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Introduction to Accounting
Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and reporting). Accounting has been defined as: the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.(AICPA) Accountancy therefore encompasses the recording, classification, and summarizing of transactions and events in a manner that helps its users to assess the financial performance and position of the entity. The process starts by first identifying transactions and events that affect the financial position and performance of the company. Once transactions and events are identified, they are recorded, classified and summarized in a manner that helps the user of accounting information in determining the nature and effect of such transactions and events.

Types of Accounting
Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and varying needs of its users. Over the past few decades, accountancy has branched out into different types of accounting to cater for the diversity of needs of its users.

Main types of accounting are as follows:

Financial Accounting, or financial reporting, is the process of producing information for external use usually in the form offinancial statements. Financial Statements reflect an entity's past performance and current position based on a set of standards and guidelines known as GAAP (Generally Accepted Accounting Principles). GAAP refers to the standard framework of guideline for financial accounting used in any given jurisdiction. This generally includes accounting standards (e.g. International Financial Reporting Standards),accounting conventions, and rules and regulations that accountants must follow in the preparation of the financial statements. Management Accounting produces information primarily for internal use by the company's management. The information produced is generally more detailed than that produced for external use to enable effective organization control and the fulfillment of the strategic aims and objectives of the entity. Information may be in the form budgets and forecasts, enabling an enterprise to plan effectively for its future or may include an assessment based on its past performance and results. The form and content of any report produced in the process is purely upon management's discretion. Cost accounting is a branch of management accounting and involves the application of various techniques to monitor and control costs. Its application is more suited to manufacturing concerns. Governmental Accounting, also known as public accounting or federal accounting , refers to the type of accounting information system used in the public sector. This is a slight deviation from the financial accounting system used in the private sector. The need to have a separate accounting system for the public sector arises because of the different aims and objectives of the state owned and privately owned institutions. Governmental accounting ensures the financial position and performance of the public sector institutions are set in budgetary context since financial

constraints are often a major concern of many governments. Separate rules are followed in many jurisdictions to account for the transactions and events of public entities. Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that govern the preparation of financial statements for public use (i.e. GAAP). Tax accountants therefore adjust the financial statements prepared under financial accounting principles to account for the differences with rules prescribed by the tax laws. Information is then used by tax professionals to estimate tax liability of a company and for tax planning purposes. Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and criminal disputes that require an assessment of the financial effects of a loss or the detection of a financial fraud. Common litigations where forensic accountants are hired include insurance claims, personal injury claims, suspected fraud and claims of professional negligence in a financial matter (e.g. business valuation). Project Accounting refers to the use of accounting system to track the financial progress of a project through frequent financial reports. Project accounting is a vital component of project management. It is a specialized branch of management accounting with a prime focus on ensuring the financial success of company projects such as the launch of a new product. Project accounting can be a source of competitive advantage for project-oriented businesses such as construction firms. Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability Accounting, , refers to the process of reporting implications of an organization's activities on its ecological and social environment. Social Accounting is primarily reported in the form of Environmental Reports accompanying the annual reports of companies. Social Accounting is still in the early stages of development and is considered to be a response to the growing environmental consciousness amongst the public at large.

Functions of Accounting:
Learning Objectives:
1. What are the important functions ofaccounting.

Record Keeping Function:

The primaryfunction ofaccountingis to keep a systematic record of financial transaction journalisation, posting and preparation of final statements. The purpose of this function is to report regularly to the interested parties by means of financial statements.

Protect Business Property:

The second function ofaccountingis to protect the property ofbusinessfrom unjustified and unwanted use. Theaccountantthus has to design such a system ofaccountingwhich protect its assets from an unjustified and unwanted use.

Legal Requirement Function:

The third function ofaccountingis to devise such a system as will meet the legal requirements. Under the provision of law, abusinessman has to file various statements e.g., income taxreturns,returnsforsales taxpurpose etc.Accountingsystem aims at fulfilling

the requirements of law.Accountingis a base, with the help of which variousreturns, documents, statements etc., are prepared.

Communicating the Results:

Accountingis the language ofbusiness. Various transactions are communicated throughaccounting. There are many parties - owners, creditors, government, employees etc, who are interested in knowing the results ofthe firm. The fourth function ofaccountingis to communicate the results to interested parties. Theaccountingshows a real and true position ofthe firmof thebusiness.

What is the accounting cycle?

The accounting cycle is often described as a process that includes the following steps: identifying, collecting and analyzing documents and transactions, recording the transactions in journals, posting the journalized amounts to accounts in the general and subsidiary ledgers, preparing an unadjusted trial balance, perhaps preparing a worksheet, determining and recording adjusting entries, preparing an adjusted trial balance, preparing the financial statements, recording and posting closing entries, preparing a post-closing trial balance, and perhaps recording reversing entries. Cycle and steps seem to be a carryover from the days of manual bookkeeping and accounting when transactions were first written into journals. In a separate step the amounts in the journal were posted to accounts. At the end of each month, the remaining steps had to take place in order to get the monthly, manually-prepared financial statements. Today, most companies use accounting software that processes many of these steps simultaneously. The speed and accuracy of the software reduces the accountants need for a worksheet containing the unadjusted trial balance, adjusting entries, and the adjusted trial balance. The accountant can enter the adjusting entries into the software and can obtain the complete financial statements by simply selecting the reports from a menu. After reviewing the financial statements, the accountant can make additional adjustments and almost immediately obtain the revised reports. The software will also prepare, record, and post the closing entries. Accounting cyclerefers to a complete sequence of accounting procedures which are required to be repeated in same order during each accounting period. Accounting cycle includes:

Recording:
First, all transactions should be recorded in the journal or books oforiginalentry known as subsidiary books as and when they take place.

Classifying:
All entries in the journal of books oforiginalentry should be posted to the appropriate ledger accounts to find out at a glance the total effect of all such transactions in a particular account.

Summarising:
Last stage is to prepare the trial balance and final accounts with a view to ascertaining the profit or loss made during a trading period and the financial position of thebusinessof a particular date.

Accounting Cycle

What Is the Basic Accounting Equation and How Does It Help You Prepare Financial Statements?
The accounting equation forms the basis for recording accounting transactions and reporting the company's financial results. Accounting students learn the accounting equation near the beginning of their college careers and build their future education on this basis. The accounting equation also provides the framework for the balance sheet.

