Chapter 1: Introduction to Financial Accounting

Accounting is the language of business. It requires the systematic record keeping of all that happens on a day to day basis in business and analyzing this 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 oss A!c" #alance $heet" %ash &lo' $tatement etc( I. UNDERSTANDING BUSINESS ORGANIZATIONS: #usiness organizations offer goods and services in order to earn a profit. )eceiving and paying cash are central to the activities of business organizations. #usiness organizations that provide goods are of t'o kinds* Merchandising (Trading) Organizati ns: buy and sell goods 'ithout any processing. Man!"act!ring Organizati ns: buy materials" process them into finished products" and sell them. Ser#ice Organizati ns: are businesses that provide services. +nlike goods" services do not have either form or substance" and" therefore" the recipient of a service can only e,perience 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 customers accounts in a departmental store. A substantial portion of the book keeper work is of a clerical in nature and is increasingly being accomplished through the use of mechanical and electronical devices.

II. $hat is Acc !nting%

Accounting is often called the language of #usiness. Accounting" as an information system" is the process of identifying" measuring" and communicating the economic information of an organization to its users 'ho need the information for decision making. The American Institute of %ertified Public Accountants defines accounting as -the art of recording" classifying and summarizing in a significant manner and in terms of money transactions and events 'hich are" in part at least" of a financial character" and interpreting the results thereof. This definition brings out the follo'ing as attributes of accounting* .vents and transactions of a financial nature are recorded 'hile the events of a non/ financial nature cannot be recorded. The record should reflect the importance of the transactions so recorded both individually and collectively" 'hich includes summarization" thereby making it amenable to analysis.

The users of the financial statements should be able to obtain the message encompassed in such financial statements" and it is the kno'ledge of accountancy" 'hich enables the user to understand the contents of the financial statements.

The Acc !nting In" r&ati n S'ste&

I2P+T P)1%.$$ 1+TP+T

.conomic events measured in financial terms

)ecording %lassifying $ummarizing Analyzing Interpreting

%ommunicating information to users 3 P4 A!c" #!$" %&$" etc5

Acc !nting (r cess:

Rec rding: )ecording commences 'hen a business transaction occurs and it has been quantified. A record of all these transactions is maintained in the order in 'hich they occur in the 0ournal #ook. )*assi"'ing: 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 edger #ook consisting of a number of accounts each complete in its o'n 'ay. + r e,a&-*e" all the receipts forming inflo's and the payments forming outflo's are grouped to ascertain the net cash position of the firm. The arrangement in this case is better kno'n as the %ash #ook. S!&&arizing: After the )ecording and %lassification phases are complete the accounts containing relevant information in the edger #ook are to be balanced and the balances listed. The $tatement giving names of these accounts and their respective balances is called the Trial #alance. 1n the basis of the Trial #alance the summaries are generated to provide information about the Profit ! oss and the Position of the firm. The reporting of these summaries is done through &inancial $tatements. &inancial $tatements can be defined to include the #alance $heet" the Profit and oss Account" 2otes to the Accounts and other incidental statements and e,planatory material 'hich are identified as part of financial statements.

In" r&ati n and the Acc !nting (r cess Identification6'hat7s relevant8 9easurement6'hich yardstick8 %lassification and accumulation6ho' do you organize the results of thousands of events8 $ummarization6ho' much information is enough" but not too much8 %ommunication6ho' often" 'hen" and to 'hom8 .!a*ities " Acc !nting In" r&ati n Information should be useful" but 'hat does that mean8 The t'o primary qualities of useful information are* :5 Relevance//the information must pertain to the decision at hand. That suggests it 'ill have predictive and feedback value and should be timely. ;5 Reliability//the information must reasonably reflect the real/'orld situation that it represents. To do so" it must be free of bias and verifiable. Other .!a*ities " Use"!* In" r&ati n Understandability//the information must be understood to be useful. +sers are assumed to have a general kno'ledge of business and a very basic kno'ledge of accounting. Comparability//the information must be reported so that comparisons bet'een similar entities can be made. Consistency//the same accounting methods must be used from period to period to evaluate results over time.

S T E P 1 I d e n t if ic a t io n o f T r a n s a c tio n

S T E P

P r e p a r a t io n o f B u s in e s s o c u m e n ts S T E P 3 ! e c o r d in g o f T r a n s a c tio n in " o u r n a l

S T E P P o s tin g to

4 # e d g e r

S T E P 5 P r e p a r a tio n o f $ n a d %u s te d T r a il B a la n c e

S T E P 6 P a s s in g o f A d %u s t in g & n t r ie s P r o f it ' S T E P 7 P r e p a r a t io n o f A d %u s t e d T r a il B a la n c e # o s s A c c o u n t

B a la n c e

( h e e t

) u n d

) lo w

( ta te m e n t

+ig!re /./: The Acc !nting (r cess III. A))OUNTING IN+ORMATION AND E)ONOMI) DE)ISIONS: Accounting information is useful in making a number of decisions that affect the income or 'ealth of individuals and organizations. Accounting reports are designed to meet the common information needs of most decision makers. .,amples of decisions that are based on accounting information include the follo'ing* :. ;. =. >. ?. @. A. B. <ecide 'hen to buy" hold or sell an equity investment. Assess the ste'ardship or accountability of mgt. Assess the ability of the enterprise to pay and provide other benefits to its employees. Assess the security for amounts lent to the enterprise. <etermine distributable profits and dividends. <etermine ta,ation policies. Prepare and use national income statistics. )egulate the activities of enterprises.

