Chapter 1: Introduction to Financial Accounting Accounting is the language of business. business. It requires the systematic record keeping of all that happens on a day – to – day basis in business and analyzing this information information to aid business decision making. The primary intension of financial accounting is the preparation of the statement revealing the income and financial position of the business on the basis of the events. The major financial statements are Profit and Loss A/c, Balance Sheet, Cash Flow Statement etc…
I. UNDERSTANDING BUSINESS ORGANIZATIONS: Business organizations offer goods and services in order to earn a profit. Receiving and paying cash are central to the activities of business organizations. Business organizations organizations that provide goods are of two kinds:
Merchand Merchandising ising (Trading) (Trading) Organiza Organizations tions:: buy and sell ell goods ods without any processing. processing. Manufacturing Organizations: Organizations: buy buy mater material ials, s, proce process ss them them into into finished products, and sell them. Service Organizations: Organizations: are businesses that provide services. Unlike goods, services do not have either form or substance, and, therefore, the recipient of a service can only experience them and can not transfer them to another person.
Book-Keeping is mainly concerned with recording of financial data relating to the business operations in
a significant and orderly manner. A book keeper may be responsible for keeping all the records of a business or only of a minor segment such as position of a customer’s accounts in a departmental store. A subs substa tant ntia iall porti portion on of the the book book keep keeper er work work is of a cler cleric ical al in natu nature re and and is incr increa easi sing ngly ly being being accomplished through the use of mechanical and electronical devices.
II. What is Accounting? Accounting is often called the language of Business. Acco Ac coun unti ting ng,, as an info inform rmat atio ion n syst system em,, is the the proc proces ess s of iden identi tify fyin ing, g, measuring, and communicating the economic information of an organization to its users who need the information for decision making. The American Institute of Certified Public Accountants defines accounting 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 a financial character, and interpreting the results thereof. • •
This definition brings out the following as attributes of accounting: •
Events and transactions of a financial nature are recorded while the events of a non-financial nature cannot be recorded.
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The record should reflect the importance of the transactions so recorded both individually and collectively, which includes summarization, thereby making it amenable to analysis. The users of the financia financiall statem statement ents s should should be able able to obtain obtain the messag message e enco encomp mpas asse sed d in such such fina financ ncia iall stat statem emen ents ts,, and and it is the the know knowle ledg dge e of accountancy, which enables the user to understand the contents of the financial statements.
The Accounting Information System INPUT
Economic events measured in financial terms
PROCESS
Recording Classifying Summarizing Analyzing Interpreting
OUTPUT
Communicatin g information to users ( P&L A/c, B/S, CFS, etc)
Accounting Process: Recording: Recording commences when a business transaction occurs and it has been quantified. A record of all these transactions is maintained in the order in which they occur in the Journal Book. Classifying: It refers to the rational segregation of the recorded information into related groups so as to make the record useful. The book containing such classified information is called the Ledger Book consisting of a number of accounts each complete in its own way. For example, all the receipts forming inflows and the payments forming outflows are grouped to ascertain the net cash position of the firm. The arrangement in this case is better known as the Cash Book. Summarizing: After the Recordin Recording g and Classifi Classificati cation on phases phases are complete complete the accounts containing relevant information information in the Ledger Book are to be balanced and the balan balances ces listed listed.. The The Statem Statement ent giving giving names names of these these accou accounts nts and their their respective balances is called the Trial Balance. On the basis of the Trial Balance the summaries are generated to provide information about the Profit / Loss and the
Position of the firm. The reporting of these summaries is done through Financial Statements. Financial Statements can be defined to include the Balance Sheet, the Profit and Loss Loss Ac Accou count, nt, Notes Notes to the Ac Accou counts nts and other other incid incident ental al statem statement ents s and explanatory material which are identified as part of financial statements.
Information and the Accounting Process • • •
Identi Identific ficati ation— on—wha what’s t’s releva relevant? nt? Meas Measur urem emen ent— t—wh whic ich h yards yardsti tick ck? ? Clas Classi sifi fica cati tion on and and accu accumu mula lati tion on—h —how ow do you you orga organi nize ze the the resu result lts s of thousands of events? • Summariz Summarizatio ation—ho n—how w much much inform informatio ation n is enoug enough, h, but but not too too much? much? • Commun Communica icatio tion—h n—how ow often often,, when, when, and and to whom whom? ? Qualities of Accounting Information Information should be useful, useful , but what does that mean? mean? The two primary primary qualities of useful information are: 1) Relevance--t Relevance--the he inform informati ation on must pertai pertain n to the decisi decision on at hand. hand. That suggests it will have predictive have predictive and feedback value and should be timely. 2) Reliability --the --the information must reasonably reflect the real-world situation that it represents. To do so, it must be free of bias and verifiable. verifiable.
Other Qualities of Useful Information •
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Understandability --the --the inform information ation must must be understood understood to be useful. useful. Users Users are assumed assumed to have have a genera generall knowle knowledg dge e of busin business ess and a very very basic basic knowledge of accounting. Comparability --the - -the info inform rmat atio ion n must must be repo report rted ed so that that comp compar aris ison ons s between similar entities can be made. Consistency --the --the same same accou accounti nting ng metho methods ds must must be used used from from period period to period to evaluate results over time.