Basic Accounting Equation

The accounting equation is: Assets = Liabilities + Owner's Equity.

[1]

Assets refer to everything the company owns. Liabilities refer to everything the company owes to another entity and may consist of money, products or services. Owner's equity refers to the remaining net worth of the business after all liabilities are satisfied. Owner's equity can be calculated by subtracting the total liabilities from the total assets. An easy way to understand the accounting equation is to consider the purchase of an automobile. The automobile is worth $20,000; the company pays $5,000 in cash and takes a loan out for $15,000. The automobile is the asset. The loan is the liability. The accounting equation can be written as follows: 20,000 (asset) = 15,000 (liability) + 5,000 (owner's equity).

Expanded Accounting Equation

An expanded form of the accounting equation breaks down the components of owner's equity. The value of owner's equity changes based on revenues, expenses and the owner's share. The expanded view of the accounting equation is written as follows: Assets = Liabilities + Owner's Equity + Revenues - Expenses - Owner's Drawing. Revenues refer to money earned by the company. Expenses refer to assets used during the period. Owner's drawing refers to money the owner takes out of the company. The basic accounting equation considers revenue, expense and owner's drawing activity under the owner's equity title. The expanded version breaks down these components since they are reported separately in the accounting records.

Recording Transactions

As the company's accountants record accounting transactions, each transaction must impact both sides of the accounting equation equally. If the assets increase, so must the liabilities or the owner's equity. If the assets decrease, so must the liabilities or the owner's equity. One asset may increase while another decreases, creating a net impact of zero. Transactions that impact revenues, expenses or owner's drawing are considered to impact owner's equity.

Financial Reporting

The balance sheet follows the format of the basic accounting equation. It lists each of the assets and calculates a total of all the assets. It also lists each of the liabilities and owner's equity accounts and calculates a total of the liability and owner's equity accounts. This total must equal the total assets. The income statement can be created from the expanded accounting equation. The income statement lists all of the revenue accounts and calculates total revenue for the period. Next, the income statement lists each of the expenses and calculates total expenses for the period. Net income is calculated by subtracting total expenses from total revenues.

Accounting Concept and Principles?

Accounting Concepts and Principles are a set of broad conventions that have been devised to provide a basic framework for financial reporting. As financial reporting involves significant professional judgments by accountants, these concepts and principles ensure that the users of financial information are not mislead by the adoption of accounting policies and practices that go against the spirit of the accountancy profession. Accountants must therefore actively consider whether the accounting treatments adopted are consistent with the accounting concepts and principles. In order to ensure application of the accounting concepts and principles, major accounting standard-setting bodies have incorporated them into their reporting frameworks such as the IASB Framework. Following is a list of the major accounting concepts and principles:

Relevance:
Information should be relevant to the decision making needs of the user. Information is relevant if it helps users of the financial statements in predicting future trends of the business (Predictive Value) or confirming or correcting any past predictions they have made (Confirmatory Value). Same piece of information which assists users in confirming their past predictions may also be helpful in forming future forecasts.

Reliability
Information is reliable if a user can depend upon it to be materially accurate and if it faithfully represents the information that it purports to present. Significant misstatements or omissions in financial statements reduce the reliability of information contained in them.

Money Measurement Concept in Accounting

Definition
Money Measurement Concept in accounting, also known as Measurability Concept, means that only transactions and events that are capable of being measured in monetary terms are recognized in the financial statements.

Timeliness of Accounting Information

Definition
Timeliness principle in accounting refers to the need for accounting information to be presented to the users in time to fulfill their decision making needs.

Importance
Timeliness of accounting information is highly desirable since information that is presented timely is generally more relevant to users while conversely, delay in provision of information tends to render it less relevant to the decision making needs of the users. Timeliness principle is therefore closely related to the relevance principle. Timeliness is important to protect the users of accounting information from basing their decisions on outdated information. Imagine the problem that could arise if a company was to issue its

financial statements to the public after 12 months of the accounting period. The users of the financial statements, such as potential investors, would probably find it hard to assess whether the present financial circumstances of the company have changed drastically from those reflected in the financial statements.

Comparability/Consistency
Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity's financial performance and position over time. Comparability of financial statements over different accounting periods can be ensured by the application of similar accountancy policies over a period of time. A change in the accounting policies of an entity may be required in order to improve the reliability and relevance of financial statements. A change in the accounting policy may also be imposed by changes in accountancy standards. In these circumstances, the nature and circumstances leading to the change must be disclosed in the financial statements. Financial statements of one entity must also be consistent with other entities within the same line of business. This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice.

Understandability
Transactions and events must be accounted for and presented in the financial statements in a manner that is easily understandable by a user who possesses a reasonable level of knowledge of the business, economic activities and accounting in general provided that such a user is willing to study the information with reasonable diligence. Understandability of the information contained in financial statements is essential for its relevance to the users. If the accounting treatments involved and the associated disclosures and presentational aspects are too complex for a user to understand despite having adequate knowledge of the entity and accountancy in general, then this would undermine the reliability of the whole financial statements because users will be forced to base their economic decisions on undependable information.

Materiality
Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements (IASB Framework). Materiality therefore relates to the significance of transactions, balances and errors contained in the financial statements. Materiality defines the threshold or cutoff point after which financial information becomes relevant to the decision making needs of the users. Information contained in the financial statements must therefore be complete in all material respects in order for them to present a true and fair view of the affairs of the entity. Materiality is relative to the size and particular circumstances of individual companies.

Going Concern

Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are prepared. Financial statements are prepared assuming that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will realize its assets and settle its obligations in the normal course of the business. It is the responsibility of the management of a company to determine whether the going concern assumption is appropriate in the preparation of financial statements. If the going concern assumption is considered by the management to be invalid, the financial statements of the entity would need to be prepared on break up basis. This means that assets will be recognized at amount which is expected to be realized from its sale (net of selling costs) rather than from its continuing use in the ordinary course of the business. Assets are valued for their individual worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.

Accruals Concept

Financial statements are prepared under the Accruals Concept of accounting which requires that income and expense must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period.

Under Accruals basis of accounting, income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an accounting period. Accruals concept is therefore very similar to the matching principle.

