FINANCIAL ACCOUNTING

What is Accounting? Accounting a process of identifying, analyzing, recording, summarizing, and reporting economic information to decision makers in the form of financial statements. It is an information system that identifies what information is to be included or excluded from the system, records that information and communicates that information to the users who are interested. Accounting is a system that provides information on: y y y y Amount of resources How resources were financed How were these resources invested. Results achieved by using these resources A widely accepted definition of accounting has been provided by the American Accounting Association. According to this definition accounting is the process of identifying, measuring and communicating information to permit judgement and decisions by the users of accounts. This definition implies that (1) there should be users of accounts who need relevant information, (2) the information should enable the users to make judgement and decisions, and (3) transactions and events are measured and the data are processed and then communicated to the users through accounting. Financial accounting focuses on the specific needs of decision makers external to the organization (e.g. stockholders, suppliers, banks, and government agencies). Financial Accounting is based on double entry system of accounting which comprises of (i) recording of business transactions in the books of prime entry, (ii) posting into respective ledger accounts, (iii) striking balance, and (iv) preparing the performance statement (profit and loss statement) and position statement (balance sheet). Financial Accounting is concerned with the collection, recording, classification and presentation of financial data to serve the purposes of the management, shareholders and stakeholders, such as, creditors, bankers, Government, etc. Who Cares?

Accounting information is useful to anyone who needs to make a decision based upon the company s performance and potential. For example: y y y y y y Investors Owners Managers Creditors Legislators Etc. Aim of Accounting: The basic aim of accounting in a business entity is to provide financial information for making decisions on its activities. Managers of an economic entity at various levels require analyzed financial information for planning and programming, for controlling expenditure, for ascertaining the extent of profitability or otherwise of a department even of each production item for undertaking new jobs, etc. To provide sufficient information for users to make informed business decisions. Accounting helps in decision making by showing where and when money has been spent, by evaluating performance, and by showing the implications of choosing one plan instead of another. From Pure Accounting Viewpoint : the fundamental accounting equation is: y y y y y y y Debit = Credit And, Assets = Liabilities And, Assets = Internal Liabilities + External Liabilities And finally, Assets = Capital + Liabilities; or A = C + L Capital = Assets Liabilities Assets = Liabilities + Owner s equity. Assets = Liabilities + Capital Withdrawals + Revenue - Expenses Jargons: Assets : y y y y Are probable future economic benefit obtained or controlled by a particular entity as a results of past transactions or event. A resource owned or controlled by an entity that is expected to provide benefits to business in the future. Owned (owner has a legal title to asset) Provide benefit now and in future Examples of assets: y y y Cash Accounts Receivable Office Supplies

y y y y y

Equipment Building Machinery Stationery Other assets Liabilities:

y y

Are probable future sacrifices of economic benefits, arising from a present obligation. Something that the business currently owes to another party Examples of Liabilities

y y y

Accounts payable Bank Loan Loan payable Equity:

y y y y y

Is the residual interest in the assets of an entity that remains after deducting it s liability Represents the value of the assets of the business that the owner can claim Assets Liabilities In business enterprises the equity is the ownership interest Ownership of the assets Capital :

Contributions that the owners invest into the business. Capital Employed :

Own + Loan capital Revenues :

y y y

Amounts earned by a firm in the ordinary course of business Commonly earned by providing goods or services to customers Any increase in owner s equity Expenses:

y y

Costs incurred by the firm to earn revenues Incurred in the ordinary course of business Process of Accounting :

y o o

Creating necessary accounting heads Assets Liabilities

o o y y y

Equity Income and Expense Double entry system Accounting equation Yield financial statements Transaction Analysis Two rules to apply

y y

Each transaction has at least two entries : Double entry system The accounting equation must always remain in balance ( A= L + E) Elements measuring financial position are:

y y y o

Assets Liabilities Equity These result in Balance sheet Elements measuring performance are:

y y o

Revenue Expenses These result in Profit and Loss statement Four Financial statements: IRBC 1) Income statement 2) Retained Earning statement 3) Balance Sheet 4) Cash flow statements Six Account types: DEALOR 1) Dividends 1. Retained earnings statement

2) Expenses 1. Income statement

3) Assets

1.