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Figure 1.1: The Accounting Process III. ACCOUNTING INFORMATION AND ECONOMIC DECISIONS: Accounting information is useful in making a number of decisions that affect the incom income e or wealth wealth of indivi individua duals ls and organi organizat zation ions. s. Ac Accou counti nting ng report reports s are are desi design gned ed to meet meet the the comm common on info inform rmat atio ion n need needs s of most most deci decisi sion on make makers rs.. Examp Examples les of decis decision ions s that that are based based on accou accounti nting ng inform informati ation on includ include e the following: 1. Decide Decide when to buy, buy, hold hold or sell an an equity equity investmen investment. t. 2. Ass Assess ess the stewar stewardshi dship p or account accountabili ability ty of mgt. 3. As Asses sess s the the abilit ability y of the enterpri enterprise se to pay and provide provide other other benefi benefits ts to its employees. 4. Ass Assess ess the secur security ity for amoun amounts ts lent to to the enterpr enterprise. ise. 5. Determine Determine distr distribut ibutable able profits profits and dividen dividends. ds. 6. Determ Determine ine taxat taxation ion polic policies ies.. 7. Prepare Prepare and use use nationa nationall income income statis statistics. tics. 8. Regulate Regulate the activi activities ties of enterpr enterprises ises.. The decision decision maker who intends intends to use accounting accounting information information should have a reasonab reasonable le understa understandin nding g of busines business s and economic economic activities activities and be willing willing to
study the information with reasonable diligence. A sophisticated understanding of accounting is an indispensable part of the tool-kit for most decision makers.
IV. CLASSIFICATION OF ACCOUNTING: In order to satisfy needs of different people interested in the accounting information, information, different branches of accounting have developed.
Accounting is generally classified into three different disciplines disciplines as shown in Figure.
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Figure 1.2 Classification of Accounting Financial Accounting: Its primary intention is to prepare the Statements revealing the Income / Loss and financial position of the business on the basis of events, which have happened in the period being reckoned. But this information, though of immense vitality does not adequately aid the managemen managementt in planning planning,, controll controlling, ing, organizin organizing g and efficien efficiently tly conductin conducting g the cours course e of the busin business ess as a result result of which which Cost Cost Ac Accou counti nting ng and Manageme Management nt Accounting are in place.
Cost Accounting: It shows shows class classifi ificat cation ion and analy analysi sis s of costs costs on the the basis basis of functions, processes, processes, products, centers etc. It also deals with cost computation, cost saving, cost reduction, etc. Managem Management ent Accountin Accounting: g: Manage Manageme ment nt Accoun Accountin ting g begins begins where where Financ Financial ial Accou Ac counti nting ng and and Cost Cost Accoun Accountin ting g ends. ends. It deal deals s with with the the proc proces essi sing ng of data data generated generated in financia financiall accountin accounting g and cost accountin accounting g for manageria manageriall decision decision-making. It also deals with application of managerial economic concepts for decisionmaking. V. OBJECTIVES OF ACCOUNTANCY: Maintaining Accounting records: Systematic recording of the monetary transactions of the firm is the initial step leading to the creation of the financial stat statem emen ents ts.. Once Once reco record rdin ing g is comp comple lete te,, the the reco record rds s are are clas classi sifi fied ed and and summarized to depict the financial performance performance of the enterprise.
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Calculating the results of Operations: The Income Statement also known as the Profit and Loss Account is prepared to reflect the profits earned or losses incurred. All the expenses incurred in the course of conducting the business are aggregated and deducted from the total revenues to arrive at the profit earned or loss incurred during the relevant period. Ascertain aining ing the finan financia ciall positi position: on: Fina Financ ncia iall heal health th or posi positi tion on is 3. Ascert ascertained with the help of the Balance Sheet. On the right hand side of the Balance Sheet are the Assets or the resources owned by the firm. On the left hand side are the Liabilities or the obligations of the business to the outsiders and and the the owne owners rs.. The The owne owners rs'' port portio ion n is call called ed the the Capi Capita tall and and is to be distinguished from that of the other liabilities such as loans and creditors. All of them are grouped in the respective heads under the Liabilities. This information on the assets and liabilities, with the help of accountancy, provides control over the resources of the firm. 4. Accounting is the precursor to financial reporting: The vital liquidity / solvency position is comprehended through the Cash and Funds Flow Statement elucidating the capital transactions, obtaining of cash and the way it has been expended, loans and their repayment, cash dividends, etc. 5. Communicating the information to the users: Financial statements so compiled are of great use to a variety of users including the provision of a firm base for the computation of the statutory tax liability and the consequent filing of return of income. VI. ADVANTAGES OF ACCOUNTING: 2.
