Lecture 3 Brief Introduction to Accounting

Introduction to Financial Management 11th Jan 2012

What is accounting?
Accounting is the activity of analyzing, recording, summarizing, reporting, reviewing, and interpreting financial information. Accounting is about ACCOUNTABILTY Most organizations are externally accountable in some way for their actions and activities. Accounting is the language of business

What Accountants Do
Accounting consists of these functions: Recording Classifying Summarizing Reporting and evaluating the financial activities of a business

Use of Accounting
Accounting is essentially an "information process" that ensures the accountability of the business to its stakeholders. Provides a record of assets owned, amounts owed to others and monies invested Provides reports showing the financial position of an organization and the profitability of its operations Helps stakeholders monitor an organizations activities and performance Enables potential investors or funders to evaluate an organization and make decisions Helps management actually manage the organization Helps the government evaluate the tax liability

Accounting as an Aid to Decision Making

Fundamental relationships in the decisionmaking process:

Event (Transaction)

Accountants analysis & recording

Financial Statements

Users

Types of Accounting Information

There are two broad types of accounting information Financial Accounts: focuses on the specific needs of decision makers external to the organization, such as stockholders, suppliers, banks, and government agencies Management Accounts: serves internal users, such as top executives, management, and administrators within organizations. Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same - to satisfy the information needs of the user.

Accounting Concepts
Financial accounting relies on several underlying concepts that have a significant impact on the practice of accounting.
Assumptions Separate entity assumption - the business is an entity that is separate and distinct from its owners, so that the finances of the firm are not co-mingled with the finances of the owners. Going concern assumption - the business is going to be operating for the foreseeable future. Stable monetary unit assumption Fixed time period assumption - information prepared and reported periodically (quarterly, annually, etc.)

Principles of Accounting
Duality concept: All transactions have two dimensions, debit and credit. Historical cost principle - assets are reported and presented at their original cost and no adjustment is made for changes in market value. Matching principle - matching of revenues and expenses in the period earned and incurred. Revenue recognition principle - revenue is realized (reported on the books as earned) when everything that is necessary to earn the revenue has been completed. Full disclosure principle - all of the information about the business entity that is needed by users is disclosed in understandable form. Conservatism principle when in doubt err on the side of caution. Materiality principle - a company must strictly state accounts and transactions that are significant to the organization's operations.

Some Definitions
An Account is a separate record for each type of asset, liability, equity, revenue, and expense used to show the beginning balance and to record the increases and decreases for a period and the resulting ending balance at the end of a period. Transaction-Any event or condition that must be recorded in the books of a business because of its effect on the financial condition of the business, such as buying and selling. A business deal or agreement.

Fundamental Accounting Equation

Assets = Liabilities + Owners Equity

Owners Equity = Assets Liabilities = what the business owns what the business owes
Assets - The properties used in the operation or investment activities of a business. Tangible (buildings, machinery, raw materials) Intangible (brand value, R&D knowhow, accounts receivable ) Liabilities - Claims by creditors to the property (assets) of a business until they are paid. Owners Equity - The owner's rights to the property (assets) of the business; also called proprietorship and net worth.

Other Accounts
Revenue (Income) - The gross increase in owner's equity (capital) resulting from the operations and other activities of the business. Expense (Cost) - Decrease in owner's equity (capital) resulting from the cost of goods, fixed assets, and services and supplies consumed in the operations of a business. Owner's Investments- Increase in owner's equity (capital) resulting from additional investments of cash and/or other property made by the owner. Owner's Drawing - Decrease in owner's equity (capital) resulting from withdrawals made by the owner.

Double entry book-keeping

Type of accounting/bookkeeping system that requires every transaction to be recorded in at least two places (accounts) using a debit and a credit. Every transaction is recorded in a "formal" journal as a debit entry in one account, and as a credit entry in another account. Periodically, usually monthly, the summarized balances from the journals are posted (transferred) to a formal business record called the general ledger.

Journal Entry
Chronological recording of financial data (taken usually from a journal voucher) pertaining to business transactions in a journal such that the debits equal credits. Journal entries provide an audit trail and a means of analyzing the effects of the transactions on an organization's financial position. Types of journals:
general journal specialised journals

General journal

Cash payments journal

General Ledger
All general ledger accounts should be thought of as specially formatted records shaped as a big T. The importance of the T structure is that it distinguishes between the left and right side of each general ledger account. Instead of saying left side and right side accountants use the terms debit and credit. Debit simply means the left side of the T account, and credit refers to the right side of the T account. The general ledger is a collection of the group of accounts that supports the value items shown in the major financial statements. It is built up by posting transactions recorded in the sales daybook, purchases daybook, cash book and general journals daybook. There are five (seven) basic categories in which all accounts are grouped: Assets, Liability, Owner's equity, Revenue, Expense, (Gains), (Loss) The main categories of the general ledger may be further subdivided into subledgers to include additional details of such accounts as cash, accounts receivable, accounts payable, etc.