Business Entity Concept

Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from its owners. The business entity is therefore considered to be distinct from its owners for the purpose of accounting. Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be considered to be drawings for the purpose of accounting much in the same way as cash drawings. The business entity concept also explains why owners' equity appears on the liability side of a balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for instance, represents a form of liability (known as equity) of the 'business' that is owed to its owner which is why it is presented on the credit side of the balance sheet. Understandability Materiality Going Concern Accruals Business Entity

In case where application of one accounting concept or principle leads to a conflict with another accounting concept or principle, accountants must consider what is best for the users of the financial information. An example of such a case would be the trade off between relevance and reliability. Information is more relevant if it is disclosed timely. However, it may take more time to gather reliable information. Whether reliability of information may be compromised to ensure relevance of information is a matter of judgment that ought to be considered in the interest of the users of the financial information.

The Role of Accounting in Business

Accounting is a process used by businesses for many reasons. The process of accounting consists of recording all transactions that occur within a business and summarizing the information. An assortment of people then uses this information. Accounting can take place either manually or with computers using accounting information system software.

Accounting

Accounting is a system used by businesses to track financial information. Businesses then analyze and use the information to make business decisions. Accounting uses a double-entry method where accountants record transactions using debits and credits to individual accounts. The individual accounts are all part of the general ledger, which is the place where a business keeps all accounts individually with balances.

Financial Information

Accounting plays a major role in businesses when it comes to the financial transactions of a business. Financial accounting records all transactions and summarizes the amounts on financial statements at the end of each month and year. Stakeholders of the business analyze the financial information. Stakeholders include

banks, stockholders, owners of the company and employees. Stakeholders use this information to make lending and investing decisions.

Managerial Information

Managerial accountants also use accounting. Managerial accounting is an internal type of accounting. Managerial accountants analyze all financial information and use it to make internal company decisions. These accountants make decisions regarding plans for the business as well as budgets and forecasts.

Cost Accounting

Cost accounting is another important aspect of a companys bookkeeping records; it plays a large role in manufacturing and retail companies. Manufacturing businesses use cost accounting to determine the cost of goods manufactured, breakeven points and on-hand inventory quantities. Retail companies use a form of cost accounting to keep track of inventory levels at all times.

Tax Purposes

Accounting also plays a large role for tax purposes. Recording consistent, accurate financial records leads to an easier calculation of income taxes. The financial information transfers from the accounting information system to the appropriate tax forms. Accounting information is useful in paying other taxes, including sales taxes, payroll taxes and quarterly estimated taxes.

Who Are Users of Accounting Information in a Business?

Users of Accounting External Information Internal &

Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization.

Internal users of accounting information include the following: Management: for analyzing the organization's performance and position and taking appropriate measures to improve the company results. Employees: for assessing company's profitability and its consequence on their future remuneration and job security.

Owners: for analyzing the viability and profitability of their investment and determining any future course of action. Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.

External users of accounting information include the following: Creditor: for determining the credit worthiness of the organization. Terms of credit are set according to the assessment of their customers' financial health. Creditors include suppliers as well as lenders of finance such as banks. Tax Authourities: for determining the credibility of the tax returns filed on behalf of the company. Investors: for analyzing the feasibility of investing in the company. Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company. Customers: for assessing the financial position of its supplier which is necessary for a stable source of supply in the long term. Regulatory Authorities: for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set in order to protect the interests of the stakeholders who rely on such information in forming their decisions.

External users are communicated accounting information usually in the form of financial statements. The purpose of financial statements is to cater for the needs of such diverse users of accounting information in order to assist them in making sound financial decisions. Accounting is a very dynamic profession which is constantly adapting itself to varying needs of its users. Over the past few decades, accountancy has branched out into different types of accounting to cater for the different needs of the users.

Accounting information in business comes in a form of financial statements and is used for investment decisions by a variety of users who can be divided into three groups: equity investors, debt investors and stakeholders including operating management. Accounting information is also used by capital market players as an important basis for judgments about company performance and future prospects for its stock price or debt securities. Effective Financial Reporting System To build an effective financial reporting system managers should recognize different users of information. Although financial reports are prepared primarily for owners, these reports are publicly available and read by interested parties seeking to assess performance of the company and its managers. Therefore, effective financial reporting should be based on recent numbers and contain four major financial statements: the balance sheet, the income statement, the statement of shareholder's equity and the cash-flow statement. Equity Investors Equity investors purchase shares to represent ownership interests in a company. Investors have a right to vote for company directors and receive dividends if they are paid. Investors use accounting information either themselves or through their representatives, such as financial and security analysts or stockbrokers. Financial information allows them to assess

company performance and see whether management is making wise business decisions. If financial statements contain information that proves weak management performance, equity investors can exercise their rights to replace management by voting at the annual shareholders' meetings.

Debt Investors Debt investors, often referred to as creditors, provide company with financing through loans. Creditors have limited influence over the company apart from control tools described in debt contracts, such as collateral assets or debt restrictions aimed to reduce default risk. This group of investors use accounting information and financial statements for assessment of the default risks and ability to payback loans. Management and Other Users Management turn to financial statements to assess strengths and strategies of competing companies or prove reliability of potential business partners. Other users, such as government agencies base their regulatory decisions based on publicly available statements. Labor unions and employees are also known to use accounting information to negotiate better wages and health benefits.

Capital Markets Publicly traded companies list their equity and debt securities on public exchanges and provide financial information to investors. Based on the information reflected in financial statements capital market players decide whether to invest in a company or not and, therefore, move market prices for a company's equity and debt securities.

What are Financial Statements Financial Statements represent a formal record of the financial activities of an entity. These are written reports that quantify the financial strength and performance of a company. Financial Statements reflect the financial effects of business transactions and events on the entity.

Types of Financial Statements

The four main types of financial statements are: Statement of Financial Position (Balance Sheet) Income Statement (Profit and Loss Account) Cash Flow Statement Statement of Changes in Equity

Statement of Financial Position

Statement of Financial Position, or Balance Sheet, presents the financial position of an entity at any given date. A Statement of Financial Position has three main components:

Assets: Something a business owns or controls. Liabilities: Something a business owes to someone Equity: What the business owes to its owners. This represents the amount of capital that is left in the business after its assets are used to pay off its outstanding liabilities.