It facilitates: to replace memory. to comply with legal requirements. to ascertain Net results of operations. to ascertain Financial position. the users to take decisions. a compliance study. control over assets. the settlement of tax liability. the ascertainment of value of business. raising of funds. Acts as legal evidence
VII. USERS OF FINANCIAL STATEMENTS: Investors and lenders are the most obvious users of accounting information. Their decisions and their uses of information have been studied and described to a much greater extent than those of other user groups. However, financial reports are also extensively used by other individuals and groups who have to rely on them as their major source of financial information. Potential users of accounting information information include:
Internal Internal Users: Users: They They includ include e Board Board of Direct Directors ors,, Partne Partners rs,, Manage Managers rs,, and Officers. They need informat information ion for planning planning and controll controlling ing operation operations, s, for making special decisions, and for formulating major plans and policies. Mana Manage gers rs us use e acco accoun unti ting ng info inform rmat atio ion n to eval evalua uate te pote potent ntia iall investment projects. Manage Managemen mentt exami examines nes the the compe competit tition ion in the the indust industry ry and makes makes fina financ ncia iall comp compar aris ison ons s of its its perf perfor orma manc nce e agai agains nstt comp compet etit itor ors’ s’ performance. External Users: A). Financing Group:
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a) Inve Invest stor ors: s: Accounti Accounting ng informa information tion enables enables investors investors to identify identify promis promising ing inves investme tment nt oppor opportun tuniti ities. es. They They need need infor informa matio tion n to decide which investments to buy, retain, or sell, as well as the timing of the purchases or sales of those investments. They also need need infor informat mation ion to monito monitorr manag manageme ement nt perfor performa mance nce and to assess the ability of the enterprise to pay dividends. b) Lend Lender ers: s: Lender Lenders s such such as banks banks and dentur denture-h e-hold olders ers need need to know about the financial stability of a business that approaches them for funds. funds. They are interest interested ed in information information that enables enables them to determine whether their loans, and the related interest will be paid when due. c) Supp Suppli lier ers: s: Present Present and potential potential supplier suppliers s are interested interested in the enterprise as an outlet for their products or services and, if the enterprise is a major customer, they will be interested in assessing the likeliho likelihood od of the situation situation continui continuing. ng. They are interest interested ed in information information that enables them to determine whether amounts owed to them will be paid when due. B). Public Group: a) Govern Governmen mentt Agenc Agencies ies:: The three levels of government in India – cent centra ral, l, stat state e and and loca locall - are are inte intere rest sted ed in the the allo alloca cati tion on of resources and, therefore, in the activities of enterprises. They also require information in order to regulate the business practices of enterpri enterprises, ses, determine determine taxation policies, policies, and provide provide a basis basis for national income and similar statistics. b) Empl Employ oyee ees: s: They They are are inte intere rest sted ed in info inform rmat atio ion n abou aboutt the the enterprise about the enterprise as well as its general operations, stability and profitability. c) Cust Custom omer ers: s: Present, potential and past customers are interested in the the fina financ ncia iall affa affair irs s of an ente enterp rpri rise se in deci decidi ding ng how how much much business to do with it, and in assessing the likely ability of the ent enterp erprise to servi ervic ce to the produc oductt or to hono onor war warranty anty agreements. d) Secu Securi rity ty Anal Analys ysts ts and and Advi Advise sers rs:: They They serv serve e the the need needs s of investors by providing them with skilled analyses and interpretation of financial reports. Securities firms to recommend to their clients whether to buy, sell or hold their investments use Analysts’ reports.
Basic Terms • • •
Assets Asset s - reso resour urces ces owned owned by by a bus busine iness ss Liabil Liabiliti ities es - debts debts and and obliga obligatio tions ns of the the busine business ss Comm Common on stoc stock k - stoc stock k repr repres esen enti ting ng the the prim primar ary y owne owners rshi hip p inte intere rest st in a corporation • Expenses: Expenses are the costs of assets consumed or services used to generate revenues Examp Examples les... ... Store Store operat operating ing expens expenses, es, Genera Generall and admin administ istra rativ tive e expenses, Interest expense • Audi uditor' tor's s Repo eport General Guide for Financial Accounting • Generally • Accepted • Accounting • Principles Accounts Provide the the most useful financial information for…Decision for…Decision Making
Primary Accounting Setting Body in the U.S. 1. Financia Financiall Accoun Accounting ting Standard Standards s Board Board GAAP Are the Rules, The FASB makes the rules. •
Acco Ac coun unti ting ng Conc Concep epts ts – Basic Basic assumpt assumption ions s or condi conditio tions ns upon upon which which the science science of accoun accountin ting g is based. • Ac Acco coun unti ting ng Conv Conven enti tion ons s – Principle Principles s or theories theories based based on which which accou accountin nting g is done. • Money Measurement Concept: In financial accountancy, an event is recorded, only if it can be expressed in monetary terms. Recording, classification and summarization of business transactions requires a common unit of measurement, which is taken as money. Hence, all transactions are recorded through a common denominator – money. Thus, if a certain event, no matter how significant for the health or even existence of the business, cannot be measured in monetary terms, that event is not recorded in accounting. Money is expressed in terms of its value at the time an event is recorded in the accounts.
• Business Entity Concept: The business is distinctly different and separate from its owner. A business entity or a company is an artificial company created by law, who has a common seal, which has a perpetual perpetual existence and does not die natural death. Hence for accounting purpose, the owner and his business should be kept separate. Accounting records are kept from the point of view of the business unit and not the owner. So, if the owner contributes fund to the business, it will be treated as a liability of the business – say the business owes this much to the owner.
• Going Concern Concept: A business entity is having a perpetual existence, which does not die a natural death. It is assumed to carry on its operations forever. It implies that the resources of the concern would continue to be used for the purposes for which they are meant to be used. For instan instance, ce, in a manufa manufactu cturin ring g concer concern, n, the land, land, buildi buildings ngs,, machin machinery ery etc., etc., are primarily required for carrying out the production and selling of certain products. This concept implies that these land, buildings, machinery etc., would continue to be used for this purpose. • Cost Concept: Cost Concept implies that in accounting, all transactions are generally recorded at cost, and not at market value. For example, if a piece of land is acquired for Rs.1 lakh, it would continue to be shown in the balance sheet at Rs.1 lakh, even when the market value of the land rises to say Rs.10 lakhs. Why should this be so? This is because cost concept is in fact closely related to the going concern concept.
