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Accounting Concepts
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Accounting Basics
▸ The system of recording and summarizing business and financial
transactions and analyzing, verifying and reporting the results for an
enterprise’s decision-makers and other interested parties
▸ The measurements and recording of this data are accomplished
through keeping a balance of the accounting equation. The
accounting model or equation: Assets = Liabilities + Owners’ Equity,
is the basis for all double-entry accounting
▸ The simplest and most fundamental account format is T account
▸ Every transaction recorded in the accounting records has both a
debit and a credit entry; hence the term double entry
▸ All transactions are recorded in accounts called asset account,
liabilities account, owners’ equity account, revenue account and
expense account.
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Accounting Basics Contd….
▸ Legitimate transactions leave an audit trail. The accounting cycle
starts with a source document such as invoice, cheque, receipt or a
receiving report
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Accounting Methods
▸ There are two primary methods of accounting; cash-basis and
accrual-basis. The main difference between the two methods is the
timing in which revenues and expenses are recorded
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Cash-basis accounting involves recording revenues and expenses based on when a company
receives or pays cash. The advantage of cash-basis accounting is simplicity, and the major
disadvantage is that the cash-rich companies might be able to overstate their financial health by
having large amounts of unrecorded accounts payable.
Accrual-basis accounting requires revenues to be recorded when they are earned and expenses
to recorded when they are incurred irrespective of the timing of the payment. This method
provides immediate feedback to the companies on their expected cash inflows and outflows
Note: GAAP mandates the use of accrual basis accounting
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Financial Statements
▸ Financial statements are consolidated reports of summarized results of
an accounting cycle, that present financial position and operating results
of an entity.
▸ Financial statements are prepared either in conformity with generally
accepted accounting principles (GAAP), such as IFRS or a country’s
specific accounting standards, or some other comprehensive basis of
accounting
▸ Typical financial statements include; balance sheet (statement of
financial position), income statement (statement of profit or loss),
statement of cash flows, statement of changes in owners’ equity or
statement of retained earning
Note: Financial statements might also include other financial data
presentations such as statement of operations and statement of revenues
and expenses etc
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Financial Statements Contd…
▸ Balance Sheet: The balance sheet, or statement of financial position
provides insight into a company’s financial situation at a specific point in
time, generally last day of the accounting period. The balance sheet is an
expansion of the accounting equation Assets = Liabilities + Owners’ Equity.
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Assets are resources owned by a company. Generally, the assets are presented
on the balance sheet in order of liquidity or how soon they can be converted to
cash
Liabilities are the obligations of the company. Liabilities are presented in order of
maturity. Those likely to mature within one year are current liabilities and those
more than one year are long-term liabilities
Owners’ equity in a firm generally represents the amount from two sources –
owners’ contribution (common or capital stock and paid-in-capital) and
undistributed earnings (usually referred to as retained earnings)
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Financial Statements Contd…
▸ Income Statement: Income statement, or the statement of profit or loss details how
much profit or loss a company earned during a period of time such as a quarter or one
year. Two basic type of accounts are reported on income statement; revenues and
expenses. Revenues represent amount received from sale of goods or services during
the accounting period. Most companies present the net sales or net service revenues
as the first line item on the income statement.
▸ Statement of Cash Flows: Statement of cash flows reports a company’s sources and
uses of cash during the accounting period. The statement is often used by potential
investors and other interested parties in tandem of income statement to determine a
company’s true financial performance during the period being reported. The statement
of cash flows has three sections:
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Cash flow from operating activities
Cash flows from financing activities
Cash flows for investing activities
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Financial Statements Contd…
▸ The Statement of Changes in Owners’ Equity and Retained Earnings: The
statement of changes in owners’ equity details the changes in total owners’
equity amount listed on the balance sheet. Because it shows how amounts
on the income statement flows through balance sheet, therefore, it also acts
as the connecting link between the two statements
▸ Similar to the changes in owners’ equity, the statement of changes in
retained earnings details all transactions affecting the retained earnings
during the accounting period
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Generally Accepted Accounting Principles
(GAAP)
▸ In order to enhance the transparency and comparability of
financial reporting, the standard setters have been working
towards having a uniform set of accounting standards. The
International Financial Reporting Standards (IFRS) have
been adopted as GAAP. However some countries like USA,
have retained their own set of accounting standards that form
GAAP for reporting countries in those jurisdictions. Currently
there is no universally accepted accounting standard
▸ IFRS is considered as principle-based accounting framework
while US GAAP is known to be a rule-based accounting
framework
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Qualitative Characteristics of useful Financial
Information
▸ Relevance
▸ Materiality
▸ Faithful Representation
▸ Comparability and Consistency
▸ Verifiability
▸ Timeliness
▸ Understabability
Comparability is the goal and consistency helps to achieve it. However,
both comparability and consistency do not prohibit a change in
accounting principle previously employed, if one of the following
circumstances apply:
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The change is required by a standards or interpretation
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Changing of Audit Principle by an Entity
Comparability is the goal and consistency helps to achieve it. However,
both comparability and consistency do not prohibit a change in
accounting principle previously employed, if one of the following
circumstances apply:
▸ The change is required by a standards or interpretation
▸ The change would result in a financial statement that would provide
more reliable and relevant information about the effects of
transactions, other events or conditions on the entity’s financial
position, financial performance or cash flows
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Going Concern
There is an underlying assumption that an entity will continue as going
concern; that is, its life will be long enough to fulfil its financial and legal
obligations. Any evidence to the contrary must be reported in the
entity’s financial statements
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Measurement of the Elements of Financial
Statements
Several different measurement bases are employed to different degrees and in
varying combinations in financial statements, and they include:
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Historical cost: Assets are recorded at the amount of cash or cash equivalents
paid, or the fair value of the consideration given to acquire them at the time of the
acquisition
Current (replacement) cost: The price which will have to be paid if same or
equivalent assets are acquired currently.