Ledgers
T Account

Difference Between Ledger and Journal

The journal is the book of first entry (original entry); the ledger is the book of second entry. It is the goal where all the entries in the journal find their ultimate destination. The journal is the book of chronological record; the ledger is the book for the analytical record. The journal, as a book of source entry, ordinarily has greater weight as legal evidence than the ledger. The unit of classification of data within the journal is the transaction; the unit of classification of data within the ledger is the account.

The process of recording in the journal is called journalising; the process of recording in the ledger is called posting.

Trial Balance
Trial balance may be defined as an informal accounting schedule or statement that lists the ledger account balances at a point in time compares the total of debit balance with the total of credit balance.

Debit and credit rules

Expanded Version of Accounting Equation

Assets = Liabilities + Beginning Owner's Equity(Capital) + Additional Owner Investments + Revenues - Expenses - Draws This can also be written as: Assets + Expenses + Draws = Liabilities + Beginning Owner's Equity(Capital) + Additional Owner Investments + Revenues Any increase on the left hand side is treated as a debit Any increase on the right hand side is treated as a credit

Accounting Cycle
Business transactions occur Business documents prepared as evidence Journal used to record transactions Ledger accounts used to summarize transactions Trial Balance Prepare the statements of financial performance (Profit and Loss Account) Prepare the statements of financial position (Balance Sheet)

Example
Mr and Mrs Crane run a small graphic design business trading under the name of Samples Limited. Mr Crane buys some stationery from Mr Smith's Stationers for 100. Mr Crane must make two equal and opposite entries somewhere is the Company's accounting ledgers to record this transaction.
This example has been taken from http://www.securetransact.net/infosheets/accounting/intro_to_bookkeeping.html

Recording the first cash transaction

If we follow through on the payment of 100, then the Company's general journal will be completed in the following way:
Date Description Analysis Code Stationery Bank Debit () 100 100 Credit () 05 May Paid Mr. Smith for supply of stationery 05 May Paid Mr. Smith for supply of stationery

After a day's trading at Samples Ltd, the same journal may look something like this:
Date
05 May 05 May 05 May 05 May 05 May

Description
Paid Mr. Smith for supply of stationery Paid Mr. Smith for supply of stationery Sold a widget to Parkins and Co Shop till funds re sale to Parkins Sold 2 widgets to Mr. Jones

Account
Stationery Bank Sales Cash Sales

Debit ()
100

Credit ()
100 250

250 500

05 May 05 May
05 May

Shop till funds re sale to Mr. Jones Cost of weeks milk supply
Paid milkman for milk supply

Cash Milk
Bank

500 10
10

860

860

Although the Cranes's have only enacted four transactions, it has taken eight entries in the ledger to reflect the day's business.

Sales Ledger
Date 05 May 05 May 05 May Description Sold 1 widget Sold 2 widgets Cash received in till Customer Code Debit () Parkins Jones 750 Credit () 250 500

Lecture 4 Financial Statements

Financial Statements
Financial statements provide information about the financial activities and position of a firm. Important financial statements are:
Balance sheet Profit & Loss statement Cash flow statement

Important Questions
What is the financial position of the firm at a given point of time? How has the firm performed financially over a given period of time? What have been the sources and uses of cash over a period of time?

BALANCE SHEET
Horizontal Form
Liabilities + Equity Share capital Reserves and surplus Secured loans Unsecured loans Current liabilities and provisions Current liabilities Provisions Assets Fixed assets Investments Current assets, loans and advances Current assets Loans and advances Miscellaneous expenditures and losses

BALANCE SHEET

Vertical (or Report) Form

I. Sources of Funds (1) Shareholders funds: (a) Capital (b) Reserves and Surplus (2) Loan funds: (a) Secured loans (b) Unsecured loans

II. Application of funds (1) Fixed assets (2) Investments (3) Current assets, loans and advances Less: Current liabilities and provisions: Net current assets (4) Miscellaneous expenditures and losses

