Title /Course Code

Principles of Accounting (438)

Q.1
i. What relationship exist between the position of an account on the balance sheet and the rules for
recording increase in that account.
The accounting equation is one of the most fundamental accounting principles that explains the notion behind
why a trial balance always balances to $0. The accounting equation shows that the total assets will always equal
the sum of liabilities and equity. Assets are located on the left side of the balance sheet equation; an increase in
an asset account is recorded by an entry on the left (or debit) side of the account.
There are two primary accounting methods – cash basis and accrual basis. The cash basis of accounting, or cash
receipts and disbursements method, records revenue when cash is received and expenses when they are paid in
cash. In contrast, the accrual method records income items when they are earned and records deductions when
expenses are incurred, regardless of the flow of cash. Accrual accounts include, among others, accounts
payable, accounts receivable, goodwill, deferred tax liability and future interest expense.
The term accrual is also often used as an abbreviation for the terms accrued expense and accrued revenue.
Accrued revenue (or accrued assets) is an asset, such as unpaid proceeds from a delivery of goods or services,
when such income is earned and a related revenue item is recognized, while cash is to be received in a later
period, when the amount is deducted from accrued revenues. An example of an accrued expense is a pending
obligation to pay for goods or services received from a counterpart, while cash is to be paid out in a latter
accounting period when the amount is deducted from accrued expenses.
In financial accounting, assets are economic resources. Anything capable of being owned or controlled to
produce value is considered an asset. Simply stated, assets represent value of ownership that can be converted
into cash. Two major asset classes are intangible assets and tangible assets. Intangible assets are identifiable
non-monetary assets that cannot be seen, touched or physically measured, are created through time and effort,
and are identifiable as a separate asset. Tangible assets contain current assets and fixed assets. Current assets
include inventory, while fixed assets include such items as buildings and equipment.
Assets = Liabilities + Owner’s Equity + Revenue – Expenses
ii. What requirement is imposed by the double entry system in the recording of any business transaction?
The double-entry system of accounting or bookkeeping means that for every business transaction, amounts must
be recorded in a minimum of two accounts. The double-entry system also requires that for all transactions, the
amounts entered as debits must be equal to the amounts entered as credits.
To illustrate double entry, let's assume that a company borrows $10,000 from its bank. The company's Cash
account must be increased by $10,000 and a liability account must be increased by $10,000. To increase an
asset, a debit entry is required. To increase a liability, a credit entry is required. Hence, the account Cash will be
debited for $10,000 and the liability Loans Payable will be credited for $10,000.
Double entry also means that the accounting equation (assets = liabilities + owner's equity) will always be in
balance. In our example, the accounting equation remained in balance because both assets and liabilities were
each increased by $10,000.
Debit and credit in accounting recording are not what they mean in the area of money and finance, but rather
designations for different accounts and descriptions of any account changes in balances. The accounting
recording system assigns all asset, expense and loss accounts as debit accounts and all liability, equity,
revenue and gain accounts as credit accounts. A debit made to a debit account and a credit made to a credit
account increase the balance of the respective accounts. On the contrary, a credit made to a debit account and
a debit made to a credit account decrease the balance of the respective accounts.
The double-entry recording system always results in an equal amount recorded in the related accounts in the
form of a debit entry and a credit entry. While a debit represents the money used in a transaction, a credit
indicates the money source for the transaction. A company may make a debit entry to a debit account to show
an increase for the account or make a debit entry to a credit account to register a decrease for the account. On
the other hand, a company may make a credit entry to a debit account to display a decrease for the account or
make credit entry to a credit account to demonstrate an increase for the account. For example, in a cash sale
transaction using the double-entry system, a company makes a debit to the cash asset account, which is a
debit account, to increase the amount of cash received from the sale, and makes a credit for the same amount
to the revenue account, which is a credit account, to increase the amount of revenue as a result of the sale.
Q.2
i. What factor should be considered when comparing the net income figure of a partnership to that of a
corporation of similar size?
A similar financial statement displays items as a percentage of a common base figure, total sales revenue, for
example. This type of financial statement allows for easy analysis between companies, or between periods, for
the same company. However, if the companies use different accounting methods, any comparison may not be
accurate.
 A similar financial statement displays entries as a percentage of a common base figure rather than as
absolute numerical figures.
 Similar statements let analysts compare companies of different sizes, in different industries, or across
time in an apples-to-apples way.
 Similar financial statements commonly include the income statement, balance sheet, and cash flow
statement.