• Duality concept: This is the fundamental accounting equation, which is the formal expression of the dual aspect concept. To reflect the two types of equities, the equation is more commonly expressed as ASSETS =LIABILITIES + OWNERS’EQUITY OR TOTAL ASSETS =TOTAL LIABILITIES
The
• Period Concept: A business entity is an artificial person having a perpetual existence. To measure income generated by the business or loss incurred by the business, the infinite life of the business is broken into small pieces called accounting periods. End of each such period it is ascertained what income the business generated or what loss the business incurred and what the financial position of the business is? These small periods are known as accounting period. Generally accounting period is one year – January 01 to December 31 as in US and an d April 01 to March 31 as in India.
• Matching Concept: In order to ascertain profit or incurred some loss in an accounting perio period, d, the expenses expenses relate related d to this this period period must be compar compared ed or matche matched d with with the revenues generated during this period. Realization Concept: Realization • Realization Realization concept deals with the point in time at which revenue may
be deemed to be realized or when a sale can be said to have taken place. Normally revenue is recognized at the time of transfer of goods or services when a return consideration is either obtained immediately or there exists a reasonable certainty of receiving a return consideration in future. For example: If a customer buys Rs 500 worth of the items at grocery stores, paying cash, the stores realizes Rs 500 from sale. If a department stores sells a suit for Rs 3000 the purchaser agreeing to pay within 30 days, the store realizes Rs 3000(in receivables)from the sale, provided that the purchaser has a good credit record so that payment is reasonably certain. •
Accrual Concept: The accrual basis of accounting recognizes revenues when sales are made or services are preformed, regardless of when cash is received. Expenses are recognized as incurred, that is, when goods are used or services are received, whether or not cash has been paid out. Net profit equals the revenues earned less expenses incurred during a period.
B) Accounting Conventions: The term term ‘conve ‘convent ntion ion’’ denote denotes s circu circums mstan tances ces or tradit tradition ions s which which guide guide the accou accounta ntant nt while while prepa preparin ring g the accou accounti nting ng statem statement ents. s. The follow following ing are are the important accounting concepts: 1. Consistency 2. Full Disclosure 3. Conservatism 4. Materiality
• Conservatism Concept: This principle emphasizes that revenues and profits should be accounted accounted only when there is a reasonable reasonable surety of recognizing it but any anticipated anticipated loss or expense should be immediately accounted for. Materiality Concept: Concept: It states that insignificant events may be disregarded, but there • Materiality
must be full disclosure of all important information.
• Consistency Concept: The consistency concept requires that once an entity has decided on one method, it will treat all subsequent events of the same character in the same fashion unless it has a sound reason to change the method of treatment of that transaction. For example, if a concern is valuing its inventory by a particular method in one year it is expected to value its inventory in the subsequent years also in the same method unless there is a strong reason to change the same. Disclosure: Accord • Full Disclosure: According ing to this this convent convention ion all account accounting ing statem statement entss should should be
honestly prepared and to that end full disclosure of all significant information should be made. On the other hand, if there is no detailed disclosure in the profit and loss account undisclosed reserves accumulated in the past periods may be used to swell the profits in the year when the company is failing badly and the shareholders may be misled into thinking that company is making profit. FORMS OF BUSINESS ORGANISATION: 1. Sole Proprietorship: Proprietorship: A single individual carries on a business. All the profits the business might earn go to him. The sole proprietor’s liability is unlimited, that is, shall the business fall into debt, and he is personally liable for paying off the debts. 2. Partnership: It comprises between two and twenty persons trading together as one firm and sharing in the profits. As well as sharing the profits, each partner shares unlimited liability for all the debts and obligations of the firm. 3. Limited Company: It is a legal entity and is treated by the law like a natural person. It must be run according to the rules laid down by the company law. Systems of Accounting –
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Cash Basis: Revenue recorded only when cash is received.Expense recorded only when cash is paid. Cash Basis in not GAAP Accrual Basis: Adheres to the: Revenue Recognition Principle, Matching principle
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Reve Revenu nue e reco record rded ed only only when when earn earned ed not not when when cash cash is recei receive vedE dExp xpen ense se recorded only when when incurred not when cash cash paid – Ac Accr crua uall Bas Basis is adhe adhere res s to.. to.... Generally Accepted Accounting Principles ACCOUNTING MECHANISM:
1. Re Rec cordi ording ng
Journalizing: The daily business transactions are recorded in the order of their occurrence in a book called Journal. Recording of entries in the journal is known as journalizing. Journals aid the recording process by • • •
Disclosi Disclosing ng in in one one place place the the complete complete effect effect of a transa transactio ction; n; Provid Providing ing a chron chronolo ologic gical al recor record d of transa transacti ctions ons;; Helpi Helping ng preven preventt or locate locate errors errors because because debit debit and credi creditt amounts amounts can can be easily compared. 2. Classifying
Ledger preparation: The process process of transfer transferring ring entries from the jou journ rnal al to the the ledg ledger er is call called ed ledg ledger er post postin ing. g. Ledg Ledger er cont contai ains ns a classified summery of all transactions recorded in journal. 3. Summarizing:
Balancing the ledger: means to make the total of amounts column appearing on the debit and credit side equal to each other. If debit side is bigger than the credit side, the difference between the two sides is known as debit balance and vice versa. Preparation of Trial Balance: Trial Balance is a statement of debit and credit totals or balances extracted from the various accounts in the ledger with a view to test the arithmetical arithmetical accuracy of the books. Prepar Preparati ation on of Profi Profitt and Loss Loss A/c: A/c: It is prepared to know the operating efficiency of the firm in terms of profit made or loss incurred during an accounting period. Preparation of Balance Sheet: It is a statement prepared with a view to measure the financial position of a business on a certain fixed date date.. It give gives s a true true and and fair fair view view of the the stat states es of affa affair irs s of the the business. II.DOUBLE ENTRY SYSTEM:
The method of writing every transaction transaction in two accounts is known as Double entry System of Accounting. Of the two accounts, one account is given debit while the other account is given credit with an equal amount. Thus, on any date, the total of all debits must be equal to the total of all credits because every debit has a corresponding credit.