Capital, Reserves and Surplus

Share Capital
Equity Share Capital Preference Share Capital

Equity Share Capital

Authorized: Issued: Subscribed: Called up: Paid up capital

Reserves and Surplus

Capital Reserve Specific Reserves General Reserve P&L A/c Credit Balance

Reserves can broadly be classified as Capital or Revenue in nature

BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X1

A. Account Form Liabilities Share capital Equity Preference Reserve & surplus Secured loans Unsecured loans Current liabilities and provisions 20 x 1 15.00 15.00 11.20 14.30 6.90 10.50 57.90 20 x 0 15.00 15.00 10.60 13.10 2.50 8.10 49.30 Assets Fixed assets Investments Rs.in crore 20 x 1 33.00 1.00 20 x 0 32.20 1.00

Current assets, loans and advances 23.40 Miscellaneous expenditures and losses 0.50

15.60 0.50

57.90 49.30

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BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1

Rs.in crores

20 x 1 I. Sources of Funds (1) Shareholders funds: (a) Share Capital 15.00 (b) Reserves and surplus 11.20 (2) Loan funds: (a) Secured loans 14.30 (b) Unsecured loans 6.90 26.20

20 x 0 25.60

21.20

15.60

47.40

41.20 32.20 1.00

II. Application of Funds (1) Fixed assets (2) Investments (3) Current assets, loans and advances Less: Current liabilities and provisions: Net current assets (4) Miscellaneous expenditures and losses

23.40

33.00 1.00 15.60

10.50 12.90 0.50 47.40

8.10 7.50 0.50 41.20

LIABILITIES

Share Capital
Reserves & Surplus Secured Loans

Unsecured Loans
Current Liabilities and Provisions
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ASSETS

Fixed Assets

Investments

Current Assets, Loans, & Advances

Miscellaneous Expenditure & Losses

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PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs.in crore) Income Sales Other income (loss) Expenditure Material and other expenditure Interest Depreciation Profit before tax Provision for tax Profit after tax Prior period adjustments Profit available for appropriations Appropriations Balance carried forward
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70.1

70.1 58.2 2.1 3.0 6.8 3.4 3.4 0.8 4.2 3.5 0.7

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs. in crore)
Net sales Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Depreciation General administration Selling Operating profit Non-operating surplus/deficit Profit before interest and tax Interest Profit before tax Provision for tax Current tax Deferred tax Profit after tax Prior period adjustments Amount available for appropriation Appropriations Balance carried forward 20 x 1 70.1 55.2 42.1 6.8 20 x 0 62.3 47.5

6.3
14.9 6.0 3.0 1.2 1.8 8.9 8.9 2.1 6.8 3.4 2.1 1.3 3.4 0.8 4.2 3.5 0.7 9.9 0.6 10.5 2.2 8.3 4.1 2.9 1.2 4.2 0.7 4.9 4.0 0.9 14.8 4.9

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PROFIT AND LOSS ACCOUNT ITEMS

Net Sales Cost of Goods Sold Gross Profit Operating Expenses

Operating Profit
Non-operating Gains and Losses Profit Before Interest and Taxes Interest

Profit before Tax

Income Tax Provision Profit After Tax Prior Period Adjustments Amount Available for Appropriation Appropriations Balance Carried Forward
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BALANCE SHEET AND FINANCE TOPICS

Share capital Equity Preference Reserves and surplus Secured loans Debentures Loans and advances Unsecured loans Current liabilities and provisions Trade creditors Provisions Fixed assets (net) Gross block Less: depreciation Investments Current assets, loans and advances Cash and bank Receivables Inventories Miscellaneous expenditure and losses Capital structure and cost of capital

Working capital financing policy

Capital budgeting Portfolio management

Cash management
Credit management Inventory management

PROFIT AND LOSS ACCOUNT AND FINANCE TOPICS

Net sales Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Selling and administration expenses Depreciation Operating profit Non-operating surplus/deficit Earnings before income and tax
Interest Profit before tax Revenue risk

Gross profit margin

Depreciation policy

Business risk Financial risk Tax planning Return on equity Dividend policy

Tax Profit after tax

Dividends Retained earnings

NET CASH FLOW

When we looked at the profit and loss account, the emphasis was on
profit after tax (also called the bottom line). In finance, however, the focus is on cash flow. A firms cash flow generally differs from its profit after tax because some of the revenues/expenses shown on its profit and loss account

may not have received /paid in cash during the year. The relationship
between net cash flow and profit after tax is as follows:

Net cash flow = Profit after tax Non cash revenues + Non cash expenses
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NET CASH FLOW

An example of non cash revenue is accrued interest income that has not yet been received. It
increases the bottom line but is not matched by a cash inflow during the accounting period the cash inflow would occur in a subsequent period. An example of a non cash expense is depreciation. In practice, analysts defined the net cash flow as: Net cash flow = Profit after tax + Depreciation + Amortisation However, note that the above expression will not reflect net cash flow accurately if there are significant noncash items beyond depreciation and amortisation.