Balance sheet

These three are recorded as Debit 4) Liabilities 1. Balance sheet

5) Owner s equity 1. 2. Common stock -> Balance sheet Retained earnings -> Retained earnings statement

6) Revenue 1. Income statement

These three are recorded as Credit Three transaction types: 1) Operating 2) Investing 3) Financing Used to complete cash flow statements.

Financial Accounting : Another Simple case On 31st March 2001 Mr. PQR resigned from his employment. On that date he receives from his employer Rs. 15,000. On 1st April 2001, he started a business with Rs. 15,000. On 2nd April he opened a Bank A/c by depositing Rs. 10,000 ; on 6th April he purchased 100 units of L at Rs. 10,000. He paid Rs. 5,000 in cash and agreed to pay balance amount after one month.. On 7th April he sold 60 units of L for cash and 30 units of L on 2 months credit term. Selling price per unit Rs. 120. April 1 Cash introduced in business Rs. 15,000 Cash Rs. 15,000 = Proprietor s Capital A/c 15,000 Asset (cash) = Capital + Liabilities 15,000 = 15,000 + 0

April 2 : Opened Bank A/c by depositing Rs. 10,000 Cash (15,000 10,000) + Bank (10,000) = Capital (15,000) Asset (Cash + Bank) 15,000 = Capital (15,000) + Liability (0) 15,000 = 15,000 + 0 April 6 : Goods purchased for Rs. 10,000 paid Rs. 5,000 in cash; by the transaction as on that his stock of goods amounted to Rs. 10,000. As he paid cash Rs. 5,000, cash balance was nil and liability for goods purchased was Rs. 5,000 Asset = Liabilities + Capital Cash (0) + Bank (10,000) + Stock (10,000) = Capital (15,000) + Liability (5,000) 20,000 = 20,000 April 7 : He sold 60 units of L for cash @ Rs. 120. He therefore received Rs. 7,200 in cash and 30 units of L for credit @ 120, therefore Rs. 3,600 becomes amount receivable. He thus withdrew 90 units of L costing Rs. 9,000 which he sold at Rs. 10,800 (Rs. 7,200 + Rs. 3,600). He therefore earned an income of Rs. 1,800 which would increase his capital. The above transactions would affect the following Accounts : Assets = Cash (0 + 7,200), Bank (10,000), Debtors 3,600 Stock (10,000 9,000) Asset = Cash 7,200 + Bank 10,000 + Debtor 3,600 + Stock 1,000 = 21,800 Capital (15,000 + 1,800) = 16,800 Liability (Creditors) = 5,000 Total Assets (21,800) = Capital (16,800) + Liability (5,000)

MACROECONOMICS

What Macroeconomics Is About Macroeconomics examines the aggregate behavior of the economy how the actions of all individuals and firms in the economy interact to produce a particular level of economic performance as a whole. ...The field of economics that studies the behavior of the aggregate economy. Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product, inflation and price levels. Macroeconomics is focused on the movement and trends in the economy as a whole. Macroeconomics is the study of: The structure, dynamic adjustment, and performance of national economies, and The government policies that affect national economic performance. The main issues of macroeconomics are: Long-run economic growth Business cycles/fluctuations Unemployment Inflation The international economy Macroeconomic policy Macroeconomics : Three questions: 1. Why do output and employment sometimes fall and what can be done about it 2. What are the sources of inflation and how can it be controlled 3. How can a nation increase it s rate of economic growth. Important mission of Modern macroeconomics: To prevent anything like the great depression from happening again. Great depression : As demand falls, aggregate output falls. Jargons: Recession : Decline in output, income and employment lasting more than few months. Depression : a recession that is large in both scale and duration. Inflation : is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation can mean either an increase in the money supply or an increase in price levels. Generally, when we hear about inflation, we are hearing about a rise in prices compared to some benchmark. If the money supply has been increased, this will usually manifest itself in higher price levels - it is simply a matter of time. For the sake of this

