The Conceptual Framework of Accounting(GAAP), Assumption, Principles and Constraint of Accounting.

The Conceptual Framework of Accounting:

Assumptions:

As noted above assumption provides a foundation for the accounting process. The assumptions are monetary unit, economic entity, time period and going concern assumption.

• Monetary Unit Assumption:The monetary unit assumption states that only transaction data that can be expressed in term of money be included in the accounting records. For example, the value of a company president is not reported in a company’s financial records because it cannot be expressed easily in dollars.
• Economic Entity Assumption: The economic entity assumption states that the activities of the entity be kept separate and distinct from the activities of the owner and of all other economic entities. For example, it is assumed that the activities of IBM can be distinguished from those of other computer companies such as Apple, Dell, and Hewlett-Packard
• Time Period Assumption: The time period assumption states that the economic life of a business can be divided into artificial time periods. Thus it is assumed that the activities of business enterprises such as General Electric, Time Warner, or any enterprise can be subdivided into months, quarters, or a year for meaningful financial reporting purposes.
• Going Concern Assumption: The going concern assumption assumes that the enterprise will continue in operation long enough to carry out its existing objectives. In spite of numerous business allures, companies have a fairly high continuance rate. It has proved useful to adopt a going concern assumption for accounting purposes.

Principles:

On the basis of the fundamental assumption of accounting the accounting profession has developed principles that dictate how economic events should be recorded and reported. The principles are revenue recognition principle, matching principle, full disclosure principle, cost principle,

• Revenue Recognition Principle: The revenue recognition principle dictates that revenue should be recognized in the accounting period in which it is earned. But applying this general principle in practice can be difficult. For example some companies improperly recognize revenue on goods that have not been shipped to customers. Similarly. Until recently financial institutions immediately recorded a large portion of their fees for granting a loan as revenue rather than spreading those fees over the life of the loan.
• Matching Principle: Expense recognition is traditionally tied to revenue recognition. “Let the expense follow the revenue”. It dictates that expense be matched with revenues in the period in which efforts are made to generate revenues that is called matching principle. Expenses are not recognized when cash is paid, or when the work is performed, or when the product is produced. Rather they are recognized when the labor (service) or the product actually makes its contribution to revenue.
• Full Disclosure Principle: The full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosed. For example, investors who lost money in Euro, WorldCom, and Global Crossing have complained that the lack of full disclosure regarding some of the company’s transactions caused the financial statements to be misleading. Investors want to be made aware of events that can albeit the financial health of a company.
• Cost Principle: The cost principle dictates that assets be recorded at their cost. Cost is used because it is both relevant and reliable. Cost is relevant because it represents the price paid the assets sacrificed or the commitment made at date of acquisition. Cost is reliable because it is objectively measurable, factual, and verifiable. It is the result of an exchange transaction . Cost is the basis used in preparing financial statements.

Constraints:

A constraint permits a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. The constraints are materiality, conservatism, cost benefit, and industry practice.

• Materiality: Materiality relates to an item’s impact on a firms overall financial condition and operations. An item is material when it is likely to influence the decision of a reasonably prudent investor or creditor. It is immaterial it its inclusion or omission has no impact on a decision maker. In short, if the item does not make a difference in decision making. GAAP does not have to be followed. To determine the materiality of an amount, the accountant usually compares it with such items as total assets, total liabilities, and net income.
• Conservatism: The Conservatism constraint dictates that when in doubt; choose the method that will be least likely to overstate assets and income. It does not mean understating assets or income. Conservatism provides a reasonable guide in difficult situations. Do not overstate assets and income.
• Cost Benefit: When choosing between two solutions, the one that will be least likely to overstate assets and income should be picked. This constraint is basically in place to show that the information provides should be beneficial enough to justify the cost to provide it. In establishing GAAP, it is important to consider the costs it will take for companies to prepare such information and the benefits that users will derive from it.
• Industry Practice: It means that the company uses the same accounting principles and methods from year to year. Pretty much this is there to ensure that the accounting procedures follow industry practices.

