FINANCIAL ACCOUNTING

BATCH: 2014-16 / TRIMESTER - I

Dr.K.Sreekumar.M.Com,FCMA,Ph.D.

August 06,2016
 FINANCIAL INTELLIGENCE

Knowing what the numbers really mean

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Scheme of Course Discussion

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 Financial intelligence for business managers

This course will support the development of your financial

intelligence.It is hoped that it will enable you to achieve greater
success,both personally and professionally.It is hoped that it helps
your company (own company or the company in which you would
work for) to be more successful as well. After this course,you will be
just a bit more motivated, a bit more interested, and a bit more excited
to understand a whole new aspect of business.

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Fundamentally, financial intelligence boils down to 4
distinct skill sets, and when you finish this course, you
should be competent in all of them. They are:

1.Understanding the foundation

2.Understanding the art
3.Understanding analysis
4.Understanding the big picture

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 1.Understanding the foundation

Managers who are financially intelligent understand the

basics of financial measurement. They can read an income
statement, a balance sheet and a cash flow statement. They
know the difference between profit and cash. They
understand why the balance sheet balances .The numbers
neither scare nor mystify them.

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 2.Understanding the art

Accounting and finance are an art as well as a science.The two

disciplines must try to quantify what can’t always be quantified,and so
rely must on rules,estimates,and assumptions. Financially intelligent
managers are able to identify where the artful aspects of finance have
been applied to the numbers and they know how applying them
differently might lead to different conclusions.Thus they are prepared
to question and challenge the numbers when appropriate.

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 3.Understanding analysis

Once you have the foundation and appreciation of art of finance,you

can use the information to analyze the numbers in greater
depth.Financially intelligent managers don’t shrink from Ratios,Return
on Investment (ROI) analysis and the like.They use these analyses to
inform their decisions,and they make better decisions for doing so.

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 4.Understanding the big picture

Finally,although it is thought that every one should undertand the

numbers side of the business,it is equally firmly believed that numbers
can’t tell the whole story.A business enterprise’s financial results must
always be understood in the context – that is,within the framework of
the big picture.Factors such as economy,the competitive
environment,regulations,changing customer needs and expectations
and new technologies will affect how you should interpret numbers
and make decisions.

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 How Financial intelligence will work for budding business managers ?

Financial intelligence doesn’t stop with book learning.Like most

disciplines and skill sets,it must not only be learned,it must also be
practiced and applied.On the practical side,we hope and expect this
course will prepare you to take actions such as the following:

1.Speak the Language

2.Ask questions
3.Use the information in your job

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 1.Speak the Language

Accounting is the language of business.Whether you like it or

not,the one thing every organization has in common is numbers
and how those numbers are tabulated,analyzed and
reported.All of you need to use the language to be taken
seriously and to communicate effectively.
As with any new language,you can’t expect to speak it fluently
first.
My advice: Never mind – jump in and try something.You will
gain confidence as you go…
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 2.Ask questions

We want you to look at financial reports and analysis with a

questioning eye. It’s not that anything is necessarily wrong with
the numbers you see. It is tremendously important to
understand the what, why and how of the numbers you are
using to make decisions. Since every company is different,
sometimes the only way to figure out all those parameters is to
ask questions.

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 3.Use the information in your job

After taking this course,you should know a lot.So use this

knowldege!Use it to improve cash flow.Use it to analyze the
next big project.Use it to analyze your company’s results.Your
job will be more fun and your impact on the company’s
performace will be greater.

From a vantage point, I would like to see you all as managers

and leaders who can link the financial results and your job.

