profit after tax (some portion) among the owners of the company in
the form of dividend – post-tax allocation, while keeping the balance portion in the business
itself in the form of reserves.

Difference between liquidity and profitability – While liquidity means availability of cash to
meet all the liabilities, it need not indicate profitability of operations. An enterprise can be liquid
because its position of cash is comfortable, i.e., the cash inflow is greater than cash out flow
because of owner’s capital as well as other borrowed funds, whereas, its operations need not be
profitable, i.e., expenses could be more than income. On the contrary, an enterprise can be
profitable but because of delay in realisation of sale bills, it could be in cash crisis.
Thus liquidity and profitability are two independent phenomena and mostly move in opposite
direction. Example, current assets. The level of current assets does indicate the level of liquidity
available with an enterprise and in case it is too high the profitability does dip in due to the cost
of carrying a high level of current assets and vice-versa.

Broad break-up of operating expenditure in a manufacturing unit –

Expenses relating to production –

a) Expenses on material – raw material, packing material, consumable stores and machinery
spares;

b) Wages paid to workers including employer’s contribution to Provident Fund, bonus, ex-
gratia, uniform and other incidental expenses etc.

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c) Expenses for manufacturing like depreciation on fixed assets used in factory, repairs and
maintenance on fixed assets used in factory, salaries paid to factory personnel, utilities like
power, water and fuel etc.

Expenses relating to administration – General and administrative expenses like salaries

paid to administrative personnel, other administrative expenses, a host of them like printing
and stationary etc.

Expenses relating to sales – Selling expenses, both direct and indirect.

Finance expenses – Interest, commission, brokerage, discount and others.

Note: In the case of a trading unit, there will be no manufacturing expenses and hence
manufacturing expenses would be absent. However, material would be replaced by trading
stocks and further, if the trading unit repacks the material before selling in the market,
packing expenses would also be incurred and this has to be included.

Similarly, in the case of a unit exten ing services, be it in finance or any other field, the unit
will not incur any expenditure on account of materials at all. Hence, in the case of a service
unit, the expenses would only be general and administrative expenses, besides selling
expenses, if any, and of course, financial expenses towards loans taken etc.

A sample of “Profit and Loss” Account (Rupees in Lacs)

Income from operations 100

Operating expenses:
Salaries 30
Repairs and maintenance 3
Depreciation 10
Office and general expenses 10
Marketing expenses
Including Commission 7
Interest and other
Charges 10
Total expenses 70
Profit before tax 30
Tax say at 35% 10.5
Profit after tax 19.5
Dividend 7.5
Profit retained in
Business 12.0
(Retained earnings)

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Learning Points:

 Interest is charged to income before determining the profit of the organisation. Once the
profit of the organisation is determined, tax is paid at the stipulated rate and the dividend is
paid only after this. Thus, dividend is profit allocation.

Opportunity cost

Suppose there are two alternative investments available to us, say one in bank deposit and the
other in shares. While the bank gives a rate of interest of 12% p.a., the return on shares is 18%
p.a.

This means that if we were to invest in shares, we ould gain 6% p.a. in comparison with the
return on bank deposit. This is known as the opportunity gain for investment in shares, in
comparison with investment in bank deposits. Similarly, investment in bank deposit would
entail a loss of 6% p.a. in comparison with investment in shares. This is known as the
opportunity cost for investment in bank deposit in comparison with investment in shares.

Thus, for every pair of alternative investment opportunities, there exists an opportunity gain or
opportunity cost, depending upon the respective rates of return. Two investments give the same
rate of return rarely and in case the rate of return is the same, there is neither an opportunity cost
nor an opportunity gain. It hould be noted that the concept of opportunity cost or gain is a
dynamic concept and not static one. It keeps on varying from time to time in accordance with
the changes in the rates of return for the same investment under consideration and is exclusive
for a pair of alternative investment opportunities at a given time.

It is seen from the above that the opportunity cost for cash on hand is the highest at any time, as
idle cash does not earn any interest. Any investment of this cash would fetch some return and
hence in comparison with a investment, cash suffers from opportunity cost. It would also be
noted that generally, the rate of return increases with the increase in risk associated with a
business.
This is so, as with higher risk, investors would be attracted only when the return is higher in
comparison with a less risky investment. This leads to the economic maxim “Risk and
Return go together”.

Secondly, while abundant cash would increase the liquidity of the enterprise, the cost is also high
for holding high level of cash. Hence, the second economic maxim, “Liquidity and
Profitability are inversely related to each other”.

Importance of “Depreciation”

The fixed assets employed in business are subject to “wear and tear”. This requires
replacement on a regular basis, as the enterprise should not suffer for want of proper asset for
production, at a future date. Hence, it is only prudent that a certain sum, as per the rules every
year, is set aside from the business income in the form of “depreciation”, so that when the time

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comes for replacement of a fixed asset, you will have created sufficient “cushion” in the
business through the amount of “depreciation” ploughed back.

The importance of “depreciation” does not rest there. By claiming depreciation, we are
reducing the profit for the year and thereby tax.

As there is no “cash out flow” involved in depreciation, the entire funds are available with the
enterprise. Thus, depreciation is at once a “business expense” and a “fund”.

Learning Points:

 Depreciation is at once an expense and a fund (resource).

 In the SLM the value of the asset can reduce to “zero”, while in the WDV, this would not
happen.

Revenue receipt/expenditure and Capital receipt/expenditure

Revenue receipt is defined as an “inflow”, which is recurring like sales revenue, dividend income
etc. It is also referred to as “revenue income”. Revenue expenditure is also recurring and hence
all the operating expenditure is revenue expenditure. Revenue receipt and revenue expenditure
decide the profit for the year, whereas, capital receipt is outside the purview of the profit and loss
account.

Then, what is a capital receipt?

Any inflow of a capital nature, like increase in capital of the owners, fresh loans taken from
outside etc. is a capital receipt. The sources for capital receipts are as under:

Share capital
Term loan
Debentures
Fixed deposits for more than 12 months
Unsecured loans from relatives, friends and promoters etc.

What is a capital expenditure?

Purchase of any fixed asset

Repayment of any earlier capital receipt like term loan, debenture etc.

While operating expenditure can be met from operating income, capital expenditure can be met
only out of capital receipts and not out of revenue income.

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 In this connection, it should be noted that profit and depreciation are taken as capital receipt even
though profit arises out of the excess of revenue income over revenue expenditure and
depreciation is an operating expenditure. Once income tax is paid on the profits, the residual
amount with depreciation added back, known as “internal accruals” constitutes capital receipt
and forms the major source for repayment of term loans or debentures.

Learning points:

 Revenue income is meant for meeting revenue expenditure and not capital expenditure.
 Capital receipt is necessary to meet capital expenditure and if revenue receipt is used for
meeting capital expenditure, there will be liquidity problem. However, capital receipt like
capital from the owners, debentures, retained earnings, depreciation etc. can be used for
revenue expenditure.
Depreciation as an expense is a part of the profit and loss account. Similarly, profit after tax also forms
part of the profit and loss account. However, once profit is taxed and retained in business, it is
reflected under “reserves” as a capital receipt. This is so, as profit retained in business belongs to the
equity shareholders. Similarly, depreciation is claimed on all fixed assets, excluding land, and hence,
as a fund, is treated as a capital receipt.

ALL THE BEST!!!!

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