The conceptual framework for developing sound reporting practices starts with a set of objectives for financial reporting. It follows with the description of qualities that make information useful. In addition elements of financial statements are defined. More detailed operating guidelines are than provided. These guidelines take the form of assumptions and principles. The conceptual framework also recognizes that constraints exist on the reporting environment.

Meaning of Credit Risk Grading, Component of Credit Risk Grading, Importance for an entrepreneur for Credit Risk Grading,

Credit Risk Grading (CRG)

The risk that an issuer of debt securities or a borrower may default on his or her obligations or that the payment may not be made on a negotiable instrument that is called credit risk. The use of a discriminate equation to classify the credit risk is called credit risk grading.

Credit grading is the process which helps the sanctioning authority to decide whether to lend or not to lend, what should be the lending price, what should be the extent of exposure, what should be the appropriate credit facility, what are the various facilities, what are the various risk mitigation tools to put a cap on the risk level. It Provides detailed and formalized credit evaluation process risk identification, measurement, monitoring and control Define target markets, risk acceptance criteria, credit approval authority, maintenance procedures and guidelines for portfolio management .

The Credit Risk Grading system should define the risk profile of borrower’s to ensure that account management, structure and pricing are adequate with the risk involved. Risk grading is a key measurement of a Bank’s asset quality, and as such, it is essential that grading is a robust process. All facilities should be assigned a risk grade. Where deterioration in risk is noted, the Risk Grade assigned to a borrower and its facilities should be immediately changed.

CRG is an important tool for credit risk management as it helps the banks and financial institutions to understand various dimensions of risk involved in different credit transaction. It provides a better assessment of the quality of credit portfolio of a bank.

Components of credit risk grading:

Financial risk:

The uncertainty of future incomes due to the company’s financing. Financial risk management refers to the practices used by corporate finance managers and accountants to limit and control uncertainty in the firm’s total portfolio. Financial risk management aims to minimize the risk of loss from unexpected changes in the prices of currencies, interest rates, commodities, and equities.

Financial risk is the principal components of credit risk grading. Two sets of financial ratio helps measure financial risk: 1. Balance sheet ratios 2. Earnings or cash flow available to pay fixed financial charges.

Business/Industry risk:

The risk related to the inability of the firm to hold its competitive position and maintain stability and growth in earnings. The uncertainty of income caused by the firm’s income. It is generally measured by the variability of the firm’s operating income over time. The Lending Guidelines should clearly identify the business/industry sectors that should constitute the majority of the bank’s loan portfolio. For each sector, a clear indication of the bank’s appetite for growth should be indicated (as an example, Textiles: Grow, Cement: Maintain, Construction: Shrink

Management Risk:

The risks associated with ineffective, destructive or under performing management, which hurts shareholders and the company or fund being managed. This term refers to the risk of the situation in which the company and shareholders would have been better off without the choices made by management. Management risk is another principal component of credit risk grading.

There is some Management risk is given below:

• Experience/relevant background
• Track record of management in see through economic cycles
• Succession
• Reputation

Security risk:

Security risk mainly depends on the potential owners or other source. Future is always uncertain, can take any step to minimize uncertain situation to the potential owner. Security risk is another principal component of credit risk grading. 

There is some Security risks are given below:

• Perishablilty
• Enforceability /Legal structure
• Forced Sale Value (calculations of force sale value should be at least guided by
• Bangladesh Bank guidelines)

Relationship risk:

Relationship risk mainly based on supplier and customer relation to the entrepreneur. If the entrepreneur can make a good relation to the customer or supplier he or she also get the loan at a lower rate.

