THE NATURE AND PURPOSE OF ACCOUNTING

1.

2.

Definitions
Accounts

can be defined as the financial records of an

organization.

Accountancy

is the procedure for recording the financial facts and

relationship that develop out of economic activity, and
for measuring the increase or decrease in value that
results from it.

Accounting

represents the techniques involved in recording the

transactions of the business on a regular basis so as
to provide summary information to assist the
management or owners of that business or entity on a
periodic basis.

Book keeping

refers to the actual record-making.

Purpose
Accounting extends far beyond purely records making, it is concerned with:
(a)
(b)
(c)
(d)

the perception of that information;

how those records are used to assist management;
how those records can be analysed
interpretation of those records:
(1)
What do they mean?
(2)
Can different companies be compared in similar business
sectors?

Financial Accounting

Management Accounting

External accounting

Internal Accounting

Past performance

Feedback and control

Historically oriented

Current, future oriented

Rules driven

No regulations

Only financial measures

Financial, operational, physical

measures

Objective

Subjective

FINANCIAL VERSUS MANAGEMENT ACCOUNTING

Financial accounting deals with reporting information that pertains to the financial
position, performance and conduct of a firm for a given period to a set of users
and the market in general. Management accounting is more oriented toward
internal decision making and purposively channels relevant and timely information
to internal managers. Both are production processes of different accounting data
for different problem-solving situations.
Finance accounting is the result of applying generally accepted accounting
principles to the recording of transactions between different entities. As such,
financial accounting statements conform to a set of rules established by the
profession. Management accounting, however, reflects the techniques from
different disciplines, including accounting, for internal problem solving. Therefore,
management accounting techniques may differ from generally accepted
accounting techniques, and from one firm to another. They do not conform to any
set of prescribed rules, and much may be left to the decision-makers
philosophies.
In short, the frame of reference used in management accounting is much broader
than that used in financial accounting. Boyd and Taylor considered the specific
difference to be the following:
1.

The managerial approach places the student in the role of a user of

financial data in decision making. The conventional approach assigns the
role of preparer of financial statements for use by others.

2.

The student of managerial accounting is called upon to use his entire

knowledge of the business world in making business decisions based upon
accounting techniques, principles and practices, and rarely deals with
decisions other than those required in the preparation of financial
statements.

3.

An attempt is made to consider the external and internal business

environment in managerial accounting. Conventional accounting usually
ignores these conditions.

4.

The arrangement and emphasis of topical material differs under the two
methods because of the differences in objectives.

5.

The purpose of managerial accounting is to make a decision related to

business problem. Conventional accounting has as its end the ability to
prepare adequate financial statements.

To this list of differences, it may be also added that financial accounting data are
required to be objective and verifiable, while management accounting emphasizes
relevance and flexibility.

THE ROLE OF MANAGEMENT ACCOUNTING

IN BUSINESS
Management accounting is an activity carried on with a business. Management
accounting is not the same as financial accounting; it is a separate type of
accounting activity. It is carried out by management accountants who need to
have special abilities which management accountants need are described below
and you must know what they are to help you in your study of management
accounting.
Management accounting is concerned with the provision of information. This
involves gathering and analyzing data to produce information. Much of this data,
such as production quantities, working time, materials costs and selling prices, will
be numerical. So management accountants must be numerate. They must also
be able to set up and operate information gathering and analyzing systems.
Management accounting is also concerned with the interpretation of information,
so the information which has been gathered must be converted into a form which
has meaning. Therefore, management accountants must understand what the
information they have gathered means. To do this, they need to understand the
way the business works, its production methods, its products and its markets.
Management accounting involves gathering, analyzing and interpreting
information which assists management. This information is communicated to
managers in the form of reports. These reports may be regular, such as monthly
profit statements, or one-off reports responding to special requests from
managers. Therefore, management accountants must be able to design reports
and set up reporting systems. They must also be able to understand what it is that
managers want to know.
Management accounting information assists management in planning, so it is
used by managers to help them to organize the future activities of the business.
Planning information is forward looking. It consists of forecasts and estimates.
These may be based on information about the businesss past performance. A
major area where management accounting information is used for planning is in
the annual operating budget for a business. Therefore, management accountants
must be forward looking, good at estimating and experts at budgeting.
There are several ways in which management accounting information assists
managers in controlling the operations of business. One is by producing reports
which compare the past (or forecast) quantities, costs and revenues for a period
with the budgeted cost. This is known as budgetary control. Another type of
reporting system, called standard costing, compares each individual products
actual costs and revenues with its planned costs and revenues. The management
accountant must be able to identify and explain the causes of any differences
between planned and actual costs (known as variances) to managers so that they
can take any necessary action. So management accountants must possess good
investigate skills. They must also be tactful and persuasive to gain the cooperation of their colleagues in other parts of the organization.