The decision maker 'ho intends to use accounting information should have a reasonable understanding of business and economic activities and be 'illing to study the information 'ith reasonable diligence. A sophisticated understanding of accounting is an indispensable part of the tool/kit for most decision makers.

I0. )1ASSI+I)ATION O+ A))OUNTING: In order to satisfy needs of different people interested in the accounting information" different branches of accounting have developed. Acc !nting is genera**' c*assi"ied int three di""erent disci-*ines as sh 2n in +ig!re.

A c c o u n t in g

) in a n c ia l A c c o u n t in g

* ost A c c o u n t in g
+ig!re /.3 )*assi"icati n " Acc !nting

+ anagem ent A c c o u n t in g

+inancia* Acc !nting: Its primary intention is to prepare the $tatements revealing the Income ! oss and financial position of the business on the basis of events" 'hich have happened in the period being reckoned. #ut this information" though of immense vitality does not adequately aid the management in planning" controlling" organizing and efficiently conducting the course of the business as a result of 'hich %ost Accounting and 9anagement Accounting are in place. ) st Acc !nting: It sho's classification and analysis of costs on the basis of functions" processes" products" centers etc. It also deals 'ith cost computation" cost saving" cost reduction" etc. Manage&ent Acc !nting: 9anagement Accounting begins 'here &inancial Accounting and %ost Accounting ends. It deals 'ith the processing of data generated in financial accounting and cost accounting for managerial decision/making. It also deals 'ith application of managerial economic concepts for decision/making. 0. OB4E)TI0ES O+ A))OUNTAN)5: Maintaining Acc !nting rec rds: $ystematic recording of the monetary transactions of the firm is the initial step leading to the creation of the financial statements. 1nce recording is complete" the records are classified and summarized to depict the financial performance of the enterprise. 2. )a*c!*ating the res!*ts " O-erati ns: The Income $tatement also kno'n as the Profit and oss Account is prepared to reflect the profits earned or losses incurred. All the e,penses 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. 3. Ascertaining the "inancia* - siti n: &inancial health or position is ascertained 'ith the help of the #alance $heet. 1n the right hand side of the #alance $heet are the Assets or
1.

the resources o'ned by the firm. 1n the left hand side are the iabilities or the obligations of the business to the outsiders and the o'ners. The o'nersC portion is called the %apital 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 iabilities. This information on the assets and liabilities" 'ith the help of accountancy" provides control over the resources of the firm. 4. Acc !nting is the -rec!rs r t "inancia* re- rting: The vital liquidity ! solvency position is comprehended through the %ash and &unds &lo' $tatement elucidating the capital transactions" obtaining of cash and the 'ay it has been e,pended" loans and their repayment" cash dividends" etc. 5. ) &&!nicating the in" r&ati n t the !sers: &inancial 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 ta, liability and the consequent filing of return of income. 0I. AD0ANTAGES O+ A))OUNTING: It facilitates* to replace memory. to comply 'ith legal requirements. to ascertain 2et results of operations. to ascertain &inancial position. the users to take decisions. a compliance study. control over assets. the settlement of ta, liability. the ascertainment of value of business. raising of funds. Acts as legal evidence 0II. USERS O+ +INAN)IA1 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 e,tent than those of other user groups. Do'ever" financial reports are also e,tensively used by other individuals and groups 'ho have to rely on them as their major source of financial information. Potential users of accounting information include* Interna* Users: They include #oard of <irectors" Partners" 9anagers" and 1fficers. They need information for planning and controlling operations" for making special decisions" and for formulating major plans and policies. 9anagers use accounting information to evaluate potential investment projects. 9anagement e,amines the competition in the industry and makes financial comparisons of its performance against competitors7 performance. E,terna* Users: A). +inancing Gr !-: a) In#est rs: Accounting information enables investors to identify promising investment opportunities. They need information to decide 'hich investments to buy" retain" or sell" as 'ell as the timing of the purchases or sales of those

II.