Total Debits = Total Credits Rules of Double Entry System: There are separate rules of the Double entry system in respect of Personal, real and nominal accounts which are discussed below:
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Figure 2.1 Rules of Double entry III. CLASSIFICATION OF ACCOUNTS: ACCOUNTS:
A) Personal Accounts: Personal account includes the account of persons with whom the business deals. These account can be classified into three categories 1. Natural personal Account –Example: Mohan’s account, Sohan’s account. 2. Artificial personal account-An account recording financial transaction with an artificial person created by law. Example: Account of club, Government, Bank. Representative Personal account-An account 3. Representative account indirect indirectly ly represent representing ing a person person is known known as a repres represen entat tative ive person personal al accou account. nt. Exampl Example: e: Salar Salaries ies outstanding account, prepaid Insurance account. B) Impersonal Accounts:
1. Real Account: It represents assets like plant and machinery, land and buildings goodwill, etc. As on a particular date, this account shows the worth of the asset. 2. Nominal Account: It consists of different types of expenses or incomes or loss of profit. These accounts show the amount of income earned or expenses incurred for a particular period say a month, a year, etc. A
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Figure 2.2 Types of Accounts Opening Entry All previous year’s assets and liabilities of B/S are brought forward to the current opening entry. entry. All asset year year as an opening asset a/c’s a/c’s are are debited All All liabil liability ity a/c’s a/c’s are are credited. The excess of assets over liabilities are credited to capital account.
Chapter 2: Final Accounts TRIAL BALANCE A list of all the accounts and their balances at a given time. It serves to prove the mathematical mathematical equality of debits and and credits after posting. It aids in the preparation preparation of financial statements.
FINANCIAL STATEMENTS: 1. Profit and Loss A/c: It summa summariz rizes es the resul results ts of the opera operatio tions ns of an enterp enterpri rise se for a given given time time period period by dis disclo closin sing g the revenu revenues es earned earned and expenses incurred. It indicates the operating success of a business in a period by measuring the net profit earned by it. 2. Balance Sheet: It presents an enterprise’s assets, liabilities, and owners’ equity at a particular point of time. It summarizes the resources of an enterprise and the claims to those resources by owners and creditors of the enterprise on a certain date. 3. Statement of Cash Flows: It reflects the major sources of cash receipts and cash payments of an enterprise. It reports the cash effects during a period of not only the enterprise’s operations operations but also its investing and financing activities. CAPITAL AND REVENUE ITEMS Capital Expenditure:
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The benefit of which is not fully derived in one year but spread over several periods.
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Eg: Acquisition of assets, additions to fixed assets
Revenue Expenditure:
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The benefit of which is derived in the year in which the expenditure was incurred.
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Eg: Raw material, Rent, wages and salaries.
FINAL ACCOUNTS OF MANUFACTURING FIRMS
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Production / Manufacturing A/c: To know the production cost Trading A/c: To know Gross Profit / Loss Profit and Loss A/c: To know the Net Profit / Loss Balance Sheet: To know the financial position
FINAL ACCOUNTS OF SERVICE BUSINESS ORGANISATIONS
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Receipts and Payments A/c: To know the Cash and Bank balances Income and Expenditure A/c: To know the Surplus made / Deficit incurred Balance Sheet: To know the financial position
FINAL ACCOUNTS OF A SOLE PROPRIETOR Trading A/c: To know the Gross Profit/ Loss
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Profit and Loss A/c: To know the operating performance of the business
i.e. Net profit / Net Loss
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Balance Sheet: To know the financial position of the firm on a particular
date. Trading Account • • • •
Over Overal alll Resu Result lt of of trad tradin ing g Give Gives s out out Gro Gross ss prof profit it Gross Gross Profi Profitt = Sales Sales - Cost Cost of Goods Goods Sold Sold Gross Gross Profit Profit = (Net (Net Sales) Sales) – (Openi (Opening ng stock stock +Net purchase purchases+ s+ Direct Direct Expens Expenses es - Closing Stock) Trading Account • • • • •
Opening St Stock Clos Closin ing g Stoc Stock k – valu valuat atio ion n Purchases Sales Dir Direct ect Expe Expens nses es –Wag –Wages es,C ,Cus usto toms ms & Impo Import rt Duty Duty,F ,Fre reig ight ht,, carr carria iage ge and and cartage inwards,Royalty inwards,Royalty – Gas, Gas, electri electricit city, y, water water,, fuel,P fuel,Pac ackin king g materi materials als Closing Entries – Trading Account
1. Trad Tradiing a/c a/c
Dr
To Opening stock a/c To Purchases a/c To Sales returns a/c To Carriage a/c To customs duty a/c To direct expenses a/c 2.