Following is an Example of Statement of Financial Position (Balance Sheet):

Statement of Financial Position as at 31st December 2011 $ Assets

Property, Plant & Equipment Cash Inventory Receivable

100,000 10,000 10,000 5,000

Total Assets

120,000

Equity

Share Capital Retained Reserves

80,000 20,000

Total Equity

100,000

Liabilities

Payables Bank Loan

5,000 15,000

Total Liability

20,000

Assets of an entity may be financed from internal sources (i.e. share capital and profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a business must be equal to the amount of capital invested by the owners (i.e. in the form of share capital and profits not withdrawn) and any borrowings, its no surprise that in the above example total Assets worth $120,000 equal to the sum of Equity ($100,000) and Liabilities ($20,000).

This leads us to the Accounting Equation: Assets = Liabilities + Equity

The Equation may be re-arranged as follows: Equity = Assets Liabilities Liabilities = Assets - Equity Elements of the financial Statements
There are five main elements of the financial statements: Assets Liabilities Equity Income Expense

The first three elements relate to the statement of financial position while the latter two relate to income statements.

Assets
Asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (IASB Framework). In simple words, asset is something which a business owns or controls to benefit from its use in some way. It may be something which directly generates revenue for the entity (e.g. a machine, inventory) or it may be something which supports the primary operations of the organization (e.g. office building). Assets may be classified into Current and Non-Current . The distinction is made on the basis of time period in which the economic benefits from the asset will flow to the entity. Current Assets are ones that an entity expects to use within one-year time from the reporting date. Non Current Assets are those whose benefits are expected to last more than one year from the reporting date. Following are the most common types of Assets and their Classification along with the economic benefits derived from those assets. Asset Machine Office Building Vehicle Classification Non-current Non-current Economic Benefit Used for the production of goods for sale to customer. Provides space to employees for administering company affairs. Used in the transportation of company products and also for commuting. Cash is generated from the sale of inventory.

Non-current

Inventory

Current

Cash Receivables

Current Current

Cash! Will eventually result in inflow of cash.

Liabilities
According to IASB Frmework liability is defined as follows: A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits (IASB Framework). In simple words, liability is an obligation of the entity to transfer cash or other resources to another party. Liability could for instance be a bank loan, which obligates the entity to pay loan installments over the duration of the loan to the bank along with the associated interest cost. Alternatively, an entity's liability could be a trade payable arising from the purchase of goods from a supplier on credit. Liabilities may be classified into Current and Non-Current. The distinction is made on the basis of time period within which the liability is expected to be settled by the entity. Current Liability is one which the entity expects to pay off within one year from the reporting date. Non-Current Liability is one which the entity expects to settle after one year from the reporting date. Following are examples of some of the common types of liabilities along with their usual classification: Liability Long Term Bank Loan Bank Overdraft Short Term Bank Loan Trade Payble Debenture Tax Payble Classification Non-current current current current Non-current Current

It may be appropriate to break up a single liability into their current and non current portions. For instance, a bank loan spanning two years and carrying 2 equal installments payable at the end of each year would be classified half as current and half as non-current liability at the inception of loan.

Equity
Equity is the residual interest in the assets of the entity after deducting all the liabilities (IASB Framework). Equity is what the owners of an entity have invested in an enterprise. It represents what the business owes to its owners. It is also a reflection of the capital left in the business after assets of the entity are used to pay off any outstanding liabilities. Equity therefore includes share capital contributed by the shareholders along with any profits or surpluses retained in the entity. This is what the owners take home in the event of liquidation of the entity. The Accounting Equation may further explain the meaning of equity: Assets - Liabilities = Equity This illustrates that equity is the owner's interest in the Net Assets of an entity. Rearranging the above equation, we have Assets = Equity + Liabilities Assets of an entity have to be financed in some way. Either by debt (Liability) or by share capital and retained profits (Equity). Hence, equity may be viewed as a type of liability an entity has towards its owners in respect of the assets they financed. Examples of Equity recognized in the financial statements include the following: Ordinary Share Capital Preference Share Capital (irredeemable) Retained Earnings Revaluation Surpluses

Income

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (IASB Framework). Income is therefore an increase in the net assets of the entity during an accounting period except for such increases caused by the contributions from owners. The first part of the definition is quite easy to understand as income must logically result in an increase in the net assets (equity) of the entity such as by the inflow of cash or other assets. However, net assets of an entity may increase simply by further capital investment by its owners even though such increase in net assets cannot be regarded as income. This is the significance of the latter part of the definition of income. There are two types of income: Sale Revenue: Income earned in the ordinary course of business activities of the entity; Gains: Income that does not arise from the core operations of the entity.

For instance, sale revenue of a business whose main aim is to sell biscuits is income generated from selling biscuits. If the business sells one of its factory machines, income from the transaction would be classified as a gain rather than sale revenue. Following are common sources of incomes recognized in the financial statements: Sale revenue generated from the sale of a commodity. Interest received on a bank deposit. Dividend earned on entity's investments. Rentals received on property leased by the entity. Gain on re-valuation of company assets.

Income is accounted for under the accruals principal whereby it is recognized for the whole accounting period in full, irrespective of whether payments have been received or not. As income is an element of the income statement, it is calculated over the entire accounting period (usually one year) unlike balance sheet items which are calculated specifically for the year end date.

Expense
Expenses are the decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (IASB Framework). Expense is simply a decrease in the net assets of the entity over an accounting period except for such decreases caused by the distributions to the owners. The first aspect of the definition is quite easy to grasp as the incurring of an expense must reduce the net assets of the company. For instance, payment of a company's utility bills reduces cash. However, net assets of an entity may also decrease as a result of payment of dividends to shareholders or drawings by owners of a business, both of which are distributions of profits rather than expense. This is the significance of the latter part of the definition of expense. Following is a list of common types of expenses recognized in the financial statements: Salaries and wages Utility expenses Cost of goods sold Administration expenses Finance costs Depreciation Impairment losses

Expense is accounted for under the accruals principal whereby it is recognized for the whole accounting period in full, irrespective of whether payments have been made or not. As expense is an element of the income statement, it is calculated over the entire accounting period (usually one year) unlike balance sheet items which are calculated specifically for the year end date.