 Importance for an Entrepreneur for Credit Risk Grading:

1. It helps the entrepreneur to get the loan easily from a bank. If an entrepreneur know the credit risk grading very well. And grading score is good for him or her. He or she will get the loan from a bank. Credit risk grading indicates the Good Financials situation, Valuable and operating business franchises, stable operating environment adequate liquidity and earnings. Acceptable management. So it helps the entrepreneur to get the loan easily from a bank.
2. It helps the entrepreneur to understand the various risks which is involved with his or her business. The entrepreneur can understand the key risk component factors which may be broadly categories under Quantitative and Qualitative factors. When an entrepreneur compute his or her credit risk grading. He or she can identify financial risk, business risk, management risk, security risk.

HOW TO COMPUTE CREDIT RISK GRADING

1. Identify all the Principal Risk Components:
2. Allocate weight to Principal Risk Components
3. Establish the Key Parameters under each risk components:
4. Assign weight to each of the key parameters.
5. Add all the weight of the key parameters to have an overall score:
6. Assign a grade based on the total weights:

Overal Concept Of Documentary credit/Letter of credit (L/Cs)

Documentary Credit/Letter Of (L/Cs)

Documentary Credit is an assurance of payment by the bank. It is an arrangement under which the bank at the request of the buyer or on its own undertakes to make payment to the seller provided specified documents are submitted.

Documentary Credit is an arrangement whereby a bank (issuing bank) acting at the request and on the instruction of a customer (the applicant) or on its own behalf undertakes to make payment to or to the order of a third party (the beneficiary) or to accept and pay bills of exchange (draft) drawn by the beneficiary, or authorize another bank to negotiate against stipulated documents provided the terms and conditions to the credit are complied. Thus, Documentary Credits are akin to bank guarantees. In popular language, they are known as Letters of Credit (L/Cs). Bank guarantees are, however, issued to cover situation of non-performance whereas Documentary Credits are issued on behalf of the buyer to cover situation of performance, i.e., the issuing bank agrees to make payment to the beneficiary once he surrenders the requisite complying documents. However, the term Documentary Credit has of late been extended to cover the situation of non-performance too. Documentary Credits have gained wider acceptance in international trade for they try to safeguard the interest of both the buyer and the seller by reducing their risks. Thus, Documentary Credit offers a unique and universally used method of achieving a commercially acceptable arrangement by providing for payment to be made against complying documents that represent the goods and making possible the transfer of those goods.

Bank as a party of Documentary credit

Parties to the documentary credit may be an issuing bank, an advising bank, a confirming bank, a reimbursing bank or a negotiating bank.

• Issuing Bank: The Issuing Bank or the Opening Bank is one which issues the credit, i.e., undertakes, independent of the undertaking of the applicant, to make payment provided the terms and conditions of the credit have been complied with. The payment may be at sight if the credit provides for sight payment or at maturity dates if the credit provides for deferred payment. Especially the issuing bank should satisfy himself on the credit worthiness of the applicant. The credit application must be in accordance with UCP 500 and in a workable format.
• Advising Bank: The Advising Bank advises the credit to the beneficiary thereby authenticating the genuineness of the credit. The advising bank is normally situated in the country/place of the beneficiary.
• Confirming Bank: A Confirming Bank is one which adds its guarantee to the credit opened by another bank, thereby, undertaking the responsibility of payment/negotiation/acceptance under the credit in addition to that of the issuing bank. A confirming bank normally does so if requested by the issuing bank and it is normally the advising bank.
• Negotiating Bank: A Negotiating Bank is the bank nominated or authorized by the issuing bank to pay, to incur a deferred payment liability, to accept drafts or to negotiate the credit.
• Reimbursing Bank: A Reimbursing Bank is the bank authorized to honor the reimbursement claims in settlement of negotiation/acceptance/ payment lodged with it by the negotiating bank or accepting bank. It is normally the bank with which the issuing bank has account from which payment is to be made.