Producing information to assist managers in decision-making is a major role for

management accounting. Decisions may be short term, such as which products to
make, how to make them, in what quantities they should be made and at what
price they should be sold. They may be long-term decisions such as whether to
develop a new product, whether to invest in new equipment and if so, which
equipment to choose, whether to expand a business or close it down and whether
to make a product or to buy it from outside. Management decisions can be
improved if they are based on reliable and relevant information.
Management accountants must be able to identify the information needed for a
particular decision, then be able to find the relevant data, analyses it, interpret the
results of their analyses and communicate the results. So, if management
accountants are to provide useful decision-making information, they must:
-

be able to distinguish between relevant and non-relevant data;

be expert at choosing and applying the right analytical technique to the

data;

be able to interpret the results of their analysis correctly;

and then be able to communicate their advice clearly to managers.

Management accounting information can be used to assist managers in

appraising the performance of individual managers, departments, products and
enterprises. Appraisal information on departments and products may come from
budgetary control or standard costing systems. A businesss performance can
also be analysed using ratios, such as the ration between profits and sales or the
ration between profits and capital invested in the business. Management
accountants must be able to interpret correctly the information which they
produce for appraisal purposes if they are to help managers make the correct
judgments on performance. If appraisal information is misleading, it could harm a
business by encouraging unsuccessful managers and/or failing to recognize and
encourage successful managers.
Management accounting can be of great benefit to an organization by providing
its managers with key information to help them to run the business better.
However, if the management accounting information provided to managers is
inaccurate, inappropriate, incomplete, confusing or late, it could do more damage
that good. As a result, the ability and expertise of the individual management
accountant and the speed and reliability of the information collecting, analysis and
reporting systems that she or he uses are very important.

BACKGROUND TO BOOK-KEEPING
A necessary part of any business or organization is the maintenance of some
form of record keeping. The earliest forms of book-keeping can be traced back to
3600 BC. Today, we have technology at our disposal to improve the efficiency
and storage ability of book-keeping.
Financial accounting is concerned with the recording, classifying and summarizing
of business transactions.
Main objective of accounting:
a.

To systematically record, classify and summarise all the business

transaction in financial terms.

b.

To provide evidence of transactions having been conducted.

c.

To provide a means of control over the financial activities of the business.

d.

To provide information to individuals/groups who have an interest in the

financial affairs of the business.

e.

To maintain financial records to meet any internal or external requirements

that influences the business.

FORMS OF BUSINESS OWNERSHIP

Profit motivated

Non-profit organizations

Profit Motivated
1.

The Sole Trader

A business that is owned by one person is a sole trader or sole proprietor.
Sole rights to all profits, make all business decisions and bears all losses
alone ever to the extent of seizure of his, or her own private property
should the business fails, liability is not limited.

2.

Partnership
When two or more person pooling their resources together to operate a
business with the purpose of making a profit. Maximum number is twenty
except for profession such as lawyers, accountants and doctors. Liability is
not limited.

3.

Limited companies Sdn Bhd or Berhad

Organizations that raise their finance by means of issuing shares. The
liability of owners of companies is limited to the amount of shares
purchased.
The management of the company is undertaken by a Board of Directors,
members of which are voted in by the owners, the shareholders.

4.

The Co-operative
A group of people with a common interest may form a venture, either as a
company or as a private organization, with the purpose of providing a
service to the community.