Sales A/c
Dr
Purchase Returns a/c Closing stock a/c
Dr Dr
To Trading a/c
Trading Account - Importance I mportance • • • •
Gross Gross profit profit disclo disclosed sed helps helps in contro controlling lling operating operating expenses expenses Gross Gross profit profit ratio ratio is compa compared red year year after after year to identify identify the the fall fall in the the figures figures Comparis Comparison on of stock stock figures figures help in in preventi preventing ng lock-up lock-up of funds funds in stocks stocks In case case of of new products products,, it is is helpfu helpfull to fix fix the the sale sale price price
P & L Account - Importance • • • •
Net profi profit/Net t/Net loss is an an index index of of profita profitabilit bility y of business business Comparis Comparison on of profit profit over period periods s helps in assessi assessing ng the busine business ss efficien efficiency cy Analysis Analysis of of expenses expenses over over periods periods help in in effective effective control control of expen expenses ses Prof Profit it and and expe expens nse e anal analys ysis is help helps s in plan planni ning ng and and fore foreca cast stin ing g the the futu future re course of action. Manufacturing Account • •
Cos Cost of of pr produc duction ion Stock – Raw Materials – Work in progress • Raw Raw Mat Mater eria ials ls cons consum umed ed • Car Carriag riage e inwa nwards • Direct wages • Fac Factor tory ove overrhea heads – Factory power – Depr Deprec ecia iati tion on on on fact factor ory y mach machin ines es • Sale of scrap Final Accounts – Adjustment Entries
Some Someti time mes s the the acco accoun unta tant nt will will come come to know know that that he had had not not take taken n some some significant information into the books of accounts. This apart it not too uncommon that certain transactions take place during or after the preparation of trial balance. In the above cases the transactions were not recorded in the books and hence they need to be adjusted in the books. books. This is done by passing passing some adjustment adjustment entries. Following the double double entry system every every adjustment will will have a two-fold effect. effect. Put in other words, the adjustment has to be carried out at two places. Normally the adjustment takes palace at any two of the following three places In Trading a/c and Balance Sheet (B/S) In Trading a/c and Profit & Loss a/c (P & L) In P & L a/c and B/S Adjustment Entries • • •
1. 2. 3. 4. 5. 6. 7. 8. 9.
Clos Closiing Stock ock Outs Outsta tandi nding ng expen expense sess Prep Prepai aid d Expe Expens nses es Accr Accrue ued d Inc Incom omee Income Income rece receive ived d in advance advance or or unearn unearned ed incom incomee Depr Deprec eciiati ation Bad de debts Prov Provis isio ion n for for bad bad debt debtss Provis Provision ion for discoun discountt on debtor debtorss
Closing Stock •
Adjustment – Taken Taken on on cred credit it s sid ide e of tradin trading g acco account unt Closing stock a/c Dr
To Trading a/c •
– Asse Assett sid side e of of Bal Balan ance ce Shee Sheett Give Given n in the the Tri Trial al bala balanc nce e – Means Means that that the the clos closin ing g stoc stock k is alrea already dy adjus adjuste ted d in the the cost cost of sales sales and hence already accounted for - Asset side of Balance Sheet
Outstanding expenses • •
Out Outstan tandin ding exp expens enses are are thos hose expe expens nses es whic hich are are due due durin uring g the accounting period but have not yet been paid Appe Ap pear ars s as as adj adjus ustm tmen entt – Expense a/c Dr To Outstanding expense a/c –
Addition Addition to the concerned concerned expense expense either either in trading trading or P&L a/c
– Liab Liabil ilit itie ies s sid side e of bal balan ance ce she sheet et • Ap Appe pear ars s in in tri trial al bala balanc nce e – Liab Liabil ilit itie ies s sid side e of Bala Balanc nce e shee sheett Prepaid expenses • •
Prep Prepai aid d expe expens nses es are are thos those e expe expens nses es which which have been been paid paid in advan advance ce during the accounting period Appe Ap pear ars s as as adj adjus ustm tmen entt – Prepaid Expense a/c Dr To expense a/c
– Deduction Deduction to the the concer concerned ned expens expense e either either in in trading trading or P&L P&L a/c a/c – As Asse sets ts side side of bala balanc nce e she sheet et • Ap Appe pear ars s in in tri trial al bala balanc nce e – As Asse sets ts side side of Bala Balanc nce e she sheet et Outstanding Income & Accrued Income • • •
Outstandi Outstanding ng income income is that that income income which which is due due during during the the accounti accounting ng period period but has not yet been received Outsta Outstandi nding ng income income & Acc Accrue rued d inco income me Appe Ap pear ars s as as adj adjus ustm tmen entt Outstandin g Income a/c Dr – Outstanding To Income a/c
– Addition Addition to the concerned concerned income income either either in trading trading or P&L a/c – As Asse sets ts side side of bala balanc nce e she sheet et • Ap Appe pear ars s in in tri trial al bala balanc nce e – As Asse sets ts side side of Bala Balanc nce e she sheet et Income received in advance • •
Inco Income me recei receive ved d in advan advance ce is that that incom income e whic which h is recei receive ved d duri during ng the accounting period but is not being earned. Appe Ap pear ars s as as adj adjus ustm tmen entt – Income a/c Dr To Income received in Advance a/c
– Deduction Deduction to the concerned concerned income income either either in trading trading or P&L a/c – Liab Liabil ilit itie ies s sid side e of bal balan ance ce she sheet et • Ap Appe pear ars s in in tri trial al bala balanc nce e – Liab Liabil ilit itie ies s sid side e of Bala Balanc nce e shee sheett Depreciation • •
Deprec Depreciat iation ion denot denotes es the decr decreas ease e in the value value of an asset asset due to the the wear and tear, lapse of time, obsolescence, obsolescence, exhaustion etc., As an an ad adjustment ent Deprecia Depreciation tion A/c Dr To Fixed Asset A/c –