Concept of Double Entry:

Every transaction has two effects. For example, if someone transacts a purchase of a drink from a local store, he pays cash to the shopkeeper and in return, he gets a bottle of dink. This simple transaction has two effects from the perspective of both, the buyer as well as the seller. The buyer's cash balance would decrease by the amount of the cost of purchase while on the other hand he will acquire a bottle of drink. Conversely, the seller will be one drink short though his cash balance would increase by the price of the drink. Accounting attempts to record both effects of a transaction or event on the entity's financial statements. This is the application of double entry concept. Without applying double entry concept, accounting records would only reflect a partial view of the company's affairs. Imagine if an entity purchased a machine during a year, but the accounting records do not show whether the machine was purchased for cash or on credit. Perhaps the machine was bought in exchange of another machine. Such information can only be gained from accounting records if both effects of a transaction are accounted for. Traditionally, the two effects of an accounting entry are known as Debit (Dr) and Credit (Cr). Accounting system is based on the principal that for every Debit entry, there will always be an equal Credit entry. This is known as the Duality Principal. Debit entries are ones that account for the following effects: Increase in assets Increase in expense Decrease in liability Decrease in equity Decrease in income

Credit entries are ones that account for the following effects: Decrease in assets Decrease in expense Increase in liability Increase in equity Increase in income

Double Entry is recorded in a manner that the Accounting Equation is always in balance. Assets - Liabilities = Capital Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or increase in liability or equity (Cr) and vice-versa. Hence, the accounting equation will still be in equilibrium.

Examples of Double Entry 1. Purchase of machine by cash

Debit Credit

Machine (Increase in Asset) Cash (Decrease in Asset) Utility Expense (Increase in Expense) Cash (Decrease in Asset) Cash (Increase in Asset) Finance Income (Increase in Income) Cash (Increase in Asset) Bank Loan (Increase in Liability) Cash (Increase in Asset) Share Capital (Increase in Equity)

2. Payment of utility bills Debit Credit Debit Credit Debit Credit Debit Credit

3. Interest received on bank deposit account

4. Receipt of bank loan principal

5. Issue of ordinary shares for cash

Ledger Accounts
Accounting Entries are recorded in ledger accounts. Debit entries are made on the left side of the ledger account whereas Credit entries are made to the right side. Ledger accounts are maintained in respect of every component of the financial statements. Ledger accounts may be divided into two main types: balance sheet ledger accounts and income statement ledger accounts.

Balance Sheet Ledger Accounts

Balance Sheet ledger accounts are maintained in respect of each asset, liability and equity component of the statement of financial position. Following is an example of a receivable ledger account: Receivable Account Debit Balance b/d 1 Sales 2 $ Credit 500Cash 1000Balance c/d 1500 3 4 $ 500 1000 1500

1. 2.

Balance brought down is the opening balance is in respect of the receivable at the start of the accounting period. These are credit sales made during the period. Receivables account is debited because it has the effect of increasing the receivable asset. The corresponding credit entry is made to the Sales ledger account. The account in which the corresponding entry is made is always shown next to the amount, which in this case is the Sales ledger. This is the amount of cash received from the debtor. Receiving cash has the effect of reducing the receivable asset and is therefore shown on the credit side. As it can seen, the corresponding debit entry is made in the cash ledger. This represents the balance due from the debtor at the end of the accounting period. The figure has been arrived by subtracting the amount shown on the credit side from the sum of amounts shown on the debit side. This accounting period's closing balance is being carried forward as the opening balance of the next period.

3.

4.

Similar ledger accounts can be made for other balance sheet components such as payables, inventory, equity capital, non current assets and so on.

Income Statement Ledger Accounts

Income statement ledger accounts are maintained in respect of incomes and expenditures. Following is an example of electricity expense ledger: Electricity Expense Account Debit Cash 1 $ Credit 2 $ 1,000 1,000

1,000Income Statement 1,000

1.

This is the amount of cash paid against electricity bill. The expense ledger is being debited to account for the increase in expense. The corresponding credit entry has been made in the cash ledger. This represents the amount of expense charged to the income statement. The balance in the ledger has been recycled to the income statement which is being debited by the same amount. Unlike balance sheet ledger accounts, there is no balance brought down or carried forward. Instead, the income statement ledger is closed each accounting period end with the balancing figure representing the charge to income statement.

2.

Accounting Equation
Double entry is recorded in a manner that the accounting equation is always in balance: Assets = Liabilities + Equity

Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from internal sources of finance such as share capital and retained profits (i.e. Equity). Therefore, assets of an entity will always equal to the sum of its liabilities and equity. The accounting equation may be re-arranged as follows: Assets - Liabilities = Equity We may test the Accounting Equation by incorporating the effects of several transactions to see whether it still balances as theorized in the accountancy literature. For the purpose of this test, we may classify accounting transaction into the following generic types: 1. 2. 3. 4. Note: For all the examples on the next pages, it will be assumed that before any transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each. Transactions that only affect Assets of the entity Transactions that affect Assets and Liabilities of the entity Transactions that affect Assets and Equity of the entity Transactions that affect Liabilities and Equity of the entity

What is a Trial Balance?

Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards the preparation of financial statements. It is usually prepared at the end of an accounting period to assist in the drafting of financial statements. Ledger balances are segregated into debit balances and credit balances. Asset and expense accounts appear on the debit side of the trial balance whereas liabilities, capital and income accounts appear on the credit side. If all accounting entries are recorded correctly and all the ledger balances are accurately extracted, the total of all debit balances appearing in the trial balance must equal to the sum of all credit balances.

Purpose of a Trial Balance

Trial Balance acts as the first step in the preparation of financial statements. It is a working paper that accountants use as a basis while preparing financial statements. Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been recorded in the books in accordance with the double entry concept of accounting. If the totals of the trial balance do not agree, the differences may be investigated and resolved before financial statements are prepared. Rectifying basic accounting errors can be a much lengthy task after the financial statements have been prepared because of the changes that would be required to correct the financial statements. Trial balance ensures that the account balances are accurately extracted from accounting ledgers. Trail balance assists in the identification and rectification of errors.

Example
Following is an example of what a simple Trial Balance looks like: ABC LTD Trial Balance as at 31 December 2011 Account Title Share Capital Furniture & Fixture Building Creditor Debtors Cash Sales Cost of sales General and Administration Expense Total 1. 2. 3. 8,000 2,000 30,000 30,000 3,000 2,000 10,000 5,000 10,000 5,000 Debit $ Credit $ 15,000

Title provided at the top shows the name of the entity and accounting period end for which the trial balance has been prepared. Account Title shows the name of the accounting ledgers from which the balances have been extracted. Balances relating to assets and expenses are presented in the left column (debit side) whereas those relating to liabilities, income and equity are shown on the right column (credit side). The sum of all debit and credit balances are shown at the bottom of their respective columns.