investments. They also need information to monitor management performance and to assess the ability of the enterprise to pay dividends. 6) 1enders: enders such as banks and denture/holders need to kno' about the financial stability of a business that approaches them for funds. They are interested in information that enables them to determine 'hether their loans" and the related interest 'ill be paid 'hen due. c) S!--*iers: Present and potential suppliers are interested in the enterprise as an outlet for their products or services and" if the enterprise is a major customer" they 'ill be interested in assessing the likelihood of the situation continuing. They are interested in information that enables them to determine 'hether amounts o'ed to them 'ill be paid 'hen due. B). (!6*ic Gr !-: a) G #ern&ent Agencies: The three levels of government in India central" state and local / are interested in the allocation of resources and" therefore" in the activities of enterprises. They also require information in order to regulate the business practices of enterprises" determine ta,ation policies" and provide a basis for national income and similar statistics. 6) E&-* 'ees: They are interested in information about the enterprise about the enterprise as 'ell as its general operations" stability and profitability. c) )!st &ers: Present" potential and past customers are interested in the financial affairs of an enterprise in deciding ho' much business to do 'ith it" and in assessing the likely ability of the enterprise to service to the product or to honor 'arranty agreements. d) Sec!rit' Ana*'sts and Ad#isers: They serve the needs of investors by providing them 'ith skilled analyses and interpretation of financial reports. $ecurities firms to recommend to their clients 'hether to buy" sell or hold their investments use Analysts7 reports. Basic Ter&s Assets / resources o'ned by a business iabilities / debts and obligations of the business %ommon stock / stock representing the primary o'nership interest in a corporation E,-enses: .,penses are the costs of assets consumed or services used to generate revenues .,amples... $tore operating e,penses" Eeneral and administrative e,penses" Interest e,pense AuditorCs )eport Genera* G!ide " r +inancia* Acc !nting Eenerally Accepted Accounting Principles Accounts Provide the the most useful financial information for(<ecision 9aking (ri&ar' Acc !nting Setting B d' in the U.S.

:. &inancial Accounting $tandards #oard GAA( Are the R!*es7 The +ASB &a8es the r!*es. Accounting %oncepts , #asic assumptions or conditions upon 'hich the science of accounting is based. Accounting %onventions , Principles or theories based on 'hich accounting is done.

Money Measurement Concept: In financial accountancy, an event is recorded, only if it can be expressed in monetary terms. Recording, classification and summari ation of business transactions re!uires a common unit of measurement, "#ic# is ta$en as money. %ence, all transactions are recorded t#roug# a common denominator & money. '#us, if a certain event, no matter #o" significant for t#e #ealt# or even existence of t#e business, cannot be measured in monetary terms, t#at event is not recorded in accounting. (oney is expressed in terms of its value at t#e time an event is recorded in t#e accounts. Business Entity Concept: '#e business is distinctly different and separate from its o"ner. ) business entity or a company is an artificial company created by la", "#o #as a common seal, "#ic# #as a perpetual existence and does not die natural deat#. %ence for accounting purpose, t#e o"ner and #is business s#ould be $ept separate. )ccounting records are $ept from t#e point of vie" of t#e business unit and not t#e o"ner. *o, if t#e o"ner contributes fund to t#e business, it "ill be treated as a liability of t#e business & say t#e business o"es t#is muc# to t#e o"ner. Going Concern Concept: ) business entity is #aving a perpetual existence, "#ic# does not die a natural deat#. It is assumed to carry on its operations forever. It implies t#at t#e resources of t#e concern "ould continue to be used for t#e purposes for "#ic# t#ey are meant to be used. +or instance, in a manufacturing concern, t#e land, buildings, mac#inery etc., are primarily re!uired for carrying out t#e production and selling of certain products. '#is concept implies t#at t#ese land, buildings, mac#inery etc., "ould continue to be used for t#is purpose. Cost Concept: ,ost ,oncept implies t#at in accounting, all transactions are generally recorded at cost, and not at mar$et value. +or example, if a piece of land is ac!uired for Rs.1 la$#, it "ould continue to be s#o"n in t#e balance s#eet at Rs.1 la$#, even "#en t#e mar$et value of t#e land rises to say Rs.1- la$#s. .#y s#ould t#is be so/ '#is is because cost concept is in fact closely related to t#e going concern concept. Duality concept0 '#is is t#e fundamental accounting e!uation, "#ic# is t#e formal expression of t#e dual aspect concept. 'o reflect t#e t"o types of e!uities, t#e e!uation is more commonly expressed as
ASSETS 91IABI1ITIES : O$NERS;E.UIT5 OR

TOTA1 ASSETS 9TOTA1 1IABI1ITIES

'#e )ccounting Identity

&ach of the permanent accounts are affected by debits and credits.

A . # / 0&
#IABI#ITI&( ebit *redit for for Increase ecrease &-$ITI&( ebit *redit for for Increase ecrease *redit for ecrease

A((&T( ebit for Increase

Period Concept: ) business entity is an artificial person #aving a perpetual existence. 'o measure income generated by t#e business or loss incurred by t#e business, t#e infinite life of t#e business is bro$en into small pieces called accounting periods. 1nd of eac# suc# period it is ascertained "#at income t#e business generated or "#at loss t#e business incurred and "#at t#e financial position of t#e business is/ '#ese small periods are $no"n as accounting period. 2enerally accounting period is one year & 3anuary -1 to 4ecember 31 as in 5* and )pril -1 to (arc# 31 as in India. Matching Concept: In order to ascertain profit or incurred some loss in an accounting period, t#e expenses related to t#is period must be compared or matc#ed "it# t#e revenues generated during t#is period. Reali ation Concept: Reali ation concept deals "it# t#e point in time at "#ic# revenue may be deemed to be reali ed or "#en a sale can be said to #ave ta$en place. 6ormally revenue is recogni ed at t#e time of transfer of goods or services "#en a return consideration is eit#er obtained immediately or t#ere exists a reasonable certainty of receiving a return consideration in future.