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BASICS OF ACCOUNTING

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 Learning Objectives

1. To understand the basics of accounting

2. Different types of accounting
3. To understand the accounting process
4. To understand the various accounting concepts and
conventions to prepare the financial statements
5. To prepare the financial statements and to understand the
importance of them

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Summary of important historic events before and after the introduction of
the double entry accounting system

Year Period Event

3500 BC India Arthshastra by Chanakya
–2000 BC Manusmriti
Mesopotamia Code of Hammurabi
Price quotes to merchants
3000 BC Ancient Egypt Taxes to the king
–1100 AD Use of papyrus
China Evaluation of efficiency of government programs
Greece Introduction of coined money
Rome Cash book for household expenses
1130 AD Medieval England Feudal system(real estate, and taxes on real estate)
–1485 AD “The Domesday Book”
“ The Great Role of the Exchequer”
1494 AD The Renaissance Luca Pacioli’s double entry system
–1700 AD Littleton's seven factors
1700 AD Before the First No newcontributions to double entry accounting
–1950 AD Management Particularly barren period for contributions to management
Accounting accounting
Revolution
1950 AD First Management Direct costing
–1980 AD Accounting Mathematics
Revolution
1980 AD Second Measurement
–1999 AD Management Control
Accounting
Revolution

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 Complementary Elements of Business Accounting

Financial Management
Accounting Accounting

Establishes a
Helps future
framework for
decisions
reporting

For shareholder Integration of the For the

protection information system management team

Uses accounting
Uses concepts and
principles and
techniques
conventions

Records past Contributes to

performance performance
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 Types of Accounting

*Source: Raiborn et al.(1993,p.13)

 Key Business Processes in Manufacturing*

*Source: Magal & Word ( 2012,p.6)

 Understanding Accounting Terms 

The golden rule of accounting goes like this:

Assets = Liabilities + Equity

This is popularly known as the Balance Sheet equation.While the

accounting formula seems intuitive, going deeper into the details
requires understanding. Before you try to understand a company or to
buy a stock using fundamental analysis, you have to read a financial
report.

Financial reports are published by publicly listed companies to inform

shareholders about their financial status. They also offer information
for potential investors to determine if they are worthy of investment.

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 Accounting Terms 

Here are the six accounting categories you need to understand before
preparing / reading a financial statement:

1.Assets – Current Assets, Fixed Assets, Investments and Intangible Assets

2.Liabilities – Current and Long-term liabilities

3.Equity – Equity = Assets Minus Liabilities

4.Revenues

5.Costs

6.Expenses

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 The Profit Equation

Profit = Revenues – Costs – Expenses

e.g. of costs - cost of goods sold

e.g. of expenses - Insurance expense, depreciation expense etc

When this is a positive number, the company is making profits. When

it’s negative, the company has made a loss for the period (yearly, or
quarterly or monthly).

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 Different Types of Profits

1. Gross Profit

2. Operating Profit

3. Net Profit Before Tax

4. Net Profit After Tax

Also there is something called as :

Profit Before Interest ,Depreciation ,Tax and Amortization (EBIDTA)

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 Debits and Credits

Every accounting transaction has a debit side and a credit side.

All debits to left and all credits to the right.
Both sides have to be equal. 

Whether a debit adds or subtracts depends on the type of account you

are looking at. The next slide shows how debits and credits affect the
various accounts.

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 Classification of Accounts

Type of Account Nature of Debit Credit

Balance in the GL
Asset Dr Increase Decrease
Liability Cr Decrease Increase
Equity Cr Decrease Increase
Revenue Cr Decrease Increase
Costs Dr Increase Decrease
Expenses Dr Increase Decrease

Any business transaction will fall into any of these classifications.

Which means that every account will fall into one of the six categories
mentioned above.

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 Understanding Financial Statements 

There are various types of financial statements that will give you insights
on a company’s financial status. The numbers may put you off, but they
are the key to understanding how the company has been operating, and
how well they have been handling different aspects of their finances.

As many of you are absolute beginners at accounting and this is your

first time reading this accounting series, please read and be familiar with
the accounting terms.

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 Financial Statements

In this section, we will look at different financial statements such as :

1.the Statement of Profit or Loss aka the Income Statement (p.120)

2.the Statement of Financial Position popularly known as Balance Sheet
(p.86,87,88 &89)
3.the Statement of Cash Flows (p.201,212&213)

Each financial statement tells you different things you need to know
about a company.

