Accounting activities and Users
Accounting consists of three basic activities—it identifies, records, and communicates the
economic events of an organization to interested users.
• Identification- to record economic events
• Recording- Record, classify & summarize
• Communication- prepare accounting reports, analyze & interpret for users
Who uses accounting data
Two groups of users for financial information
• Internal users- Managers who plan, organize and run a business which include marketing
manager, production manager, production supervisor, finance director, company officers.
• External users- individuals or organizations outside a company who want financial
information about the company; investors (owners), creditors (suppliers & bankers).
Ethics in Financial reporting
Ethics are the standards of conduct used to judge actions as right or wrong, honest or dishonest,
and fair or unfair.
Threats where ethics can be compromised
1) Self-interest threat: When personal gain affects your decisions.
Example: An accountant overlooks errors in financial reports to secure a bonus.
2) Self-review threat: When you have to check your own work.
Example: An auditor reviews financial statements they helped prepare.
3) Advocacy threat: When you promote someone else's interests too much.
Example: Supporting a client in a legal case compromises objectivity.
4) Familiarity threat: When close relationships affect your judgment.
Example: An accountant ignores mistakes in a report prepared by a close friend.
5) Intimidation threat: When you're pressured to act unethically.
Example: A boss threatens to fire an accountant unless they manipulate figures.
IFAC 5 principals of ethics
1) Integrity: Always be honest and do the right thing.
Example: Never lie about financial numbers.
2) Objectivity: Stay fair and avoid letting personal feelings or relationships influence your
decisions.
Example: Don’t favor a friend when preparing reports.
3) Professional competence and due care: Keep learning to stay skilled and always do
your best work.
Example: Take extra care to ensure reports are accurate and professional.
4) Confidentiality: Keep information private unless legally required to share it.
Example: Don’t talk about client details with others without permission.
5) Professional behavior: Follow the rules and always act in a way that brings respect to
your profession.
Example: Avoid actions like cheating or breaking laws.
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Measurement Principles
GAAP uses two main measurement principles: historical cost (recording assets at their original
cost) and fair value (recording assets at their current market value).
• Historical cost- The historical cost principle means assets are recorded at their original
purchase price and stay at that value, even if their market value changes.
Example: If land bought for $300,000 increases to $400,000, it is still recorded as
$300,000.
• Fair value- The fair value principle states that assets and liabilities are reported at their
current market value. This is often more useful for actively traded assets like investment
securities.
Most companies use historical cost, but fair value is applied when assets are actively traded.
Assumptions in Accounting
1) Monetary Unit Assumption
It states that only transactions measurable in monetary terms are recorded in the
accounting records. This assumption allows businesses to quantify economic events
effectively. However, it excludes non-quantifiable information, such as employee morale
or the health of a business owner, even though such factors may be significant.
2) Economic Entity Assumption
It ensures that a business's activities are kept separate from those of its owner and other
entities. This principle applies to various types of organizations, including businesses
like Sally's Boutique, government units, schools, and churches, maintaining clear
boundaries for financial reporting.
Business Structures under Economic Entity Assumption
1. Proprietorship
o Owned by one person.
o Owner manages and is personally liable for debts.
o Business records are kept separate from personal records.
o Examples: Small businesses, like salons or bookstores.
2. Partnership
o Owned by two or more people.
o Partners share profits, losses, and personal liability.
o Business activities are separate from personal activities.
o Examples: Law firms, medical practices, and accounting firms.
3. Corporation
o Separate legal entity with ownership divided into shares.
o Stockholders have limited liability.
o Ownership is transferable, and the corporation has unlimited life.
o Examples: Large companies like Apple, Ford, or Walmart.
These assumptions ensure clarity and consistency in financial reporting.
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Role of Auditors and the Necessity of Ethics in the Mentioned Scandals
1. Enron (2001)
• Scandal: Enron engaged in fraudulent accounting practices by hiding debts through
off-balance-sheet special purpose entities (SPEs) to inflate profits and conceal losses.
• Role of Auditors:
o Arthur Andersen, Enron's auditor, failed to maintain independence and
objectivity.
o The firm overlooked irregularities and even destroyed audit documents during
investigations.
• Necessity of Ethics:
o Auditors are expected to act with integrity and objectivity, ensuring that
financial reports reflect the true financial position.
o Ethical compliance could have prevented the collusion and document
destruction, maintaining trust in financial reporting.
2. WorldCom (2002)
• Scandal: WorldCom overstated its profits by capitalizing operating expenses, thereby
inflating earnings by $11 billion.
• Role of Auditors:
o Internal auditors eventually uncovered the fraud, but the external auditors,
Arthur Andersen, failed to identify or report the irregularities.
o Lack of due diligence and ethical responsibility contributed to the prolonged
fraud.
• Necessity of Ethics:
o Auditors should have upheld the principles of professional competence and due
care, rigorously verifying financial statements.
o Ethical practices could have ensured timely detection and reporting of the
fraud.
3. Satyam (2007)
• Scandal: Known as the "Indian Enron," Satyam manipulated financial statements by
inflating revenues, profits, and cash balances, resulting in a fraud of over $1 billion.
• Role of Auditors:
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o PricewaterhouseCoopers (PwC), Satyam's auditors, failed to verify bank balances
and revenue authenticity.
o They neglected professional skepticism and accepted fraudulent documentation
at face value.
• Necessity of Ethics:
o Ethical principles, such as integrity and objectivity, were compromised when
auditors failed to question and critically examine irregularities.
o Strict adherence to ethical codes could have exposed the fraud sooner,
safeguarding stakeholders’ interests.
Why Ethics is Critical in Accounting and Auditing?
1. Trust and Confidence: Ethical practices ensure stakeholders can trust the financial
information presented to them.
2. Prevention of Fraud: Strong ethical standards act as a deterrent to fraudulent behavior
by management or auditors.
3. Regulatory Compliance: Ethics aligns with laws and regulations, avoiding legal
repercussions.
4. Protection of Reputation: Companies and auditors maintaining ethical integrity
safeguard their long-term reputation and sustainability.
Lessons Learned
These scandals underscore the critical importance of ethical practices in accounting and
auditing, emphasizing the need for:
• Stringent ethical training for professionals.
• Regulatory reforms to enforce ethical compliance.
• Independent auditing standards to maintain objectivity and accountability.
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