+ r e,a&-*e: If a customer buys )s ?FF 'orth of the items at grocery stores" paying cash" the stores realizes )s ?FF from sale. If a department stores sells a suit for )s =FFF the purchaser agreeing to pay 'ithin =F days" the store realizes )s =FFF3in receivables5from the sale" provided that the purchaser has a good credit record so that payment is reasonably certain.

Accrual Concept: '#e accrual basis of accounting recogni es revenues "#en sales are made or services are preformed, regardless of "#en cas# is received. 1xpenses are recogni ed as incurred, t#at is, "#en goods are used or services are received, "#et#er or not cas# #as been paid out. 6et profit e!uals t#e revenues earned less expenses incurred during a period.

B) Acc !nting ) n#enti ns: The term Gconvention7 denotes circumstances or traditions 'hich guide the accountant 'hile preparing the accounting statements. The follo'ing are the important accounting concepts* :. %onsistency ;. &ull <isclosure =. %onservatism >. 9ateriality

Conser!atism Concept: '#is principle emp#asi es t#at revenues and profits s#ould be accounted only "#en t#ere is a reasonable surety of recogni ing it but any anticipated loss or expense s#ould be immediately accounted for. Materiality Concept: It states t#at insignificant events may be disregarded, but t#ere must be full disclosure of all important information. Consistency Concept: '#e consistency concept re!uires t#at once an entity #as decided on one met#od, it "ill treat all subse!uent events of t#e same c#aracter in t#e same fas#ion unless it #as a sound reason to c#ange t#e met#od of treatment of t#at transaction. +or example, if a concern is valuing its inventory by a particular met#od in one year it is expected to value its inventory in t#e subse!uent years also in t#e same met#od unless t#ere is a strong reason to c#ange t#e same. Full Disclosure: )ccording to t#is convention all accounting statements s#ould be #onestly prepared and to t#at end full disclosure of all significant information s#ould be made. 7n t#e ot#er #and, if t#ere is no detailed disclosure in t#e profit and loss account undisclosed reserves accumulated in t#e past periods may be used to s"ell t#e profits in t#e year "#en t#e company is failing badly and t#e s#are#olders may be misled into t#in$ing t#at company is ma$ing profit.

+ORMS O+ BUSINESS ORGANISATION:

/. S *e (r -riet rshi-: A single individual carries on a business. All the profits the business might earn go to him. The sole proprietor7s liability is unlimited" that is" shall the business fall into debt" and he is personally liable for paying off the debts. 3. (artnershi-: It comprises bet'een t'o and t'enty persons trading together as one firm and sharing in the profits. As 'ell as sharing the profits" each partner shares unlimited liability for all the debts and obligations of the firm. <. 1i&ited ) &-an': It is a legal entity and is treated by the la' like a natural person. It must be run according to the rules laid do'n by the company la'. S'ste&s " Acc !nting , )ash Basis* )evenue recorded only 'hen cash is received..,pense recorded only 'hen cash is paid. %ash #asis in n t EAAP

, Accrual Basis0 )d#eres to t#e0 Revenue Recognition 8rinciple, (atc#ing principle

)evenue recorded only 'hen earned not 'hen cash is received.,pense recorded only 'hen incurred not 'hen cash paid , Accrual #asis adheres to... Eenerally Accepted Accounting Principles A))OUNTING ME)=ANISM: /. Rec rding 4 !rna*izing: The daily business transactions are recorded in the order of their occurrence in a book called 0ournal. )ecording of entries in the journal is kno'n as journalizing. 4 !rna*s aid the rec rding -r cess 6' <isclosing in one place the complete effect of a transactionH Providing a chronological record of transactionsH Delping prevent or locate errors because debit and credit amounts can be easily compared. 3. )*assi"'ing 1edger -re-arati n: The process of transferring entries from the journal to the ledger is called ledger posting. edger contains a classified summery of all transactions recorded in journal. <. S!&&arizing: Ba*ancing the *edger: 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 bet'een the t'o sides is kno'n as debit balance and vice versa. (re-arati n " Tria* Ba*ance: Trial #alance is a statement of debit and credit totals or balances e,tracted from the various accounts in the ledger 'ith a vie' to test the arithmetical accuracy of the books. (re-arati n " (r "it and 1 ss A>c: It is prepared to kno' the operating efficiency of the firm in terms of profit made or loss incurred during an accounting period. ,