4.

Limitations of a trial balance

Trial Balance only confirms that the total of all debit balances match the total of all credit balances. Trial balance totals may agree in spite of errors. An example would be an incorrect debit entry being offset by an equal credit entry. Likewise, a trial balance gives no proof that certain transactions have not been recorded at all because in such case, both debit and credit sides of a transaction would be omitted causing the trial balance totals to still agree. Types of accounting errors and their effect on trial balance are more fully discussed in the section on Suspense Accounts.

How to prepare a Trial Balance

Following Steps are involved in the preparation of a Trial Balance: 1. 2. 3. All Ledger Accounts are closed at the end of an accounting period. Ledger balances are posted into the trial balance. Trial Balance is cast and errors are identified.

4. 5. 6.

Suspense account is created to agree the trial balance totals temporarily until corrections are accounted for. Errors identified earlier are rectified by posting corrective entries. Any adjustments required at the period end not previously accounted for are incorporated into the trial balance.

Closing Ledger Accounts

Ledger accounts are closed at the end of each accounting period by calculating the totals of debit and credit sides of a ledger. The difference between the sum of debits and credits is known as the closing balance. This is the amount which is posted in the trial balance. How closing balances are presented in the ledger depends on whether the account is related to income statement (income and expenses) or balance sheet (assets, liabilities and equity). Balance sheet ledger accounts are closed by writing 'Balance c/d' next to the balancing figure since these are to be rolled forward in the next accounting period. Income statement ledger accounts on the other hand are closed by writing 'Income Statement' next to the residual amount because it is being transferred to the income statement as revenue or expense incurred for the period. The steps involved in closing a ledger account may be summarized as below: 1. Add the totals of both sides of a ledger of BOTH sides.Closing balance is the balancing figure on the side with the lower balance. 3. In case of ledger accounts of assets, liabilities and equity, 'balance c/d' is written next to the closing balance whereas in case of income and expenses ledger accounts, 'Income Statement' is written next to the closing balance. The closing balances of all ledger accounts are posted into the trial balance.

2. The higher of the totals among the debit side and credit side must be inserted at the end

4.

Next sections contain examples illustrating how the various types of ledger accounts are closed at the period end 31 December 2011.

Posting Closing ledger balances into Trial Balance:

Closing Balance of all ledger accounts are posted into the trial balance. It is important to remember that a debit closing balance in the ledger account appears on the credit side but in the trial balance it is presented in the debit column and vice versa. Posting of closing balances should be done carefully as many errors may occur during the posting process such as Posting Error, Transposition Errors and Slide error. Following is an example of a trial balance prepared from the closing balances of the ledgers detailed above.

ABC LTD Trial Balance as at 31 December 2011 Account Title Debit $ Credit $

Share Capital Bank Loan Cash Salaries Expense Sales Revenue Total 35,000 30,000 5,000

10,000 10,000

15,000 35,000

Bank Reconciliation?
Bank reconciliation statement is a report which compares the bank balance as per company's accounting records with the balance stated in the bank statement. It is normal for a company's bank balance as per accounting records to differ from the balance as per bank statement due to timing differences. Certain transactions are recorded by the entity that are updated in the bank's system after a certain time lag. Likewise, some transactions are accounted for in the bank's financial system before the company incorporates them into its own accounting system. Such timing differences appear as reconciling items in the Bank Reconciliation Statement. The purpose of preparing a Bank Reconciliation Statement is to detect any discrepancies between the accounting records of the entity and the bank besides those due to normal timing differences. Such discrepancies might exist due to an error on the part of the company or the bank.

Importance of Bank Reconciliation

Preparation of bank reconciliation helps in the identification of errors in the accounting records of the company or the bank. Cash is the most vulnerable asset of an entity. Bank reconciliations provide the necessary control mechanism to help protect the valuable resource through uncovering irregularities such as unauthorized bank withdrawals. However, in order for the control process to work effectively, it is necessary to segregate the duties of persons responsible for accounting and authorizing of bank transactions and those responsible for preparing and monitoring bank reconciliation statements. If the bank balance appearing in the accounting records can be confirmed to be correct by comparing it with the bank statement balance, it provides added comfort that the bank transactions have been recorded correctly in the company records. Monthly preparation of bank reconciliation assists in the regular monitoring of cash flows of a business.

Preparing a Bank Reconciliation Statement

Following is a sample Bank Reconciliation Statement:

ABC LTD Bank Reconciliation Statement as at 31 December 2011 Balance as per corrected Cash Book 1 xxx Add: Unpresented Cheques 2 xxx Less: Deposits in Transit 3 (xxx) Errors in Bank Statement 4 (xxx) Balance as per Bank Statement xxx

1. Balance as per corrected Cash Book:

This is the starting point of a bank reconciliation. Corrected bank balance is calculated by adjusting the cash book ledger balance for transactions that are recorded by the bank but not by the entity as shown below:

Balance as per Cash Book Add: Direct Credits Interest on Deposit Less: Bank Charges Direct Debits Standing Order Errors in Cash Book Balance as per corrected Cash Book

xxx 5 6 7 8 9 10 xxx xxx (xxx) (xxx) (xxx) (xxx) xxx

Depreciation
Methods of depreciation
There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

[edit]Straight-line

depreciation

Straight-line depreciation is the simplest and most-often-used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life) and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value. Straight-line method:

For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number of years of its useful life. This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation. book value = original cost accumulated depreciation Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value.

Book value at beginning of year $17,000 (original cost) $14,000 $11,000 $8,000 $5,000

Depreciation Accumulated Book value at expense depreciation end of year $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $6,000 $9,000 $12,000 $15,000 $14,000 $11,000 $8,000 $5,000 $2,000 (scrap value)

If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to depreciation recapture. In addition, this gain above the depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain. If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.

[edit]Declining-balance

method (or Reducing balance method)

Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years are called accelerated depreciation methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is thedeclining-balance method. Under this method the book value is multiplied by a fixed rate. Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the double-declining-balance method. To illustrate, suppose a business has an asset with $1,000 original cost, $100 salvage value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straightline depreciation rate equals (100% / 5) = 20% per year. With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate is used. The table below illustrates the double-declining-balance method of depreciation.