discussion, we will consider inflation as measured by the core Consumer Price Index (CPI), which is the standard measurement of inflation used in the U.S. financial markets. Core CPI excludes food and energy from its formulas because these goods show more price volatility than the remainder of the CPI. GDP : Gross domestic product in the United States represents the total aggregate output of the U.S. economy. It is important to keep in mind that the GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%, or the net growth over the period. The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year. Cost push and demand pull inflation Consider two of the main causes of inflation namely cost-push and demand-pull factors. Inflation is a sustained increase in the general price level leading to a fall in the purchasing power of money. Inflationary pressures can come from domestic and external sources and from both the supply and demand side of the economy. Cost push inflation Cost-push inflation occurs when businesses respond to rising costs, by increasing their prices to protect profit margins. There are many reasons why costs might rise: 1. 1. Component costs: e.g. an increase in the prices of raw materials and components. This might be because of a rise in global commodity prices such as oil, gas copper and agricultural products used in food processing a good recent example is the surge in the world price of wheat. 2. Rising labor costs - caused by wage increases that exceed improvements in productivity. Wage and salary costs often rise when unemployment is low (creating labor shortages) and when people expect inflation so they bid for higher pay in order to protect their real incomes. 3. Higher indirect taxes imposed by the government for example a rise in the duty on alcohol, cigarettes and petrol/diesel or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply, suppliers may pass on the burden of the tax onto consumers. 1. A fall in the exchange rate this can cause cost push inflation because it normally leads to an increase in the prices of imported products. For example during 2007-08 the pound fell heavily against the Euro leading to a jump in the prices of imported materials from Euro Zone countries.

2.

3.

1.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of GDP together with a rise in the level of prices. One of the risks of cost-push inflation is that it can lead to stagflation. Important note: Many of the causes of cost-push inflation come from external economic shocks e.g. unexpected volatility in the prices of internationally traded commodities and large-scale movements in variables such as the exchange rate. A country can also import cost-push inflation from another country that is suffering from rising inflation of its own. Demand pull inflation

Demand pull inflation occurs when aggregate demand and output is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap. When there is excess demand in the economy, producers are able to raise prices and achieve bigger profit margins because they know that demand is running ahead of supply. Typically, demand-pull inflation becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long run trend growth of potential GDP. The last time this happened to any great extent in the UK economy was in the late 1980s. Demand pull inflation can be shown in a diagram such as the one below. Possible causes of demand pull inflation 1. 1. A depreciation of the exchange rate which makes exports more competitive in overseas markets leading to an injection of fresh demand into the circular flow and a rise in national and demand for factor resources there may also be a positive multiplier effect on the level of demand and output arising from the initial boost to export sales. 2. Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct or indirect taxation or higher government spending and borrowing. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased borrowing feeds through directly into extra demand in the circular flow. 3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand for example in raising demand for loans or in causing rise in house price inflation. 4. Faster economic growth in other countries providing a boost to UK exports overseas. 5. Improved business confidence which prompts firms to raise prices and achieve better profit margins

2.

3. 4. 5.

Demand pull inflation is most likely to occur when an economy is becoming stretched and is said to be danger of over-heating. This is often seen towards the end of a boom when output is expanding beyond the economy s usual capacity to supply, the result being higher prices and also a larger trade deficit (imports act as a kind of safety valve to take away some of the excess AD). What should we look out for as evidence for cost-push and demand-pull inflation? Cost-push inflation 1. 2. 3. 4. 1. The rate at which wages and salaries are rising 2. Data on producer prices and input costs such as the prices of raw materials 3. Trends in international commodity prices 4. The effects of changes in indirect taxes on prices

Demand-pull inflation 1. 2. 3. 4. 5. 6. 7. How fast is aggregate demand growing (and the component parts I.e. C+I+G+X-M) Estimated size of the output gap Profitability of businesses in different sectors of the economy Growth of the money supply and credit / consumer borrowing Trends in the values of assets such as property prices Indicators of consumer and business confidence Whether a firm s prices are rising faster than their costs (tells you what is happening to profit margins)