(re-arati n " Ba*ance Sheet: It is a statement prepared 'ith a vie' to measure the financial position of a business on a certain fi,ed date. It gives a true and fair vie' of the states of affairs of the business. II.DOUB1E ENTR5 S5STEM: The method of 'riting every transaction in t'o accounts is kno'n as D !6*e entr' S'ste& " Acc !nting. 1f the t'o accounts" one account is given debit 'hile the other account is given credit 'ith 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. T ta* De6its 9 T ta* )redits R!*es " D !6*e Entr' S'ste&: There are separate rules of the <ouble entry system in respect of Personal" real and nominal accounts 'hich are discussed belo'*
R u le s o f D e b it a n ! "e it

P e " s o n a l # $ $ o u n ts T ' e " e $ e i( e " D e b it )

R e a l # $ $ o u n ts * ' a t $ o & e s in

% o & in a l # $ $ o u n ts # ll e + p e n s e s a n lo s s e s

T ' e g i( e " ! "e it )

* 'at goes out

# ll in $ o & e s a n

g a in s

+ig!re 3./ R!*es " D !6*e entr' III. )1ASSI+I)ATION O+ A))OUNTS:

A) (ers na* Acc !nts* Personal account includes the account of persons 'ith 'hom the business deals. These account can be classified into three categories
:. Nat!ra* -ers na* Acc !nt .,ample* 9ohan7s account" $ohan7s account. ;. Arti"icia* -ers na* acc !nt/An account recording financial transaction 'ith an artificial person created by la'. .,ample* Account of club" Eovernment" #ank. =. Re-resentati#e (ers na* acc !nt/An account indirectly representing a person is kno'n as a representative personal account. .,ample* $alaries outstanding account" prepaid Insurance account. B) I&-ers na* Acc !nts: /. Rea* Acc !nt: It represents assets like plant and machinery" land and buildings good'ill" etc. As on a particular date" this account sho's the 'orth of the asset. 3. N &ina* Acc !nt: It consists of different types of e,penses or incomes or loss of profit.

These accounts sho' the amount of income earned or e,penses incurred for a particular period say a month" a year" etc.
# $ $ o u n ts

P e "s o n a l # $ $ o u n ts E g , -n i( i u a ls . / i" & s . ! o & p a n ie s . B a n k s . e t$ , R e a l # $ $ o u n ts

-& p e " s o n a l # $ $ o u n ts % o & in a l # $ $ o u n ts R e la te to e + p e n s e s o " lo s s e s o " in $ o & e s o " p " o fits ,

# s s e t s lik e $ a s ' . la n . b u il in g s . p la n t a n & a $ ' in e " 0 . p a te n ts . g o o 1 ill& . e t$ ,

+ig!re 3.3 T'-es " Acc !nts O-ening Entr' All previous year7s assets and liabilities of #!$ are brought for'ard to the current year as an -ening entr'. All asset a!c7s are de6ited All liability a!c7s are credited. The e,cess of assets over liabilities are credited to ca-ita* acc !nt.

Chapter ": Final Accounts

TRIA1 BA1AN)E A list of all the accounts and their balances at a given time. It serves to prove the mathematical equality of debits and credits after posting. It aids in the preparation of financial statements. +INAN)IA1 STATEMENTS: /. (r "it and 1 ss A>c: It summarizes the results of the operations of an enterprise for a given time period by disclosing the revenues earned and e,penses incurred. It indicates the operating success of a business in a period by measuring the net profit earned by it. 3. Ba*ance Sheet: It presents an enterprise7s assets" liabilities" and o'ners7 equity at a particular point of time. It summarizes the resources of an enterprise and the claims to those resources by o'ners and creditors of the enterprise on a certain date. <. State&ent " )ash +* 2s: 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 enterprise7s operations but also its investing and financing activities. )A(ITA1 AND RE0ENUE ITEMS )a-ita* E,-endit!re:

The benefit of 'hich is not fully derived in one year but spread over several periods. .g* Acquisition of assets" additions to fi,ed assets

Re#en!e E,-endit!re:

The benefit of 'hich is derived in the year in 'hich the e,penditure 'as incurred. .g* )a' material" )ent" 'ages and salaries.

+INA1 A))OUNTS O+ MANU+A)TURING +IRMS

(r d!cti n > Man!"act!ring A>c: To kno' the production cost Trading A>c: To kno' Eross Profit ! oss (r "it and 1 ss A>c: To kno' the 2et Profit ! oss Ba*ance Sheet: To kno' the financial position

+INA1 A))OUNTS O+ SER0I)E BUSINESS ORGANISATIONS

Recei-ts and (a'&ents A>c: To kno' the %ash and #ank balances Inc &e and E,-endit!re A>c: To kno' the $urplus made ! <eficit incurred Ba*ance Sheet: To kno' the financial position

+INA1 A))OUNTS O+ A SO1E (RO(RIETOR Trading A>c: To kno' the Eross Profit! oss

(r "it and 1 ss A>c: To kno' the operating performance of the business i.e. 2et profit ! 2et oss Ba*ance Sheet: To kno' the financial position of the firm on a particular date.