Book value at beginning of year $1,000 (original cost) $600 $360 $216 $129.60

Depreciation rate 40% 40% 40% 40%

Depreciation Accumulated Book value at expense depreciation end of year $400 $240 $144 $86.40 $400 $640 $784 $870.40 $900 $600 $360 $216 $129.60 $100 (scrap value)

$129.60 - $100 $29.60

When using the double-declining-balance method, the salvage value is not considered in determining the annual depreciation, but the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used. The process continues until the salvage value or the end of the asset's useful life, is reached. In the last year of depreciation a subtraction might be needed in order to prevent book value from falling below estimated Scrap Value. Since double-declining-balance depreciation does not always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life. It is possible to find a rate that would allow for full depreciation by its end of life with the formula:

, where N is the estimated life of the asset (for example, in years).

[edit]Activity

depreciation

Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the rate by the actual activity level. [edit]Sum-of-years'

digits method

Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than straight line, but less than declining-balance method. Under this method annual depreciation is determined by multiplying the Depreciable Cost by a schedule of fractions. depreciable cost = original cost salvage value book value = original cost accumulated depreciation Example: If an asset has original cost of $1000, a useful life of 5 years and a salvage value of $100, compute its depreciation schedule. First, determine years' digits. Since the asset has useful life of 5 years, the years' digits are: 5, 4, 3, 2, and 1. Next, calculate the sum of the digits. 5+4+3+2+1=15 The sum of the digits can also be determined by using the formula (n2+n)/2 where n is equal to the useful life of the asset. The example would be shown as (52+5)/2=15 Depreciation rates are as follows: 5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year, and 1/15 for the 5th year.

Book value at Total Depreciation Depreciation beginning of depreciable rate expense year cost $1,000 $900 (original cost) $700 $460 $280 $160 $900 $900 $900 $900 5/15 4/15 3/15 2/15 1/15 $300 ($900 * 5/15) $240 ($900 * 4/15) $180 ($900 * 3/15) $120 ($900 * 2/15) $60 ($900 * 1/15)

Book value Accumulated at depreciation end of year $300 $540 $720 $840 $900 $700 $460 $280 $160 $100 (scrap value)

[edit]Units-of-production

depreciation method

Under the units-of-production method, useful life of the asset is expressed in terms of the total number of units expected to be produced:

Suppose, an asset has original cost $70,000, salvage value $10,000, and is expected to produce 6,000 units. Depreciation per unit = ($70,00010,000) / 6,000 = $10 10 actual production will give the depreciation cost of the current year. The table below illustrates the units-of-production depreciation schedule of the asset.

Book value at Book value Units of Depreciation Depreciation Accumulated beginning of at production cost per unit expense depreciation year end of year $70,000 1,000 (original cost) $60,000 $49,000 $37,000 $24,000 1,100 1,200 1,300 1,400 $10 $10 $10 $10 $10 $10,000 $11,000 $12,000 $13,000 $14,000 $10,000 $21,000 $33,000 $46,000 $60,000 $60,000 $49,000 $37,000 $24,000 $10,000 (scrap value)

Depreciation stops when book value is equal to the scrap value of the asset. In the end, the sum of accumulated depreciation and scrap value equals the original cost. [edit]Units

of time depreciation

Units of time depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year. A simple example can be given for construction companies, where some equipment is used only for some specific purpose. Depending on the number of projects, the equipment will be used and depreciation charged accordingly. [edit]Group

depreciation method

Group depreciation method is used for depreciating multiple-asset accounts using straight-line-depreciation method. Assets must be similar in nature and have approximately the same useful lives.

Asset

Historical Salvage Depreciable Depreciation Life cost value cost per year $500 $5,000 5 $1,000

Computers $5,500

[edit]Composite

depreciation method

The composite method is applied to a collection of assets that are not similar, and have different service lives. For example, computers and printers are not similar, but both are part of the office equipment. Depreciation on all assets is determined by using the straight-line-depreciation method.

Asset

Historical Salvage Depreciable Depreciation Life cost value cost per year $500 $100 $600 $5,000 $ 900 $5,900 5 3 $1,000 $ 300 $1,000 $ 6,500

Computers $5,500 Printers Total

4.5 $1,300

Composite life equals the total depreciable cost divided by the total depreciation per year. $5,900 / $1,300 = 4.5 years. Composite depreciation rate equals depreciation per year divided by total historical cost. $1,300 / $6,500 = 0.20 = 20% Depreciation expense equals the composite depreciation rate times the balance in the asset account (historical cost). (0.20 * $6,500) $1,300. Debit depreciation expense and credit accumulated depreciation. When an asset is sold, debit cash for the amount received and credit the asset account for its original cost. Debit the difference between the two to accumulated depreciation. Under the composite method no gain or loss is recognized on the sale of an asset. Theoretically, this makes sense because the gains and losses from assets sold before and after the composite life will average themselves out. To calculate composite depreciation rate, divide depreciation per year by total historical cost. To calculate depreciation expense, multiply the result by the same total historical cost. The result, not surprisingly, will equal to the total depreciation Per Year again. Common sense requires depreciation expense to be equal to total depreciation per year, without first dividing and then multiplying total depreciation per year by the same number. [edit]Tax

depreciation

Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. Such deductions are allowed for individuals and companies. Where the assets are consumed currently, the cost may be deducted currently as an expense or treated as part of cost of goods sold. The cost of assets not currently consumed generally must be deferred and recovered over time, such as through depreciation. Some systems permit full deduction of the cost, at least in part, in the year the assets are acquired. Other systems allow depreciation expense over some life using some depreciation method or percentage. Rules vary highly by country, and may vary within a country based on type of asset or type of taxpayer. Many systems that specify depreciation lives and methods for financial reporting require the same lives and

methods be used for tax purposes. Most tax systems provide different rules for real property (buildings, etc.) and personal property (equipment, etc.). [edit]Capital

allowances

A common system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year. This is often referred to as a capital allowance, as it is called in United Kingdom. Deductions are permitted to individuals and businesses based on assets placed in service during or before the assessment year. Canada's Capital Cost Allowance are fixed percentages of assets within a class or type of asset. Fixed percentage rates are specified by type of asset. The fixed percentage is multiplied by the tax basis of assets in service to determine the capital allowance deduction. The tax law or regulations of the country specifies these percentages. Capital allowance calculations may be based on the total set of assets, on sets or pools by year (vintage pools) or pools by classes of assets. [edit]Tax