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ACCOUNTING INCOME VERSUS ECONOMIC INCOME

Accounting income diverges from economic income due to the
following reasons:

Use of the accrual principle

Omission of changes in value Depreciation Treatment of R & D and advertising expenditures Inflation

Creative accounting

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COMPONENTS OF CASH FLOWS

Operating Cash inflows from operations Cash outflows from operations = Cash flow from operations + Investing Cash inflows from investing activities Cash outflows from investing activities = Cash flow from investing activities + Financing Cash inflows from financing activities Cash outflows from financing activities = Cash flow from financing activities =

Net cash flow for the period

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CASH FLOW STATEMENT

LIABILITIES
CAPITAL RESERVES & SURPLUS

ASSETS
FIXED ASSETS

INVESTMENTS LOANS INVENTORIES

CURRENT LIABILITIES
AND PROVISIONS

DEBTORS
CASH

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SOURCES

USES

FINANCING OPERATING FINANCING OPERATING

CAPITAL RES. & SURPLUS LOANS CURRENT LIABILITIES & PROVISIONS FIXED ASSETS INVESTMENTS INVENTORIES DEBTORS

CAPITAL RES. & SURPLUS LOANS CURRENT LIABILITIES & PROVISIONS FIXED ASSETS INVESTMENTS INVENTORIES DEBTORS

INVESTMENT INVESTMENT OPERATING OPERATING

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CASH FLOW STATEMENT FOR HORIZON LTD, FOR THE PERIOD 1.4.20X0 TO 31.3.20X1
(Rs. in crore) (A) Cash Flow from Operating Activities Net profit before tax and extraordinary items Adjustments for Interest paid Depreciation Operating profit before working capital changes Adjustments Debtors Inventories Advances Trade credit Advances Provisions Cash generated from operations Income tax paid Cash flow before extraordinary items Extraordinary item Net cash flow from operating activities 6.8

2.1 3.0
11.9 (4.6) (3.3) 0.5 1.5 0.7 0.2 6.9 (3.4) 3.5

3.5
(Contd.)

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(Contd.) (Rs.in crore) (B) Cash Flow from Investing Activities Purchase of fixed assets Net cash flow from investing activities (C) Cash Flow from Financing Activities (3.8) (3.8)

Proceeds from term loans

Proceeds from inter-corporate deposits Interest paid Dividend paid (2.8)

1.2
4.4 (2.1)

Net cash flow from financing activities

(D) Net Increase in Cash and Cash Equivalents Cash and cash equivalents as on 1.04.20x0 Cash and cash equivalents as on 31.03.20x1 0.4 0.6

0.7

1.0

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MANIPULATION OF THE BOTTOM LINE

1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE
FOLLOWING YEAR 2. ALTER THE OTHER INCOME FIGURE BY PLAYING WITH NON-OPERATIONAL IETMS 3. FIDDLE WITH THE METHOD & RATE OF DEPRECIATION 4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR.

5. MAKE INADEQUATE PROVISIONS . . LIABILITIES

6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS 7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES. 8. REVALUE ASSETS . . CREATE . . IMPRN . . RESERVES 9. LENGTHEN ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE. WHY ? PROJECT IMAGE OF LOW RISK PROMOTE PERCEPN . . COMPETENT MGT INCREASE MGRL COMPENN QUALITY OF PROMPTNESS CANDOUR IN ANALYSING PAST PERFORMANCE

REPORTING MEANINGFUL DISCUSSION . . PROSPECTS Centre for Financial Management , Bangalore

TAXES Taxes may be divided into two broad categories : direct taxes and indirect taxes. A tax is a direct tax if the impact and incidence of the tax is on the same person. Example : Income tax A tax is an indirect tax if the impact is on one person but through the process of shifting, the incidence is on another. Example : Excise duty
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CORPORATE INCOME TAX

A companys taxable income is determined by taking into account its revenues, expenses, and deductions on account of various incentives and reliefs. The taxable income is subject to a tax rate of 30 percent for domestic companies and 40 percent for foreign companies.
While computing the taxable income, among other things, bear in mind the provisions relating to the following depreciation, interest expense, dividend payment, dividend income, unabsorbed business loss and depreciation, exemptions and deductions, minimum alternate tax, and advance tax.
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CORPORATE INCOME TAX

A variety of exemptions and deductions are granted under the Income Tax Act.