Trading Account 1verall )esult of trading Eives out Eross profit Eross Profit I $ales / %ost of Eoods $old Eross Profit I 32et $ales5 31pening stock J2et purchasesJ <irect .,penses / %losing $tock5 Trading Account 1pening $tock

%losing $tock valuation Purchases $ales <irect .,penses Kages"%ustoms 4 Import <uty"&reight" carriage and cartage in'ards")oyalty , Eas" electricity" 'ater" fuel"Packing materials )* sing Entries ? Trading Acc !nt

1. 'rading a9c

4r
To 1pening stock a!c To Purchases a!c To $ales returns a!c To %arriage a!c To customs duty a!c To direct e,penses a!c

;.

$ales A!c Purchase )eturns a!c %losing stock a!c

<r <r <r To Trading a!c

Trading Acc !nt @ I&- rtance Eross profit disclosed helps in controlling operating e,penses Eross profit ratio is compared year after year to identify the fall in the figures %omparison of stock figures help in preventing lock/up of funds in stocks In case of ne' products" it is helpful to fi, the sale price

( A 1 Acc !nt @ I&- rtance 2et profit!2et loss is an inde, of profitability of business %omparison of profit over periods helps in assessing the business efficiency Analysis of e,penses over periods help in effective control of e,penses Profit and e,pense analysis helps in planning and forecasting the future course of action. Man!"act!ring Acc !nt %ost of production $tock , )a' 9aterials , Kork in progress )a' 9aterials consumed %arriage in'ards <irect 'ages

&actory overheads , &actory po'er , <epreciation on factory machines $ale of scrap +ina* Acc !nts ? AdB!st&ent Entries $ometimes the accountant 'ill come to kno' that he had not taken 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 'ere not recorded in the books and hence they need to be adjusted in the books. This is done by passing some adjustment entries. &ollo'ing the double entry system every adjustment 'ill have a t'o/fold effect. Put in other 'ords" the adjustment has to be carried out at t'o places. 2ormally the adjustment takes palace at any t'o of the follo'ing three places In Trading a!c and #alance $heet 3#!$5 In Trading a!c and Profit 4 oss a!c 3P 4 5 In P 4 a!c and #!$ Adjustment .ntries

1. 2. 3. 4. 5. :. ;. =. >.

,losing *toc$ 7utstanding expenses 8repaid 1xpenses )ccrued Income Income received in advance or unearned income 4epreciation <ad debts 8rovision for bad debts 8rovision for discount on debtors

)* sing St c8 Adjustment , Taken on credit side of trading account )* sing st c8 a>c Dr T Trading a>c , Asset side of #alance $heet Eiven in the Trial balance , 9eans that the closing stock is already adjusted in the cost of sales and hence already accounted for / Asset side of #alance $heet

O!tstanding e,-enses

1utstanding e,penses are those e,penses 'hich are due during the accounting period but have not yet been paid Appears as adjustment , E,-ense a>c Dr T O!tstanding e,-ense a>c

, Addition to the concerned e,pense either in trading or P4 a!c , iabilities side of balance sheet Appears in trial balance , iabilities side of #alance sheet (re-aid e,-enses Prepaid e,penses are those e,penses 'hich have been paid in advance during the accounting period Appears as adjustment , (re-aid E,-ense a>c Dr T e,-ense a>c

, <eduction to the concerned e,pense either in trading or P4 a!c , Assets side of balance sheet Appears in trial balance , Assets side of #alance sheet O!tstanding Inc &e A Accr!ed Inc &e 1utstanding income is that income 'hich is due during the accounting period but has not yet been received 1utstanding income 4 Accrued income Appears as adjustment , O!tstanding Inc &e a>c Dr T Inc &e a>c

, Addition to the concerned income either in trading or P4 a!c , Assets side of balance sheet Appears in trial balance , Assets side of #alance sheet Inc &e recei#ed in ad#ance Income received in advance is that income 'hich is received during the accounting period but is not being earned. Appears as adjustment , Inc &e a>c Dr T Inc &e recei#ed in Ad#ance a>c

, <eduction to the concerned income either in trading or P4 a!c , iabilities side of balance sheet Appears in trial balance , iabilities side of #alance sheet De-reciati n <epreciation denotes the decrease in the value of an asset due to the 'ear and tear" lapse of time" obsolescence" e,haustion etc."