Non-Profit Organization
1.

Government and semi-government bodies

Government departments operate with the purpose of providing a service
to the public, such as health and educations.

2.

Private clubs and societies

Operations created by persons with a mutual interest in order to benefit
these members rather than earn a profit. Examples include church groups,
Lions and Rotary Clubs.

ACCOUNTING REPORTS
Public companies (Bhd) are required to publish financial statements at least
annually and many large companies also issue them half-yearly (internal reports).
All companies are required to file an annual return with the Registrar of
Companies.
Companies listed on the KL Stock Exchange are also required to furnish certain
information to the Exchange. Companies wishing to obtain funds from the public
must publish a prospectus which contains accounting information.
Companys Capital Structure

Equity
Debts

Equity ordinary shares

carry voting rights no fixed dividend

most popular type of shares
can be issued through
- Public Issue (IPO)
- Right Issues.
- Offer for Sale
- Bonus Issues

Debts

Preference Shares, Debentures & Loans

Usually non voting no rights to vote
Fixed dividend or interest.

Preference Shares

Cumulative
Non-cumulative
Participating

Capital Gearing

Difference between Equity Capital and Debt Capital

Gearing

High geared high debt capital compared to equity capital

Low geared low debt capital compared to equity capital
High or low good depend on economic conditions.

Bonds

Guarantee payment of principle

Low risk defer payments at worst
Company has to do financial planning to redeem the bond
Agreement to be signed between issuer and buyer
7

Is a confidence factor for people to buy

Read agreement before buying.

Share buy back

Statutory limit 10%

Substantial cash outflow
Company involved in share buy back - dangerous
Dangerous trend
Depends on the structure of the company
Company must be cash rich
Depends on the potential of the firm
If potential is good buy back at lower price and reissue later.

RATIOS ANALYSIS AND INTERPRETATION

OF FINANCIAL STATEMENTS
Many individuals and groups are interested in the data appearing in a firms
financial statement, including managers, owners, prospective investors, creditors,
labour unions, government agencies and the general public. These parties are
usually interested in the profitability and financial strength of the firm in question,
although such factors are size, growth and the firms effort to meet its social
responsibilities may also be of interest.
Managers, owners and prospective investors may ask the following questions:
1.

How do profits compare with those of previous years?

2.

How do profits compare with other firms in the industry?

Creditors may ask:

1.

Will our debt be repaid on time?

2.

Will the interest payments be met?

Union may ask:

1.

How can we show that the firm can support a particular wage increase?

These kind of questions can be answered by interpreting the data in financial

reports.

SOURCES OF FINANCIAL INFORMATION

The financial statements of an entity, with their accompanying schedules and
explanatory notes, are the primary means by which the management
communicates information about the entity to the users of general purpose
financial reports. In addition to financial data published by an entity, a wealth of
information is available from other sources. Financial advisory services published
financial data for most companies and details of company reports are general
available in most public libraries. Individual companies and industry analysts are
also available from stock-broking firms. A wealth of information is also available in
various economic and financial newspapers and journals.
Information contained in the various sources of financial data is expressed
primarily in monetary terms.
Ratio analysis have been developed to provide an efficient means by which a
decision-maker can identity important relationships between items in the same
statements and ratios are calculated in order to reduce the financial data to a
more understandable basis for the evaluation of the financial condition and past
operating performance of the entity.
A financial statement ratio is calculated by dividing the ringgit amount of one item
reported in the financial statements by the ringgit amount of another item
reported. The purpose is to express a relationship between two relevant items
that is easy to interpret and compare with other information. In ratio form, the
relationship between the two items can be more easily compared with such other
standards of other companies or industry wide.
Some careful thoughts must however be taken in choosing these ratios that
express relationships relevant to the area of immediate concern. We must also
keep in mind that a ratio, when used by itself, may have little significance.