Types of documentary letter of credit:

Documentary credits are basically two types:

1. Revocable credit: This type of credit can be revoked or cancel at any time without the consent of, or notice of the beneficiary. In case of seller (beneficiary), revocable credit involves risk, as the credit may be amended or cancelled while the goods are in transit and before the documents are presented, or, although presented, before payment has been made. In modern banking, the use of revocable credit is not widely spread.
2. Irrevocable Credit: The irrevocable credit is a commonly used type of documentary credit. The credit which can not be revoked, varied or change / amended without the consent of all parties- buyer, seller, issuing bank, and confirming bank irrevocable credit gives the seller grater assurance of payments, but he remains dependent on an undertaking of a foreign bank. Irrevocable credit may be confirmed or unconfirmed.

Types of documentary credits according to payment methods:

• Sight Payment: The payment is made as soon as documents shown to the issuing Bank and payment received from importer. Instruction is given to reimbursing bank to give payment.
• Deferred Payment: The payment of this kind of L/C is made after 30, 60, 90, 120 or 180 days soon as documents shown to the issuing Bank. The credit with deferred payment differs only slightly in its effect on the beneficiary from the credit with time draft.

Special Types of Documentary Credit

1. Revolving Credit:A revolving credit is one where, under the terms and conditions thereof, the amount of the credit is renewed or reinstated without specific amendment to the credit being needed.  Revocable credit may be revocable or irrevocable. It can revolve in relation to time or value.
2. Back to Back Credit:One credit backs another. It may so happen that the beneficiary / seller of an L/C is unable to supply the goods direct as specified in the credit as a result of which he need to purchase the same and make payment to another supplier by opening a second letter of credit. In this case, the second credit called a "Back to back credit". This concept involve opening of second credit on the strength of first credit, i.e. mother L/C opened by foreign importers. Under back to back concept, the mother L/C stands as security for opening of second credit.
3. Transferable Credit:A transferable credit is one which can be transferred by the original beneficiary to one or more parties. In transferable credit, the original beneficiary becomes the middleman and transferee becomes the actual supplier of goods. It is normally used when the first beneficiary does not supply the merchandise himself, but is a middleman and thus wishes to transfer part, or all, of his rights and obligations to the actual supplier as second beneficiary.
4. Red Clause Credit:A Red clause credit is a credit with a special clause incorporated into it that authorized the advising bank or confirming bank to make advances to the beneficiary before presentation of documents.
5. Green Clause credit: A green clause credit is a credit with a special clause incorporated into it that which not only authorizes the advising bank to grant pre-shipment advances but also storage cost for storing the goods prior to shipment. 
6. Standby Letter of Credit: The standby credit is very similar in the nature to a guarantee. The beneficiary can claim payment in the event that the principal does not comply with its obligations to the beneficiary. Payment can usually be realized against presentation of a sight draft and written statement that the principal has failed to fulfill his obligation.

Overall Concept of Foreign trade and Foreign Exchange Market

Meaning Of Foreign Trade

One of the largest businesses carried out by the commercial bank is foreign trading. The trade among various countries falls for close link between the parties dealing in trade. The situation calls for expertise in the field of foreign operations. The bank, which provides such operation, is referred to as rending international banking operation. Mainly transactions with overseas countries are respects of import; export and foreign remittance come under the preview of foreign exchange transactions. International trade demands a flow of goods from seller to buyer and of payment from buyer to seller. In this case the bank plays a vital role to bridge between the buyer and seller.

Foreign trade

Foreign trade can be easily defined as a business activity, which crosses national boundaries. These may be between parties or government ones. No country can produce all kinds of goods and another country, from this sense; mainly this is the origin of foreign trade. When two countries exchange goods or services between them we can call it foreign trade. Many writers define it in many ways. Some of them are given below:

According to Prot C.P. Kridleberger - 

“International trade is the transaction of goods and services between two or more countries”

According to Professor O.M. Amos- 

“International trade is the exchange of goods across nation trade is the exchange of goods across nation al boundaries”.

According to V.M. Mittari - 

“International trade is a trade among different countries or trade across political frontiers”.