As an adjustment <epreciation A!c To &i,ed Asset A!c <r

, <ebit side of P4 a!c , <eduction from the concerned asset account on assets side of balance sheet Appears in trial balance , <ebit side of P4 a!c Bad de6ts #ad debt is a debt that cannot be recovered and is a loss As an adjustment #ad debts A!c To <ebtors a!c 1 <ebit side of P4 A!c 1 <eduction from debtors on the assets side of #alance sheet Appears in trial balance , <ebit side of P4 a!c (r #isi n " r Bad A d !6t"!* de6ts Provision for the likely #ad and doubtful debts As an adjustment P4 A!c <r To Provision for bad debts a!c 1 Add to the bad debts on the debit side of P4 A!c 1 <eduction from debtors on the assets side of #alance sheet (r #isi n " r Disc !nt n De6t rs Provision for discount is making a provision for the good debts As an adjustment P4 A!c <r To Provision for discount on debtors a!c 1 1 Add to the discount a!c on the debit side of P4 A!c <eduction from debtors on the assets side of #alance sheet <r

)ll balance s#eets are built up from 3 main categories, namely assets, liabilities and s#are#olders funds. '#e relations#ip bet"een t#em can be loo$ed at eit#er from t#e point of vie" of s#are#olders ?a proprietary approac#@ or from t#e point of vie" of t#e company as a "#ole ?an entity approac#@. '"o forms of t#e fundamental balance s#eet identity can t#us be derived0 Proprietary0 assets & liabilities A s#are#older funds

Entity0

assets A liabilities B s#are#older funds

Cery broadly, all t#at is being said is t#at, firstly, "#at a company o"ns less "#at a company o"es is e!ual to t#e value of t#e s#are#olders funds invested in it and t#at, secondly, "#at a company o"ns is financed partly by t#e o"ners ?t#e s#are#olders@ and partly by outsiders ?t#e liabilities@. Either way, a balance sheet must by definition, balance.

) proprietary approac# balance s#eet "ill loo$ li$e t#e follo"ing ?vertical balance s#eet@.

&i,ed assets J %urrent assets / %urrent liabilities I2et assets or capital employed / ong term liabilities I $hare capital and reserves
A entity approach balance sheet 'ill look like the follo'ing 3Dorizontal balance sheet5.

EI)<IEI'I1* 1!uity capital B Eong term liabilities B ,urrent liabilities

)**1'* +ixed assets B ,urrent assets

Assets +ixed assets D ,urrent assets0 )ssets are somet#ing of value to t#e business, "#ic# can eit#er be turned into cas# or used to produce revenue.

Fi#ed assets

'#ose assets "#ic# are intended for use on a continuing basis in an underta$ings activities. 1xamples are buildings, e!uipment, ve#icles. *toc$s, for example, are not regarded as fixed assets since t#ey are ac!uired eit#er for immediate resale ?for example cigarettes as sold by a tobacconist@ or as ra" materials for use in manufacturing operations. It is intention that determines whether an asset is fixed or not. 8lant and ve#icles, for example, are t#e current assets of a company "#ose business it is to manufacture t#em for sale.

Concepts in!ol!ed in !aluation o$ $i#ed assets:

Matching +ixed assets are an example of a good purc#ased for use over several periods and are not c#arged entirely against profits of year of purc#ase but spread over t#eir years of use. Cost !aluation %historical !alue& Going concern 'asis +ixed assets are typically included at "#atever proportion of cost is still expected to yield useful benefits in t#e future. It is assumed t#at t#e business "ill last long enoug# for t#ese to be realised, "#ic# is !uite different from an approac# "#ic# valued assets at scrap values. '#ere are different $inds of fixed assets in t#e balance s#eet suc# as tangible fixed assets, investments and intangible fixed assets. Investments *#ares, loans, bonds and debentures #eld eit#er as fixed tangible assets or current assets. '#ese are usually valued at cost. Intangi'le $i#ed assets 6onFmonetary fixed asset "#ic# is "it#out p#ysical substance. '#is category of asset includes not only suc# GidentifiableH intangibles as patents, trade mar$s and copyrig#ts, but also good"ill. Good(ill ) company is not Iust a collection of tangible assets. It is, or s#ould be, a going concern "#ose total value, by reason of its proven ability to earn profits, is greater t#an t#e sum of its parts. It is t#e difference bet"een t#e total value and t#e sum of t#e parts "#ic# constitutes good"ill. It s#ould not be regarded as in any "ay a fictitious asset0 to be valuable, an asset does not #ave to be tangible. 2ood"ill is, #o"ever, very difficult to value obIectively and company la" does not permit it to be appear in t#e balance s#eet unless it #as been purc#ased, and even t#en it is usually "ritten off immediately or !uite !uic$ly. In some group balance s#eets an item appears entitled Ggood"ill arising on consolidationH or Ggood"ill on ac!uisitionH. '#is represents t#e excess of t#e cost of s#ares in subsidiary companies over t#e boo$ value of t#eir net tangible assets at t#e date of ac!uisitionJ t#at is,

t#e parent company "as "illing to pay more to purc#ase a company t#an t#e sum of its tangible and net current assets. Current assets

,omprise t#ose assets "#ic# are not intended for continuing use in t#e business. 1xpected to be turned into cas# or used in course of trading "#ic# can normally be expected to be turned into cas# "it#in one year from t#e date of t#e balance s#eet. 1xamples include ban$ balance, prepayments, amount o"ing from debtors, cas#, stoc$s. *toc$s are anot#er example of matching concept F Iust #o" far to ta$e it depends upon t#e materiality concept. )ia'ilities