Adobe Acrobat Adobe Acrobat

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Statement of Funds Flow

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Ratio Analysis

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 Preliminary Theory

Financial Accounting is managing debits and credits,

that’s all.

Debits equals credits.

Rs.10000 worth of debits means you must have Rs.10000
worth of credits.

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 Preliminary Theory

There are only three categories of debits –

Assets ,Costs and Expenses

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 Contingency Theory
Preliminary Defined
Theory

There are only three categories of Credits-

Liabilities, Equity and Revenues

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 Preliminary Theory

Assets are things you own.

Liabilities are things you owe.

Equity is investment in the company.

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 ACCOUNTING MECHANICS:
RECORDING OF BUSINESS TRANSACTIONS

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 Accounting Mechanics - Basic Records

1. Basic Accounting Mechanics - Transactions

2. Rules of Debit and Credit
3. Types of Accounts
4. Books of Accounts
5. Maintenance of the Cash Book and Petty Cash Book
6. The Special Journals and Ledger maintained by an
Organization
7. Recording the Transaction in the Various Books
8. Journalizing the Transactions
9. Posting Entries in Ledger Accounts
10. Bank Reconciliation Statement

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 Business Transaction

Every transaction has both a debit and a credit that must balance.
Every account will fall into one of the six categories mentioned earlier.

The transactions that take place in a business enterprise during a

specific period may effect increases and decreases in assets, liabilities,
capital (equity), revenue,cost and expense items.

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 Generally Accepted Accounting Principles (GAAP)

Accounting principles are judged on their general acceptability to the

makers and users of financial statements and reports. They present a
generally accepted and uniform view of the accounting profession in
relation to good accounting practice and procedures. Hence the name
generally accepted accounting principles.

Accounting principles, rules of conduct and action are described by

various terms such as concepts, conventions, doctrines, tenets,
assumptions, axioms, postulates, etc. But for our purpose we shall
use all these terms synonymously except for a little difference
between the two terms – concepts and conventions.

The term “concept” is used to connote accounting postulates i.e.

Necessary assumptions or conditions upon which accounting is
based. The term convention is used to signify customs or traditions as
a guide to the preparation of accounting statements.
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 Principles of Accounting

Principles of Accounting

Accounting Concepts Accounting Conventions

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 Accounting Concepts (Postulates or assumptions)

1. Business Entity Concept

2. Going Concern Concept
3. Money Measurement Concept
4. Cost Concept
5. Dual Aspect
6. Periodic Matching Of Costs And Revenues
7. Realization Concept

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 Accounting Conventions

1. Convention Of Conservatism
2. Convention Of Full Disclosure
3. Convention Of Consistency
4. Convention Of Materiality

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 What is an Account?

To make up to-date information available when needed

and to be able to prepare timely periodic financial
statements, it is necessary to maintain a separate record
for each item. For e.g. It is necessary to have a separate
record devoted exclusively to record increases and
decreases in cash, another one to record increases and
decreases in supplies, a third one on machinery, etc.

The type of record that is traditionally used for this

purpose is called an account.

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 Parts of an Account?

The simplest form of an account has three parts:

i.A title which gives the name of the item recorded in the
account
ii. A space for recording increases in the amount of the item,
and
iii. A space for recording decreases in the amount of the item.

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 Format of ‘T’ shaped Account

This form of an account is known as a ‘T’ account

because of its similarity to the letter ‘T’ as illustrated
below:
Title
Left Side Right Side
DE BIT SIDE CREDIT SIDE

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 BOOKS OF ACCOUNTS

A business organization maintains three important books of accounts,

namely
1.Journal
To record non-cash transactions like credit sales, credit purchases, sales
returns, purchase returns, year-end adjustments, if any. These books are
also called subsidiary books. Format of these books is given in the
subsequent pages.
2.Ledger
Ledger contains a classified summary of all transactions recorded in cash
book and journal. A ledger is not an independent record. The transactions
recorded in a ledger are derived from either cash book or journal.
3.Cash Book
To record cash receipts and payments including receipts and payments
through a bank. A separate cash book is kept to record petty expenses.
The petty cash book is recorded by imprest system.