Different modes of International Trade Payments

In International trade methods of payment could take any of the following forms:

1. Cash in advance
2. Open account
3. Collection
4. Documentary credit

The first three are traditional trade payment methods, which view the bank's role as an agency for transmitting and receiving funds or documents. Under documentary credit, on the other hand, the bank assures payment subject to the completion of documentary conditions.

1. Cash in advance

Under this system the exporter may receive value of export in advance from the importer before the actual shipment of goods through cheque, draft or T.T. This practice though expensive and risky is resorted to in cases where either the buyer's credit worthiness is doubtful or where there is an unstable political or economic environment in the buyer's country or where manufacturing process or service delivered are specialized and capital intensive.

2. Open account

An open account method is an arrangement between the buyer and seller whereby the goods are manufactured and delivered before payment is made. Under this method, since the payment has to be made at some stated future date and there is no negotiable instrument in evidence of the buyer's commitment to pay the seller faces the risk of release of goods without assurance of payment.

3. Collection

Collection is a method under which goods are shipped and the bills of exchange (Draft) is drawn by the seller on the buyer. The documents are sent to the bank with clear instruction for collection through on of its correspondent bank located in the buyer's country. The documents are to be delivered only after the payment has been made or Draft is accepted.

4. Documentary credit

• Documentary credit is the classic form of international trade payment, especially in trade between distance partners. This method substantially reduces payment related risk for both exporter and importer.
• Documentary credit is a conditional bank undertaking of payment. It is a conditional undertaking given by a bank (Issuing Bank) at the request of a customer (Applicant) or on its own behalf to pay a seller (Beneficiary) against stipulated documents provided all the terms and conditions of the credit are complied with.
• These stipulated documents are likely to include those required for commercial, regulatory, insurance or transport purposes, such as commercial invoice, certificate of origin, insurance policy or certificate and a transport document of a type appropriate to the mode of transport used.

Foreign Exchange Market

The market composed of banks, serving firm and consumers who wish to buy or sell various foreign currencies is called foreign exchange market. The foreign exchange market is a market where conversions take place. In our country inter Bank Foreign Currency/Exchange Market operated through electronic media using Dealing Room of Bank/Financial Institution for buying and selling of foreign currency among banks and other financial institutions at floating rate based on market demand and supply. Only authorized dealers deal directly with each other in foreign exchange markets who are licensed to operate in the foreign market by the Bangladesh Bank. Authorized deals who are generally commercial bank on behalf of their customer handles all the foreign transaction.

Type of Foreign Exchange Market:

There are three types of foreign exchange market existed in our country-

• Spot Market- where exchange of one currency with another takes place on the spot.
• Forward Market- where actual delivery of the currency will happen at a future date as per agreement of present date.
• 0ption Market- Wherein a contract is made specifying the right to buy or sell a standard amount of foreign currency within a specific date at a certain price.

Term Used in Foreign Exchange Market Operation:

Usually three terms used in our foreign exchange market operation. There are-

• Arbitrage- Spot purchase of FC where the price is low and sells where the price is high i.c. By low and sell high. Currency Arbitrage due to price difference in to financial centers.
• SWAP- Purchasing FC on the spot for selling Forward or selling spot for purchasing forward Due to difference in interest rate of the concerned currencies.
• Hedging- to avoid exchange risk, agreement is made to day to buy or sell FC to be delivered at some future date at a rate agreed upon to day

Overall Concept of Foreign Exchange

Meaning Of Foreign Exchange

Foreign Exchange:

One of the largest businesses carried out by the commercial bank is foreign trading. The trade among various countries falls for close link between the parties dealing in trade. The situation calls for expertise in the field of foreign operations. The bank, which provides such operation, is referred to as rending international banking operation. Mainly transactions with overseas countries are respects of import; export and foreign remittance come under the preview of foreign exchange transactions. International trade demands a flow of goods from seller to buyer and of payment from buyer to seller. In this case the bank plays a vital role to bridge between the buyer and seller.