lives and methods

Some systems specify lives based on classes of property defined by the tax authority. Canada Revenue Agency specifies numerousclasses based on the type of property and how it is used. Under the United States depreciation system, the Internal Revenue Servicepublishes a detailed guide which includes a table of lives based on types of businesses in which assets are used. The table also incorporates specified lives for certain commonly used assets (e.g., office furniture, computers, automobiles) which override the business use lives. U.S. tax depreciation is computed under the double declining balance method switching to straight line or the straight line method, at the option of the taxpayer.[7] IRS tables specify percentages to apply to the basis of an asset for each year in which it is in service. Depreciation first becomes deductible when an asset is placed in service. [edit]Additional

depreciation

Many systems allow an additional deduction for a portion of the cost of depreciable assets acquired in the current tax year. The UK system provides a first year capital allowance of 50,000. In the United States, two such deductions are available. A deduction for the full cost of depreciable tangible personal property is allowed up to $250,000. This deduction is fully phased out for businesses acquiring over $800,000 of such property during the year.[8] In addition, additional first year depreciation of 50% of the cost of most other depreciable tangible personal property is allowed as a deduction. [9] Some other systems have similar first year or accelerated allowances. [edit]Real

property

Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States and Canada, permit depreciation for real property using only the straight line method, or a small fixed percentage of cost. Generally, no depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and land improvements over a 15 or 20 year life, all using the straight line method. [10]

[edit]Averaging

conventions

Depreciation calculations can become complex if done for each asset a business owns. Many systems therefore permit combining assets of a similar type acquired in the same year into a pool. Depreciation is then computed for all assets in the pool as a single calculation. Calculations for such pool must make assumptions regarding the date of acquisition. The United States system allows a taxpayer to use a half year convention for personal property or mid-month convention for real property.[11] Under such a convention, all property of a particular type is considered acquired at the midpoint of the acquisition period. One half of a full period depreciation is allowed in the acquisition period and in the final depreciation period. United States rules require a mid-quarter convention for personal property if more than 40% of the acquisitions for the year are in the final quarter.

Accounting Ratios | Financial Ratios:

Learning Objectives: 1. Define and explain the term accounting ratios. 2. What are advantages and limitations of using accounting orfinancial ratios. 3. Howfinancial ratiosare classified. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured.

Definition of Accounting Ratios:

The term "accounting ratios" is used to describe significant relationship between figures shown on abalance sheet, in a profit and loss account, in a budgetary control system orin anyother part of accounting organization.Accounting ratiosthus shows the relationship between accounting data. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. It may be expressed in the form of co-efficient, percentage, proportion, or rate. For example the current assets and current liabilities of abusinesson a particular date are $200,000 and $100,000 respectively. The ratio of current assets and current liabilities could be expressed as 2 (i.e. 200,000 / 100,000) or 200 percent or it can be expressed as 2:1 i.e., the current assets are two times the current liabilities. Ratio sometimes is expressed in the form of rate. For instance, the ratio between two numerical facts, usually over a period of time, e.g. stock turnover is three times a year.

Advantages of Ratios Analysis:

Ratio analysis is an important and age-old technique of financial analysis. The following are some of the advantages / Benefits of ratio analysis:

1. Simplifies financial statements:It simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of thebusiness
2. Facilitates inter-firm comparison:It provides data for inter-firm comparison. Ratios highlight the factors associated with with successful and unsuccessful firm. They also reveal strong firms and weak firms, overvalued and undervalued firms. 3. Helps in planning:It helps in planning and forecasting. Ratios can assist management, in its basic functions of forecasting. Planning, co-ordination, control and communications. 4. Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the performance of different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future. 5. Help ininvestmentdecisions:It helps ininvestmentdecisions in the case of investors and lending decisions in the case of bankers etc.

Limitations of Ratios Analysis:

The ratios analysis is one of the most powerful tools of financial management. Though ratios are simple to calculate and easy to understand, they suffer from serious limitations.
1. Limitations of financial statements:Ratios are based only on the information which has been recorded in the financial statements. Financial statements themselves are subject to several limitations. Thus ratios derived, there from, are also subject to those limitations. For example, non-financial changes though important for thebusinessare not relevant by the financial statements. Financial statements are affected to a very great extent by accountingconventionsand concepts. Personal judgment plays a great part in determining the figures for financial statements. 2. Comparative study required:Ratios are useful in judging the efficiency of thebusinessonly when they are compared with past results of thebusiness. However, such a comparison only provide glimpse of the past performance andforecastsfor future may not prove correct since several other factors likemarketconditions, management policies, etc. may affect the future operations. 3. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as final regarding good or bad financial position of thebusiness. Other things have also to be seen. 4. Problems of price level changes:A change in price level can affect the validity of ratios calculated for different time periods. In such a case the ratio analysis may not clearly indicate the trend in solvency and profitability of the company. The financial statements, therefore, be adjusted keeping in view the price level changes if a meaningful comparison is to be made through accounting ratios. 5. Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There are no well accepted standards or rule of thumb for all ratios which can be accepted as norm. It renders interpretation of the ratios difficult. 6. Limited use of single ratios:A single ratio, usually, does not convey much of a sense. To make a better interpretation, a number of ratios have to be calculated which is likely to confuse the analyst than help him in making any good decision.

7. Personal bias:Ratios are only means of financial analysis and not an end in itself. Ratios have to interpreted and different people may interpret the same ratio in different way. 8. Incomparable:Not only industries differ in their nature, but also the firms of the similarbusinesswidely differ in their size and accounting procedures etc. It makes comparison of ratios difficult and misleading.

Classification of Accounting Ratios:

Ratios may be classified in a number of ways to suit any particular purpose. Different kinds of ratios are selected for different types of situations. Mostly, the purpose for which the ratios are used and the kind of data available determine the nature of analysis. The various accounting ratios can be classified as follows:
Classification of Accounting Ratios / Financial Ratios

(A)Traditional Classification or Statement Ratios (B)Functional Classification or Classification According to Tests (C)Significance Ratios or Ratios According to Importance
Profit and loss account ratios or revenue/income statement ratios Balance sheetratios or position statement ratios Composite/mixed ratios or inter statement ratios

Profitability ratios Liquidity ratios Activity ratios Leverage ratios or long term solvency ratios Primary ratios Secondary ratios