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Conceptual Framework of Financial Accounting

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 POSTING IN THE LEDGER ACCOUNTS

Now let us prepare the ledger accounts based on the

entries passed earlier. A separate account is opened in
ledger for each account. All the debit entries and credit
entries are duly entered. At the end, the accounts are
properly balanced. In other words, the total of all debit
entries is adjusted against the total of credit entries and
balance is brought forward to the next accounting period.

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 Can we try to understand how transactions are recorded/
accounted?

Each account will have a catalogue number known as account code with a
description. For e.g.

0100 Cash
0101 Petty Cash
A listing of all these accounts are called as Chart of Accounts .Now picture if
this big Chart of Accounts listed all the activities in each account under their
descriptions ,with an ending balance.

0100 01.04.2016 Cash (Beginning/Opening Balance) 0

04.04.2016 Deposit 10
10.04.2016 Withdrawal -5
20.04.2016 Deposit 20
30.04.2016 Ending /Closing Balance ?

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 Ledger Account format

Dr CASH A/C (0100) Figures in Rs Cr

01-04-2016 Opening Balance 0 10-04-2016 Withdrawal 5

04-04-2016 Deposit 10 30-04-2016 Ending Balance 25

20-04-2016 Deposit 20      

    30     30

Microsoft Office
Excel 97-2003 Worksheet

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 Journal

When a business transaction takes place, the first record of

it is done in a book called journal. The journal records all
the transactions of a business in the order in which they
occur. The journal may therefore be defined as a
chronological record of accounting transactions. It shows
names of accounts that are to be debited or credited, the
amounts of the debits and credits and any other additional
but useful information about the transaction. A journal does
not replace but precedes the ledger.

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 Journal Format

JOURNAL

Date Particulars L.F Debit (Rs) Credit(Rs)

06-08-2016 Cash a/c Dr 3 30000 

  To Sales a/c 9   30000

Microsoft Office
Excel 97-2003 Worksheet

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 Sub divisions of Journal

All non-cash transactions should be recorded in the journal. Some

of the subsidiary books are:

1.Purchase Book
2.Purchase Returns Book
3.Sales Book
4.Sales Returns Book
5.Bills Receivable Book
6.Bills Payable Book
7.Journal Proper.

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 General Ledger – the Big Book

The general ledger contains all the accounts of an enterprise. It

is only a device for reclassifying and summarizing all information
recorded in the cash book and Journal.

Thus, the ledger is not an independent record and the

transactions recorded in this must be derived from either the
cash book or journal.

Thus, with the journalizing and posting of transactions in the

ledgers, the recording of entries in the books is complete and
this sets the stage for the preparation of the Financial
Statements of the organization.

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 Illustration:1  Preparation of Journal

Narayan an entrepreneur transacted the following business:

Microsoft Excel
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 Posting in the Ledger Account

Now let us prepare the ledger accounts based on the

entries passed earlier. A separate account is opened in
ledger for each account. All the debit entries and credit
entries are duly entered. At the end, the accounts are
properly balanced. In other words, the total of all debit
entries is adjusted against the total of credit entries and
balance is brought forward to the next accounting period.

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 Subsidiary Books and Cash Book

Subsidiary Books Rules of posting

Purchase Journal Individual entries in the book are credited to the respective
accounts. Totals are posted to the debit side of the
Purchases Account in the GL periodically.
Sales Journal Individual entries in the book are debited to the respective
accounts. Totals are posted to the credit side of the Sales
Account in the GL periodically.

Cash Journal (Book) Individual entries for receipts and payments are debited or
credited to the respective accounts. For preparation of final
accounts, the balance is taken from this Journal/Book.

