Understanding Financial Statements

Business
Transaction

Outflow of
Inflow of Funds
Funds

External Sources
Purchase of
Revenues (I) L (Capital and
Assets (A)
Loans)

Revenue
Direct Income
Expenses (E)

Indirect Income

 Every Transaction has two aspects and according to this system both the aspects are recorded.
If Then (Either / Or)

A is created  Another A reduces

 L Increases
 E Decreases
 I Increases
L is created  Another L reduces
 A increases
 E Increases
 I decreases
E is incurred  A reduces
 L increases
I is generated  A Increases
 L reduces

Classification of Accounts:
1. Assets: Indicates the resources which the firm enjoys.
2. Liabilities: Indicates the amounts which the firm owes to the outsiders.
3. Expenses: Amount which has been spent or even lost in carrying on operations.
4. Income: Amounts earned by the firm

Ledger:
 Based on entries made in the journal, accounts are prepared in T form (as discussed earlier)
 The book which contains the accounts is called ledger.
 Ledger is also called the principal books of account.

Trial Balance:
  After passing the accounts in ledger, a statement is prepared showing the debit and credit balances in two
separate columns.
 These two columns agree automatically.
 T B helps to establish arithmetical accuracy of the books of accounts.
 Financial statements are normally prepared based on agreed T B.
 T B serves as a summary of what is contained in the ledger.
Proof of the Accounting Equation:
LHS = L + P = L + (I – E) = L + I – E = A = RHS (applying the accounting equation)

Profit and Loss Account:

 This is prepared for a certain period.
 The revenue incomes and revenue expenses pertaining to that year for which the Profit and Loss Account is
being prepared are considered and the profit or loss is computed.
 All revenue expenses chargeable to that year is taken into consideration irrespective of the fact, whether it is
actually paid or not.
 Similarly, all revenue incomes are also considered irrespective of the fact whether it is actually received or
not.
Balance Sheet:
 This is prepared at a particular date.
 Balance Sheet reflects the financial position of the organization at that particular date.
 Balance Sheet depicts the assets and liabilities position of the organization at that particular date.

Fundamentals Concepts of Accounts:

1. Entity Concept: The business of the owner and the owner himself are considered as two separate entities. It
is due to this reason, that the owners fund (Capital plus accumulated Surplus is regarded as a liability of the
business entity)
2. Going Concern Concept: The business entity to have perpetual existence.
3. Historical Cost Concept: Value of an asset is to be determined on the basis of the cost of acquisition.
4. Accrual Concept: Recognition of revenue and costs as they are earned or incurred rather than money
actually received or paid.
5. Consistency: Whatever may be the accounting policies adopted, these are to be followed consistently
promoting comparability.
6. Conservatism: It is not prudent to account or provide for unrealized gain but it is desirable to guard or
provide against all possible losses.
7. Matching Principle: If any income is recognized in the books of accounts then the simultaneous expenditure
should also be booked.

Qualities of well-presented accounts:

 Readability
 Transparency
 Comparability
 Reflecting a true and fair view of the state of affairs of the business.
 Informative
 Compliance with the fundamental principles and assumptions
 Supplemented with adequate disclosures for inconsistencies, non-compliance with reasons thereof.

Why it is necessary to develop a good accounting system:

 Proper reflection of the actual financial performance/results/position.
  Aids in evaluating the strengths and weaknesses of the organization.
 The first word in MIS
 Information base for decision making by the management
 Compliance with various legal formalities and statutory regulations
Users of Accounting Information:
 Internal User: Management
 External Users: Investors, Employees, Lenders, Suppliers, Customers, Government, Tax Authorities and other
statutory bodies, General Public

Accounting as MIS:
 A large portion of accounting information is prepared for management decision making.
 Accounting data is used as basic source document for MIS
 Management also depends on other data source for information.
 Accounting system can be molded to serve requirements of management
 Accounting is an essential service function to management.
Transactions of Photocopy Wala:
1)Started business with cash Rs. 60,000, deposited Rs. 20,000 at bank, brought paper worth Rs. 10,000 from
home
2) Bought furniture for Rs. 10,000 and paid cash.
3) Bought machines worth Rs. 60,000 and paid Rs. 40,000 cash and balance to be paid after 2 months.
4) Paid Office Rent Rs. 3,000 by cheque.
5) Took a bank loan of Rs. 80,000.
6) Received cash for services Rs. 20,000.
7) Paid interest on bank loan Rs. 4500.
8) Repaid 10% of the bank loan.
9) Withdrew cash of Rs. 10,000 from the bank for personal use.
10) Provided services to Mr. ABC and billed him for Rs. 5000, amount yet to be received.
11) Collected Rs. 3000 from Mr. ABC