Debi Debitt side ide of P&L P&L a/c
–
Deduction Deduction from from the the concer concerned ned asset asset accoun accountt on assets assets side side of balance balance sheet • Ap Appe pear ars s in in tri trial al bala balanc nce e – Debi Debitt side ide of P&L P&L a/c Bad debts Bad debt is a debt that cannot be recovered and is a loss •
As an an ad adjustment ent Bad debts A/c
Dr
To Debtors a/c - Debit si side of of P& P& L A/c - Deduct Deduction ion from from debtor debtors s on the the asset assets s side side of Bala Balance nce shee sheett • Ap Appe pear ars s in in tri trial al bala balanc nce e – Debi Debitt side ide of P&L P&L a/c Provision for Bad & doubtful debts • •
Provis Provision ion for for the the likel likely y Bad Bad and dou doubtf btful ul debt debts s As an an ad adjustment ent P&L A/c Dr To Provision for bad debts a/c
- Add to the the bad bad debt debts s on on the the debit debit sid side e of P& L A/c - Deduct Deduction ion from from debtor debtors s on the the asset assets s side side of Bala Balance nce shee sheett Provision for Discount on Debtors • •
Provisio Provision n for discount discount is making making a provisio provision n for the good good debts debts As an an ad adjustment ent P&L A/c Dr To Provision for discount discount on debtors debtors a/c -
Add to the the disc discoun ountt a/c a/c on the the debit debit sid side e of P& L A/c Deduct Deduction ion from from debtor debtors s on the the asset assets s side side of Bala Balance nce shee sheett
All balance sheets are built up from 3 main categories, namely assets, liabilities and shareholders funds. The relationship between them can be looked at either from the point of view of shareholders (a proprietary approach) or from the point of view of the compa company ny as a whole whole (an entity entity approa approach) ch).. Two forms of the fundamen fundamental tal balance sheet identity can thus be derived: Proprietary :
assets – liabilities = shareholder funds
Entity :
assets = liabilities + shareholder funds
Very broadly, all that is being said is that, firstly, what a company owns less what a company owes is equal to the value of the shareholders shareholders funds invested in it and that, secondly, what a company owns is financed partly by the owners (the shareholders) and partly by outsiders (the liabilities). Either way, a balance sheet must by definition, balance.
A proprietary approach balance sheet will look like the following (vertical balance sheet).
Fixed assets + Current assets - Current liabilities =Net assets or capital employed - Long term liabilities = Share capital and reserves A entity approach balance balance sheet will look like like the following (Horizontal balance balance sheet).
LIABILITIES
=
ASSETS
Equity capital
Fixed assets
+
+
Long termliabilities
Current assets
+ Current liabilities liabilities
Assets Fixed assets & Current assets: Assets are something of value to the business, which can either be turned into cash or used to produce revenue.
Fixed assets
Those assets which are intended for use on a continuing basis in an undertakings activities. Exampl Examples es are are build building ings, s, equip equipmen ment, t, vehicl vehicles. es. Stocks Stocks,, for exampl example, e, are are not regarded as fixed assets since they are acquired either for immediate resale (for examp example le cigare cigarette ttes s as sold sold by a tobacc tobacconi onist) st) or as raw materia materials ls for use in manufacturing operations. It is intention that determines whether an asset is fixed or not. Plant and vehicles, for example, are the current assets of a company whose business it is to manufacture them for sale.
Concepts involved in valuation of fixed assets: Matching Fixed assets are an example of a good purchased for use over several periods and are not charged entirely against profits of year of purchase but spread over their years of use. Cost valuation (historical value) Going concern basis Fixe Fixed d asse assets ts are are typi typica call lly y incl includ uded ed at what whatev ever er prop propor orti tion on of cost cost is stil stilll expected to yield useful benefits in the future. It is assumed that the business will last long enough for these to be realised, which is quite different from an approach which valued assets at scrap values. There are different kinds of fixed assets in the balance sheet such as tangible fixed assets, investments and intangible fixed assets. Investments Shares Shares,, loans, loans, bonds bonds and deben debentur tures es held held either either as fixed fixed tangib tangible le asset assets s or current assets. These are usually valued at cost.
Intangible fixed assets Non-monetary fixed asset which is without physical substance. This category of asset includes not only such “identifiable” intangibles as patents, trade marks and copyrights, but also goodwill.
Goodwill A company is not just a collection of tangible assets. It is, or should be, a going concern whose total value, by reason of its proven ability to earn profits, is greater than the sum of its parts. It is the difference between the total value and
the sum of the parts which constitutes goodwill. It should not be regarded as in any way a fictitious asset: to be valuable, an asset does not have to be tangible. Goodwill is, however, very difficult to value objectively and company law does not permit it to be appear in the balance sheet unless it has been purchased, and even then it is usually written off immediately or quite quickly. In some grou group p bala balanc nce e sheet eets an item tem appea ppearrs entit ntitlled “g “goo oodw dwil illl aris arisin ing g on consolidation” or “goodwill on acquisition”. This represents the excess of the cost of shares in subsidiary companies over the book value of their net tangible assets at the date of acquisition; that is, the parent company was willing to pay more to purchase a company than the sum of its tangible and net current assets.