Realizable (settlement) value: The cash or cash equivalent that could currently be
obtained by selling the asset in the market in an orderly disposal.
Present value (discounted): The present discounted value of the future net cash
inflows that the asset is expected to generate in the normal course of business
Fair value. The price that would be received to sell an asset in an orderly
transaction between market participants at the measurement date
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Departure from GAAP
There may be occasions when an entity may require to deviate from GAAP.
However, when is it justified is a matter of professional judgement. Generally
departure from GAAP can be justified under fol circumstances:
▸ There are concerns that assets and income would be overstated and
expenses or liabilities would be understated
▸ It is common practice in entity’s industry for a transaction to be reported in a
certain way
▸ The substance of the transaction is better reflected by not strictly following
GAAP
▸ A departure produces results that are reasonable under the circumstances
▸ Expected cost of following GAAP exceed the expected benefit of compliance
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Principle of Conservatism
The principle of conservatism requires that when there is any doubt, one
should avoid overstating assets or income and understanding expenses
or liabilities. The intention is to provide reasonable guideline in a
questionable situation
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Materiality
The amount an item is material if its omission would affect the
judgement of a reasonable person who is relying on the financial
statement. The materiality threshold does not mean that
immaterial items do not have to be recorded; rathe, strictly
following GAAP is necessary only when the item has a significant
effect on financial statement of an entity. In addition, aggregate
impact of immaterial items should also be considered
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Cost-Benefit
A departure from GAAP is permitted if the expected cost of
reporting a transaction in compliance with GAAP exceed the
expected benefits of compliance. However, the fact that
complying with GAAP would be more expensive or would make
the financial statements look weaker is not a reason tto use nonGAAP method of accounting for a transaction
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Financial Statement Fraud
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Occupational Fraud
The use of one’s occupation for personal enrichment through deliberate misuse of
misapplication of the employing organization’s resources or assets. Three major
types of occupational fraud are:
Conflict of
Interest
Bribery
Illegal
Gratuities
Economic
Extortion
Theft of Cash
Receipts
Net Worth /Net
Income Under
Statement
Net Worth /Net
Income Over
Statement
Inventory and
other Assets
Cash
Theft of Cash
on Hand
Financial Statement Fraud
Asset Misappropriation
Corruption
Fraudulent
Disbursements
Larceny
Misuse
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What is Financial Statement Fraud
Deliberate misrepresentation of financial condition of an enterprise accomplished
through the intentional misstatement or omission of amounts or disclosures in the
financial statement to deceive financial statement users.
Financial statement fraud is a means to an end, rather than an end itself:
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Creating a delay, so they can quietly fix business problems that prevent their
company from securing loans or complying of covenants etc
To obtain or renew financing that would not be granted or would be smaller
otherwise
Securing personal benefits like bonus money etc which are calculated based on
sales or profits
Financial statement fraud usually has devastating effect company’s reputation
and financial position. Although it is least common type of occupational fraud, yet
it is more costly than corruption and asset misappropriation
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Financial Statement Frauds
Fraud in financial statements takes the form of:
▸ Overstated assets and revenues, and
▸ Understated liabilities and expenses
To falsely reflect financially stronger company
However, in some cases the financial statement fraud takes the opposite shape:
▸ Assets and revenues are understated, and
▸ Liabilities and expenses are overstated
Primarily to save taxes
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Classifications of Financial Statement Schemes
There are five classifications of financial statement schemes:
▸ Fictitious revenues (mysterious account receivables on the books that are
long overdue are warning sign of fictitious revenue scheme)
▸ Timing difference (including improper revenue recognition) (to move revenue
and expenses between one period and the next, thereby increasing or
decreasing the earning as desired)
▸ Improper asset valuations
▸ Concealed liabilities and expenses
▸ Improper disclosures
Financial statement frauds can entail a combination of these schemes
Note: detection is most through tips from insiders and financial statement analysis
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Financial Statement Analysis
▸ The accounts expressed in whole amounts yield limited amount of
information. However, conversion of these numbers into ratios or
percentages allows the reader of the statements to analyse them based on
their relationship to each other.
▸ Moreover, it allows the reader to compare the current performance with the
past performance.
▸ The determination of the reasons for the relationship and changes in
amounts can be important in fraud detection and investigation.
▸ Financial statement analysis include the following:
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Vertical analysis
Horizontal analysis
Ratio analysis