H.E. Evitt defined  

“Foreign Exchange” as the means and methods by which rights to wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of the currency of another country.

Foreign Exchange Department is an international department of the bank. It deals with globally and facilitates international trade through its various modes of services. It bridges between importers and exporters. Bangladesh Bank issues license to scheduled banks to deal with foreign exchange. These banks are known as Authorized Dealers. If the branch is authorized dealer in foreign exchange market, it can remit foreign exchange from local country to foreign country. This department mainly deals with foreign currency. This is why this department is called foreign exchange department.

Some national and international laws regulate functions of this department. Among these, Foreign Exchange Act, 1947 is for dealing in foreign exchange business, and Import and Export Control Act, 1950 is for Documentary Credits. Governments’ Import &Export policy is another important factor for import and export operation of banks.

Foreign trade financing is an integral part of banking business. Documentary Credit (also called letters of credit or “L/Cs”) is the key player in the foreign exchange business. According to foreign exchange regulation Act, 1947, as adapted in Bangladesh,

"Foreign exchange means foreign currency and includes all deposits, credit and balances payable in foreign currency as well as all foreign currency instruments, such as Drafts, Travelers cheques, Bills of Exchange and promissory notes payable in any foreign country. Anything that conveys a right to wealth in another country is foreign exchanges”. 

With the globalization of economies international trade has become quite competitive. Timely payment for exports and quicker delivery of goods is, therefore, a pre-requisite for successful international trade operations. Growing complexity of international trade, separation of commercial parties across the globe and operating in a totally unknown environment underlined the need for evolving a system that balances between the expectations of the seller and the buyer. Documentary Credit has emerged as a vital system of trade payment, and fulfilled the requisite commercial need. This system substantially reduces payment-related risks for both exporter and importer. Not surprisingly, therefore, the letter of credit is the classic form of international export payment, especially in trade between distant partners. Payment, acceptance or negotiation of the credit is made by the bank upon presentation by the seller of stipulated documents (e.g., bill of lading, invoice, inspection certificate).

Foreign exchange refers to the process or mechanism by which the currency of one country is converted into the currency of another country and thereby involves the international transfer of money. It is the means and method by which rights to wealth in a country’s currency are converted into rights to wealth in another country’s currency. In banks when we talk of foreign exchange, we refer to the general mechanism by which a bank converts currency of one country into that of another. Foreign trade gives rise to foreign exchange. Foreign trade is transacted either in the currency of the exporter’s country or that of the importer’s country, or that of a third country acceptable to both the exporter and the importer.

Dr. Paul Einzig

“Foreign exchange is the system or process of converting one national currency into another and of transferring the ownership of money from one country to another.”

Mr. H. E. Evitt

“Foreign exchange is that section of economic science which deals with the means and methods by which rights to wealth in one country’s currency are converted into rights to wealth in terms of another country’s currency. It involves the investigation of the method by which the currency of one country is exchanged for that of another, the causes which render such exchange necessary, the forms which in exchange may take and the ratios or equivalent values at which such exchanges are effected.”

The term “currency” as earlier stated includes not only such notes and coins as are legal tenders, but also bank balances and deposits in foreign currency and all instruments- credit instruments which are capable of being used as currency, such as bills of exchange, promissory notes, letter of credit, travelers cheques, cheques, drafts, airmail transfers, telegraphic transfers (TT) and all other instruments which convey to holder a right to wealth.

Thus foreign exchange means foreign currency and includes –

1. All deposits, credits and balances payable in any foreign currency and any drafts, travelers cheques, letters of credit and bills of exchange, expressed or drawn in local currency but payable in any foreign currency; and
2. Any instrument payable, at the option of the drawee or holder thereof or any other party thereto, either in local currency or in foreign currency or party in one and party in the other.

Foreign exchange is concerned with the settlement of international indebtedness, the methods of effecting the settlements and the instruments used in this connection, and the variation in the rates of exchange at which settlement of international indebtedness is made.