While most firms do not report their statements in similar format, it is beneficial for analysts to do so to
compare two or more companies of differing size or different sectors of the economy. Formatting financial
statements in this way reduces bias that can occur and allows for the analysis of a company over various
periods. This analysis reveals, for example, what percentage of sales is the cost of goods sold and how that
value has changed over time. Similar financial statements commonly include the income statement, balance
sheet, and cash flow statement.
Similar financial statements reduce all figures to a comparable figure, such as a percentage of sales or assets.
Each financial statement uses a slightly different convention in standardizing figures.
The balance sheet provides a snapshot overview of the firm's assets, liabilities, and shareholders' equity for the
reporting period. A similar balance sheet is set up with the same logic as the similar income statement. The
balance sheet equation is assets equals liabilities plus stockholders' equity.
The balance sheet thus represents a percentage of assets. Another version of the similar balance sheet shows
asset line items as a percentage of total assets, liabilities as a percentage of total liabilities, and stockholders'
equity as a percentage of total stockholders' equity.
ii. What do you understand the concept and meaning of amalgamation?
An amalgamation is a combination of two or more companies into a new entity. Amalgamation is distinct from
a merger because neither company involved survives as a legal entity. Instead, a completely new entity is
formed to house the combined assets and liabilities of both companies.
The term amalgamation has generally fallen out of popular use in the United States, being replaced with the
terms merger or consolidation. But it is still commonly used in countries such as India.
Amalgamation is a way to acquire cash resources, eliminate competition, save on taxes, or influence the
economies of large-scale operations. Amalgamation may also increase shareholder value, reduce risk
by diversification, improve managerial effectiveness, and help achieve company growth and financial gain.
On the other hand, if too much competition is cut out, amalgamation may lead to a monopoly, which can be
troublesome for consumers and the marketplace. It may also lead to the reduction of the new company's
workforce as some jobs are duplicated and therefore make some employees obsolete. It also increases debt: by
merging the two companies together, the new entity assumes the liabilities of both.
The terms of amalgamation are finalized by the board of directors of each company. The plan is prepared and
submitted for approval. For instance, the High Court and Securities and Exchange Board of India (SEBI) must
approve the shareholders of the new company when a plan is submitted.
The new company officially becomes an entity and issues shares to shareholders of the transferor company. The
transferor company is liquidated, and all assets and liabilities are taken over by the transferee company.
Q.3
You are employed by a business consulting firm as an information system specialist. You have just begun
an assignment with a startup company and have been given the assignment of discussing with the owner
her need for an accounting system. How would you respond to the following questions from the owner?
a. Who designs and install accounting system?
Take an accounting course. Buy accounting software. Hire an accountant. Go to a CPA and see if they will take
you as a client. Approach a banker for advice.
Nothing could make a business more vulnerable than a weak and porous system of accounting. We simply
carryout a preliminary study of our client’s business management process (BMP) and thereafter design a system
that adequately captures all the intricacies of financial transactions and controls.
In recommending a system and perhaps a complimentary application package, we consider such things as nature
of business, volume of transactions and workflows. At each stage of the design and implementation, we carry
along the client for input and modifications that are indispensable in a robust but tailor made system. In the end,
our client’s satisfaction and efficiency is priority.
b. What is the purpose of an accounting system and what are its basic functions?
An information system is a formal process for collecting data, processing the data into information, and
distributing that information to users. The purpose of an accounting information system (AIS) is to collect,
store, and process financial and accounting data and produce informational reports that managers or other
interested parties can use to make business decisions. Although an AIS can be a manual system, today most
accounting information systems are computer-based.
Functions of an Accounting Information System
Accounting information systems have three basic functions:
 1. The first function of an AIS is the efficient and effective collection and storage of data concerning an
organization’s financial activities, including getting the transaction data from source documents,
recording the transactions in journals, and posting data from journals to ledgers.
2. The second function of an AIS is to supply information useful for making decisions, including
producing managerial reports and financial statements.
3. The third function of an AIS is to make sure controls are in place to accurately record and process data.
Parts of an Accounting Information System
An accounting information system typically has six basic parts:
1. People who use the system, including accountants, managers, and business analysts
2. Procedure and instructions are the ways that data are collected, stored, retrieved, and processed
3. Data including all the information that goes into an AIS
4. Software consists of computer programs used for processing data
5. Information technology infrastructure includes all the hardware used to operate the AIS
6. Internal controls are the security measures used to protect data
c. How does management s explanation enhance the usefulness of financial accounting information?
Financial accounting provides information to enable stockholders, creditors, and other stakeholders to make
informed decisions. This information can be used to evaluate and make decisions for an individual company or
to compare two or more companies. However, the information provided by financial accounting is primarily
historical and therefore is not sufficient and is often synthesized too late to be overly useful to management.
Managerial accounting has a more specific focus, and the information is more detailed and timelier. Managerial
accounting is not governed by GAAP, so there is unending flexibility in the types of reports and information
gathered. Managerial accountants regularly calculate and manage “what-if” scenarios to help managers make
decisions and plan for future business needs. Thus, managerial accounting focuses more on the future, while
financial accounting focuses on reporting what has already happened. In addition, managerial accounting uses
nonfinancial data, whereas financial accounting relies solely on financial data.
For example, Daryn’s Dairy makes many different organic dairy products. Daryn’s managers need to track their
costs for certain jobs. One of the company’s top-selling ice creams is their seasonal variety; a new flavor is
introduced every three months and sold for only a six-month period. The cost of these specialty ice creams is
different from the cost of the standard flavors for reasons such as the unique or expensive ingredients and the
specialty packaging. Daryn wants to compare the costs involved in making the specialty ice cream and those
involved in making the standard flavors of ice cream. This analysis will require that Daryn track not only the
cost of materials that go into the product, but also the labor hours and cost of the labor, plus other costs, known
as overhead costs (rent, electricity, insurance, etc.), that are incurred in producing the various ice creams. Once
the total costs for both the specialty ice cream and the standard flavored ice cream are known, the cost per unit
can be determined for each type.