PROFITABILITY RATIOS
Profitability analysis consists of tests used to evaluate an entitys profit
performance during the year. The results are combined with other data to forecast
potential profitability.
1. Return on Total Assets = Operating profit before income tax + interest expenses

Average total assets

Measures rate or return earned through operating total assets provided by both
creditors and owners.
2. Return on ordinary = Op. profit & extra items after income tax Preference dividend
Shareholders equity
Average ordinary shareholders equity
Measures rate of return earned on assets provided by owners.
3. Profit margin = Operating profit after income tax
Net sales revenue
Measures net profitability of each dollar of sales.
4. Earning per share = Op. profit after income tax Preference dividends
Weighted average no. of ordinary share outstanding
Measures profit earned on each ordinary share.
5. Price earning ratio =

Market price per ordinary share

Earning per ordinary share

Measures the amount investors are paying for a dollar of earnings.

6. Earning yield = Earning per ordinary share
Market price per ordinary share
Measures the return to an investor purchasing shares at the current market price.
7. Dividend yield = Annual dividend per ordinary share
Market price per ordinary share
Measures the rate of return to shareholder based on current market price.
8. Dividend pay out = Total dividend to ordinary shareholders
Operating profits & extra ordinary item
after Income tax Preference dividends
Measures the percentage of profits paid out to ordinary shareholders.

10

LIQUIDITY RATIOS
1.

Current ratio

Current assets
Current liabilities

A measure of short-term liquidity indicates the ability of an entity to meet it short

term debts from its current asset.
2.

Quick ratio

Cash bank + Marketable securities + Net receivable

Current liabilities

A more rigorous measure of short-term liquidity indicates the ability of the entity to
meet unexpected demands from liquid current assets.
3.

Receivable turnover

Net sales revenue

Average receivable balance

Measures the effectiveness of collections, used to evaluate whether receivables

balance is excessive.
4.

Average collection period

Average receivable balance X 365

Net sales revenue

Measures the average number of days taken by an entity to collect its

receivables.
5.

Stock turnover

Cost goods sold

Average stock balance

Indicates the liquidity of inventory. Measure the number of times inventory was
sold on the average during the period.

11

FINANCIAL STABILITY RATIOS

1.

Debt ratio

Total liabilities
Total assets

Measures percentage of assets extent of using gearing.

2.

Equity ratio

Total shareholders equity

Total assets

Measures percentage of assets provided by shareholders and the extent of using

gearing.
3.

Capitalism ratio

Total assets
Total shareholders equity

The reciprocal of the equity and thus measures the same thing.
4.

Asset turnover ratio

Net sales revenue

Average total assets

Measures the effectives of an entity in using its assets during the period.
5.

Times interest earned

Op profit before income tax Interest expense

Interest expense

Measures the ability of the entity to meet its interest payments out of current
profits.

CASH FLOW EFFICIENCY RATIO

1.

Cash flow to sales

Cash from operations

Net sales revenue

Measures ability to convert sales revenue into cash flows.

2.

Operations index

Cash from operations

Operating profit after income tax

An index measuring the relationship between profit from operations and operating
cash flow.
3.

Cash flow return

Cash from op. + Tax paid + Interest paid on assets

Average total assets

Measures the operating cash flow return on assets before interest and tax.

12

LIMITATION OF FINANCIAL ANALYSIS

1.

Financial analysis is performed on historical data.

2.

Non monetary issues are not evaluated.

BUDGETS
Budgeting is the process of estimating money inflows and outflows to determine a
financial plan that will meet objectives.
A budget is a quantitative expression of a plan of action prepared in advance of
the period to which it can relates. Budgets may be prepared for the business as a
whole, for departments.

CAPITAL INVESTMENT ANALYSIS

Capital investments are often determinants of an organizations level of activity
and profitability. Therefore the evaluation of investment alternatives is regarded
as an important managerial consideration. Examples of capital investment may
include:
-

Expansion of existing facilities.

Updating computer systems.
Introduction of a new product.
Replacement of equipment.

METHODS OF INVESTMENT APPRAISALS

A.

Non-discounted Methods of Appraisal

1.
2.

B.

Payback Period
Accounting Rate of Return

Discounted Cash Flows (DCF) Methods of Appraisal

3.
4.
5.