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Cash Book

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Purchases Book & Purchase Return Book

Microsoft Excel
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Sales Book & Sales Return Book

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General Ledger (GL)

Capital Account

Shyam Account

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General Ledger (GL)

Purchases Account

Sales Account

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Purchase Returns Account

Sales Returns Account

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Gopalan Account

Wages Account

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Commission Received Account

Kamal’s Account

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Postage and Telegrams Account

Stationery Account

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Salaries Account

Rent Account

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Drawings Account

Murthy’s Account

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Furniture Account

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Preparation of Financial Statements:
Trail Balance and Adjustments

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 Trial Balance

A Trial Balance is a summary of all the General Ledger

Balances outstanding as on a particular date. All the debit
balances from the ledger are shown on one side and all
the credit balances are shown on the other side. You are
aware that a debit balance in a general ledger account
indicates an excess of debit side over the credit side of the
ledger. Similarly, a credit balance in a ledger account
indicates the excess of credit side over the debit side.
Now, if all the debit and credit balances were recorded on
the two sides of the Trial Balance, it stands to reason that
the two sides should be equal, since in the journal for
each item of debit, there was a credit item.

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Trial Balance of Narayan as on January 31, 19x1

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You may notice from the above trial balance that the total of
debits is equal to the total of credits. When the trial balance
tallies it establishes the arithmetical accuracy of records.
There should be no surprise in this, because all the entries
and ledger accounts are prepared using the double entry
system. Hence the total of all debits should be equal to the
total of all credits.

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 Illustrations 2 and 3

Microsoft Word Microsoft Excel

Document Worksheet

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 Illustration 2: Preparation of Trial Balance

From the following Balances pertaining to Kiran Kumar, prepare the Trial Balance as on March
31, 2016.

Microsoft Excel
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Trial Balance of Kiran Kumar as on 31.03.2016

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 Illustration 3:Correcting aTrial Balance

An inexperienced accountant prepared the following trial balance. Though it has tallied, there are still some  errors.

Trial Balance as at December 31,2015

Microsoft Excel
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 Adjustments in Trial Balance

Before an accountant can proceed to prepare the financial

statements from the trial balance, he has to process some
additional information, which he either already knows or
receives from some other divisions or departments. The
following are a few examples showing where adjustment
entries would be required:

The accountant may know (or be instructed by the Accounts

Manager) that the depreciation on building is to be charged at
the rate of 5%.

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The accountant would ascertain that the salary of three
workers for January is unpaid at the end of the month.

The accountant is informed by the storekeeper that the goods

lying unsold in the store (representing closing stock) is worth
Rs.17,000 at cost.

The accountant knows or is informed that the loan of

Rs.2,00,000 was taken at an interest of 12% per annum. He
also knows that the interest accrued for January is unpaid as
on January 31, since there is no ledger account for any interest
paid.

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The accountant knows that the insurance premium was paid
for the whole year, whereas the accounts are being prepared
for one month.

The accountant is informed that Rs.500 may not be collected

from PQR Company owing to some technical dispute.

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In view of the above information, certain “adjustment entries”
will have to be made in the Journal. Adjustment entries
usually represent the recording of additional information and
not actual transactions. Different types of adjustment entries
are discussed here:

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In view of the above information, certain “adjustment entries”
will have to be made in the Journal. Adjustment entries
usually represent the recording of additional information and
not actual transactions. Different types of adjustment entries
are discussed here:

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1. Closing Inventory
2. Outstanding or Accrued Expense
3. Prepaid Expense
4. Outstanding or Accrued Income
5. Income Received in Advance
6. DEPRECIATION
7. PROVISIONS FOR BAD AND DOUBTFULDEBTS
8. Bad Debts
9. Cash Discounts Payable 
10. Cash Discounts Receivable
11. Recovery of Bad Debts Written-off

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Preparation of Financial Statements:
Profit and Loss Account

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After learning this chapter, you will be conversant with:

1.Preparation of Profit and Loss Account from a given Trial

Balance
2.Distinction between Capital and Revenue Expenditure
3.Preparation of Profit and Loss Account giving Double
Effect to Adjustments given outside the Trial Balance

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