If the income tax payable on the total income of a company, as computed under the Income Tax Act, is less than 10.0 percent of its book profit, the tax payable shall be deemed to be 10.0 percent of such book profit.

Advance tax is payable on the current income of the company in four installments during the financial year.
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CORPORATE INCOME TAX

1. Depreciation is charged on blocks of assets which represent a group of assets within the broad class of assets such as buildings, plant, machinery, and furniture, for which a common rate of depreciation is applicable.
2. While interest on borrowings is a tax-deductible expense, dividend on share capital is not.

3. Unabsorbed business loss of any year can be carried forward and set off against income under the head of business of subsequent years.

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INDIRECT TAXES
The three most important indirect taxes are the excise duty, the sales tax, and the customs duty.
The excise duty is a levy on the goods manufactured in the country. Sales tax is a levy on sale of goods. Customs duty is a levy on the import of goods into India or the export of goods out of India.

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FREE CASH FLOW

Free cash flow is the cash flow available for

distribution to investors (lenders and shareholders)

after the firm has made investments in fixed assets and working capital to support its operations.

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CASH FLOW SUMMARY

A. The cash flow identity

Cash flow from assets = Cash flow to lenders + Cash flow to shareholders
B. Cash flow from assets Cash flow from assets = Operating cash flow Net capital spending

Change in net working capital

where Operating cash flow Capital spending = PBIT Taxes + Depreciation = Ending net fixed assets Beginning net fixed assets + Depreciation Change in net working capital = Ending net working capital Beginning net working capital C. Cash flow to lenders Cash flow to lenders = Interest paid Net new borrowing

D. Cash flow to shareholders Cash flow to shareholders = Dividends paid Net new share capital raised
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SUMMING UP
The balance sheet shows the financial position (or condition) of a firm at a given point of time. It provides a snapshot and may be regarded as a static picture. The income statement (referred to in India as the profit and loss account) reflects the performance of a firm over a period of time. The cash flow statement portrays the flow of cash through the business during a given accounting period. Assets are classified into following categories : (i) fixed assets, (ii) investments, (iii) current assets, loans and advances, and (iv) miscellaneous expenditures and losses. Liabilities are classified into the following categories : (i) share capital, (ii) reserves and surplus, (iii) secured loans, (iv) unsecured loans, and (v) current liabilities and provisions. The important items in the profit and loss account are: (i) net sales, (ii) cost of goods sold, (iii) gross profit, (iv) operating expenses, (v) operating profit, (vi) non-operating surplus/deficit, (vii) profit before interest and tax, (viii) interest, (ix) profit before tax, (x) tax and (xi) profit after tax. The important topics in finance can be keyed to the balance sheet and the profit and loss account.
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 From a financial point of view, a firm basically generates cash and spends cash. The activities that generate cash are called sources of cash and the activities that absorb cash are called uses of cash. Increase in owners' equity and liabilities and decrease in assets represent sources of cash. Decrease in owners equity and liabilities and increase in assets, on the other hand represent uses of cash. To understand how cash flows have been influenced by various decisions, it is helpful to classify cash flows into three categories: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Corporate managements have discretion in influencing the occurrence, measurement and reporting of revenue, expenses, assets and liabilities. They may use this latitude to manage the bottom line. Taxes can be one of the major cash outflows for a firm. The magnitude of the tax burden is determined by the tax code, which is subject to change.

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 Taxes may be divided into two broad categories: direct taxes and indirect taxes. A tax is referred to as a direct tax if the impact and incidence of the tax is on the same person. Income tax, wealth tax, and gift tax are examples of direct taxes. A tax is regarded as an indirect tax if the impact and incidence of the tax is on different persons. Excise duty, sales tax, and customs duty are the three important indirect taxes.

We have a balance sheet identity which says that the value of a firm's assets is equal to the value of its liabilities plus the value of its equity. In the same manner we have a cash flow identity which says that :
Cash flow from assets = Cash flow to lenders + Cash flow to shareholders

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