1.

Net Present Value

Internal Rate of Return (IRR)
Profitability Index.

Payback Period Method

-

Calculate how long it takes to recover the initial investment.

Suitable for high risk investment.
Simple to use.
Concentrates on short term results of an investment.
Measures liquidity rather than profitability.
Cash flows beyond pay back period not considered.
Time value of money not considered.
13

Example:
Project
Initial Investment
Net Cash Flows Year

Payback Period Choice

2.

1
2
3
4
5
=

A
RM
10,000
5,000
3,000
2,000
2,000
1,000

B
RM
10,000
5,000
5,000
1,000
1,000
-

C
RM
10,000
5,000
4,000
4,000
4,000
1,000

3 years
3

2 years
1

2 years 3 months
2

Accounting Rate of Return

-

Calculated by dividing the proposals annual net profit by the initial

investment.

Ignores the timing of outflows and inflows.

Considers the income received over the life of the project.

No universally accepted method of calculating Accounting Rate of

Return.

Alternative name Return on Capital Employed

AAR

Average Net Profit

Initial Investment

Example:
A firm is considering three projects each with an initial outlay of RM2,5000 and a
life of 5 years. The estimated profits are as follows:

After Tax and Depreciation Profits

Year
1
2
3
4

Project A
RM
250
250
250
250
-------1,250
====

Project B
RM
500
450
100
100
-------1,250
====

Project C
RM
100
100
450
500
-------1,250
====

14

Calculate the ARR based on

a.
Initial capital invested.
b.
Average capital invested.
Solution:

Project A

Project B

Project C

Average profits

RM 1,250
5

RM 1,250
5

RM 1,250
5

RM 250 p.a.

RM 250 p.a.

RM 250 p.a.

Therefore ARR (based on initial capital of RM 2,500)

3.

250
2,500

250
2,500

250
2,500

20%

20%

20%

Net Present Value (NPV)

-

Present Values involves calculating the value of cash inflow and outflow
in present day terms taking into consideration the interest factor only.

Net Present value is the difference between the present value of the
inflows and present value of outflows.

Example:
Below in the projected Cash Flow of a Project
Year 0
1
2
3
4
5

(RM 2,000)
RM 400
RM 600
RM 700
RM 600
RM 500

Assuming the cost of capital is 10% calculate the NPV

Solution:
Year

Cash Flows

Discounted Factor 10%

Present value

0
1
2
3
4
5

(RM 2,000)
RM 400
RM 600
RM 700
RM 600
RM 500

1.000
0.909
0.826
0.751
0.683
0.621

(RM 2,000)
RM 363.60
RM 495.60
RM 525.70
RM 409.80
RM 310.50

The capital investment of RM 2,000 does not need discounting because it is

already in present day terms.
15

4.

Internal Rate of Return (IRR)

-

Calculates the rate of return or discount rate which results in an NPV of nil.
Trial and Error method.
Often misunderstood.

Example:
Below is the projected cash flow of a project:
Year

Cash Flows

0
1
2
3
4
5

(RM 2,000)
RM 400
RM 600
RM 700
RM 600
RM 500

Calculate IRR
Solution:
Try and Error method.
Discount Factor selected 10% and 15%.

Year Cash Flow

Discount
Factor 10% Present Value

Discount
Factor 15% Present Value

0
1
2
3
4
5

1.000
0.909
0.826
0.751
0.683
0.621

1.000
0.866
0.756
0.676
0.572
0.497

(RM 2,000)
400
600
700
600
500

(RM 2,000)
263.60
495.60
525.70
409.80
310.50
105.2
=====

(RM 2,000)
3,460.40
453.60
473.20
343.20
248.50
(135.10)
=======

From the above calculation, the IRR will be more than 10% but less than 15%.
IRR

= 10% + (105.2 x 5)
105.20 + 135.10
= 10% + (105.20 x 5)
240.30
= 12.19%

5.

Profitability Index
-

Total of cash inflow over the total of cash outflow.

When NPV is positive PI will be more than I.
PI more than I accept, less than I reject.
16