Current assets
Comprise those assets which are not intended for continuing use in the business. Expected to be turned into cash or used in course of trading which can normally be expected to be turned into cash within one year from the date of the balance sheet. Examples Examples include include bank balance, balance, prepaymen prepayments, ts, amount amount owing owing from debtors, debtors, cash, stocks. Stocks Stocks are anothe anotherr examp example le of matching conc concep eptt - just just how how far far to take take it depends upon the materiality concept. materiality concept.
Liabilities
Obliga Obligatio tions ns arisin arising g from from past past transa transacti ctions ons or other other events events and invol involvin ving g a company in a probable future transfer of cash, goods or services. Can be classified as current or long term liabilities.
Current liabilities Obligations which have to be settled within a relatively short space of time. Examples include amounts owing to creditors, bank overdraft, tax liability Current assets- Current liabilities = Net Current Assets or Working Capital (a measure of liquidity). Fixed assets + current assets - current liabilities = Capital Employed or Net Assets or Net Worth
Long term liabilities Long Long term term liabi liabilit lities ies repre represen sentt the extent extent to which which the firm, firm, not wishin wishing g to borrow further long term funds from shareholders, has borrowed from outsiders. The major parts consist of both long term loans (not wholly repayable within 5 years) and medium term loans (repayable within 5 years). Banks Banks are an obviou obvious s sourc source e of outsid outside e financ finance e and many many firms firms long long term term liab liabil ilit itie ies s are are in the the form form of bank bank loan loans. s. Thes These e are are not not the the only only form form of borro borrowin wings gs.. There There are are also also debent debenture ures s and debent debenture ure stocks stocks which which may may be secu secure red d by fixe fixed d or floa floati ting ng char charge ges s or may may alte altern rnat ativ ivel ely y be unse unsecu cure red d debentures.
Shareholders funds The shareholders funds section of the group balance sheet is subdivided into Share Capital and Reserves. Reserves. Shareholders differ from debenture holders in three important ways; they are owners of the company, not lenders; they receive dividends (a share of the profits), profits), not interest; interest; and, except except in special special circumstan circumstances, ces, the cost of their their shares will not be repaid (redeemed) to them by the company. Shares can be either ordinary or preference. The latter is usually entitled only to a dividend at a fixed rate, but has priority of repayment in the event of the comp compan any y bein being g woun wound d up. up. Pref Prefer eren ence ce shar shares es may may be cumu cumula lati tive ve or nonnoncumulative.
Every share has a par value but this is not necessarily the same as the issue price of the shares or their market price. Shares can be issued at more than their par value: this gives rise to a share premium reserve. reserve . Once a share has been issued, its market price fluctuates from day to day, but this has no effect on the firms balance sheet. A company does not have to issue all its shares at once, nor does it have to reques requestt full full paymen paymentt on the share shares s immedi immediate ately. ly. Compan Companies ies norm normall ally y have have authority to issue (i.e. have authorised capital of) shares even though they have not issued them. Also shares can be partly paid. For example, a 25p share could be payable 5p on application for the shares, a further 5p on allotment, when the directors decide to whom the shares are going to be issued (or allotted), and the remaining 15p in calls. Thus, in summary, one can distinguish distinguish authorised, issued, called up and paid-up share capital.
Reserves Reserves consist of the retained profit (or loss), the share premium account and other reserves such as a revaluation reserve. This is created as a result of the revaluation of fixed assets on the other side of the balance sheet. It is very important not to confuse reserves with cash. To say that a company has large reserves is not the same thing as saying that it has plenty of cash. If a company has reserves it must have net assets of equal amount, but these assets may be of any kind (e.g. machinery, stock in trade). Thus it is perfectly possible for a company to have both large reserves and a large bank overdraft.
An example of a balance sheet
(£, 000) FIXED ASSETS N et fix e d as s ets I n v e st m e n ts
10 0 50 150 15 0
CURRENT ASSETS S to c k s D eb to r s C ash TO T A L AS S E T S
25 25 25 22 5
CURRENT LIABILITIES C r ed ito r s T O T A L A S S E T S L E S S C U R R E N T L I A B I L IT I E S
50 17 5
L o n g t er m l ia b i liti e s CAPITAL AND RESERVES C a ll ed u p s h ar e ca p it al S h a r e p r e m iu m P ro fit an d l o s s a cc o u n t S H A R E H O LD E R S F U N D S
50 125 12 5 25 75 25 12 5
Relation between the P&L statement and the balance sheet
It is worth looking more closely at the link between the profit and loss account and the balance sheet. How can a company company grow – that is, how can it increase increase its assets? Look again at the identity Entity :
assets = liabilities + shareholder funds
It is clear that the only ways to increase the assets are to increase the liabilities (to borrow) or to increase the shareholders funds. How can a company increase the latter? There are two possibilities: it can issue more shares or it can plough back profits (assuming of course that it is making some). Ploughing back profits is the simplest but not necessarily the cheapest source of long term finance for a company. Also the more a company ploughs back the less, in the short run at least, there will be available for paying dividends.