7bligations arising from past transactions or ot#er events and involving a company in a probable future transfer of cas#, goods or services. ,an be classified as current or long term liabilities. Current lia'ilities 7bligations "#ic# #ave to be settled "it#in a relatively s#ort space of time. 1xamples include amounts o"ing to creditors, ban$ overdraft, tax liability ,urrent assetsF ,urrent liabilities A 6et ,urrent )ssets or .or$ing ,apital ?a measure of li!uidity@. +ixed assets B current assets F current liabilities A ,apital 1mployed or 6et )ssets or 6et .ort# )ong term lia'ilities Eong term liabilities represent t#e extent to "#ic# t#e firm, not "is#ing to borro" furt#er long term funds from s#are#olders, #as borro"ed from outsiders. '#e maIor parts consist of bot# long term loans ?not "#olly repayable "it#in 5 years@ and medium term loans ?repayable "it#in 5 years@. <an$s are an obvious source of outside finance and many firms long term liabilities are in t#e form of ban$ loans. '#ese are not t#e only form of borro"ings. '#ere are also debentures and debenture stoc$s "#ic# may be secured by fixed or floating c#arges or may alternatively be unsecured debentures.

*hareholders $unds '#e s#are#olders funds section of t#e group balance s#eet is subdivided into Share Capital and Reserves. *#are#olders differ from debenture #olders in t#ree important "aysJ t#ey are o"ners of t#e company, not lendersJ t#ey receive dividends ?a s#are of t#e profits@, not interestJ and, except in special circumstances, t#e cost of t#eir s#ares "ill not be repaid ?redeemed@ to t#em by t#e company. *#ares can be eit#er ordinary or preference. '#e latter is usually entitled only to a dividend at a fixed rate, but #as priority of repayment in t#e event of t#e company being "ound up. 8reference s#ares may be cumulative or nonFcumulative.

1very s#are #as a par value but t#is is not necessarily t#e same as t#e issue price of t#e s#ares or t#eir mar$et price. *#ares can be issued at more t#an t#eir par value0 t#is gives rise to a share premium reserve. 7nce a s#are #as been issued, its mar$et price fluctuates from day to day, but t#is #as no effect on t#e firms balance s#eet. ) company does not #ave to issue all its s#ares at once, nor does it #ave to re!uest full payment on t#e s#ares immediately. ,ompanies normally #ave aut#ority to issue ?i.e. #ave aut#orised capital of@ s#ares even t#oug# t#ey #ave not issued t#em. )lso s#ares can be partly paid. +or example, a 25p s#are could be payable 5p on application for t#e s#ares, a furt#er 5p on allotment, "#en t#e directors decide to "#om t#e s#ares are going to be issued ?or allotted@, and t#e remaining 15p in calls. '#us, in summary, one can distinguis# aut#orised, issued, called up and paidFup s#are capital.

Reser!es

?K, ---@

+IL14 )**1'* Reserves consist of t#e retained profit ?or loss@, t#e s#are premium account and ot#er reserves suc# as 6et fixed assets a revaluation reserve. '#is is created as a result of t#e revaluation1-of fixed assets on t#e ot#er side of Investments 5t#e balance s#eet. 15It is very important not to confuse reserves "it# cas#. 'o say t#at a company #as large reserves is not ,5RR16' )**1'* t#e same t#ing as saying t#at it #as plenty of cas#. If a company #as *toc$s 25 reserves it must #ave net assets 4ebtors 25 of e!ual amount, but t#ese assets may be of any $ind ?e.g. mac#inery, stoc$ in trade@. '#us it is ,as#perfectly possible for a company to #ave bot# large reserves and a large 25 ban$ overdraft. '7')E )**1'* 225 ,5RR16' EI)<IEI'I1* )n example of a balance s#eet ,reditors '7')E )**1'* E1** ,5RR16' EI)<IEI'I1* Eong term liabilities ,)8I')E )64 R1*1RC1* ,alled up s#are capital *#are premium 8rofit and loss account *%)R1%7E41R* +564* 51;5 5125 25 ;5 25 125

Relation 'et(een the P+) statement and the 'alance sheet It is "ort# loo$ing more closely at t#e lin$ bet"een t#e profit and loss account and t#e balance s#eet. %o" can a company gro" & t#at is, #o" can it increase its assets/ Eoo$ again at t#e identity Entity0 assets A liabilities B s#are#older funds

It is clear t#at t#e only "ays to increase t#e assets are to increase t#e liabilities ?to borro"@ or to increase t#e s#are#olders funds. %o" can a company increase t#e latter/ '#ere are t"o possibilities0 it can issue more s#ares or it can ploug# bac$ profits ?assuming of course t#at it is ma$ing some@. 8loug#ing bac$ profits is t#e simplest but not necessarily t#e c#eapest source of long term finance for a company. )lso t#e more a company ploug#s bac$ t#e less, in t#e s#ort run at least, t#ere "ill be available for paying dividends.