Financial Accounting – An Introduction

by
Dr Vandana Bhama
FORE School of Management, Delhi
Why Financial Accounting?
• An organization uses resources – labor, materials,
various services, buildings and equipment.

• These resources need to be financed or paid for.

• People in an organization need information about

the amounts of these resources.

• Parties outside the organization need similar

information to make judgements about the
organization.
 Accounting – The Language of Business
• Communicating information about a business.

• It is to apply a thorough knowledge of the theory of accounting, that is,

generally accepted accounting principles to the practical field of
business in order that income and financial position may be stated fairly.

• After analyzing properly the information supplied by the accounting

statements, the users of the same take decisions for future activities.

• Thus, the language of accounting expresses the whole story through the
various processes of accounting.
Enabling preparation of Financial
Statements
1. The Profit and Loss Account - Measuring the financial performance,
i.e. the profit earned or the loss suffered by the firm.

2. The Balance Sheet – Measure the financial position, i.e., What is

the status of the money invested or what the enterprise owns and what
is owes, respectively.
Accounting Cycle
Accounting Transactions lead to the creation of

Assets

Liabilities

Income

Expenses
 Assets
• E.g – Land, buildings, plant and machinery, vehicles, furniture, office
equipment, inventories of raw materials, work-in-progress and
finished goods, amount receivable from customers to whom finished
goods sold on credit etc.

• The resources controlled by a business enterprise which enable it to

carry out its business operations for generating revenue.
 Types of Assets
• Fixed Assets – E.g. -Land, buildings, plant and machinery, vehicles,
furniture and office equipment, representing physical infrastructure.
These assets provide long-term economic benefit, usually spanning
beyond one year, to the firm but they themselves are not held for sale.

• Current Assets – E.g. -inventories of raw materials, work-in-progress and

finished goods, amount receivable from customers to whom finished
goods sold on credit.
These assets are held for consumption (raw material/WIP) or for sale
(Finished goods) and are expected to be realized in cash (debtors). Cash
itself is a current asset.
 Investment Assets
• Surplus funds cannot be kept idle and are therefore invested into
shares or debentures of other companies.

• Assets held by a firm for earning income by way of dividends, interest

gain on their disposal which is called capital gain.

• There is also a risk of losing money also on their disposal, known as

capital loss.
 Liabilities

• E.g – Owner’s capital, term loan, bank borrowings for financing

current assets, amount payable to suppliers from whom the raw
materials purchased on credit.

• These sources represent liabilities since they have to be paid back.

These are the obligations of the business enterprise that arise in the
course of its business operations and are to be discharged/settled in
future.
 Types of Liabilities

• Long-term (non-current) Liabilities – E.g. Term loan, Owner’s capital

Any liability repayable over a period exceeding one is termed as long term
liability.

• Current liabilities – E.g. Bank borrowings for financing current assets, amount
payable to suppliers from whom the raw materials purchased on credit.

Current Liabilities have to be essentially discharged during the operating cycle

(creditors and advances from customers) and in any case within one year (bank
borrowings).
 Accounting Equation for Financial Position
• Assets and Liabilities put together constitute the financial position of
an enterprise.

 Assets = Liabilities, or
 Assets = Outside Liabilities plus Owner’s Capital, or
 Assets less Outside Liabilities = Owner’s Capital
The basic accounting equation is also known as the balance sheet identity.

More the excess of assets over the outside liabilities, more strong is the
financial position and vice-versa.
 Income and Expenses
• Income - Business activities of a firm generate revenue or income.
• Sale of goods is the most common business income.

• Expenses – These are incurred in the course of the business

operations of the enterprise towards generating income.
• E.g – raw material consumed for production, production expenses like
– wages, power, fuel etc., other administrative expenses like salaries,
office rent, travelling and other marketing expenses.
 Profit and Loss Account
• Excess of income and gains over expenses and losses represents net
profit earned by the business and net loss in a vice versa case.

• Net Profit = Increases Owner’s Capital

• Net Loss = Reduces Owner’s Capital
Accounting Equation for Financial
Performance
 Assets = Liabilities, or

 Assets = Outside Liabilities plus Owner’s Capital, or

 Assets less Outside Liabilities = Owner’s Capital, or

 Assets less Outside Liabilities = Owner’s Brought in Capital less

Owner’s Drawings plus Net Profit (–Net Loss), or

 Assets less Outside Liabilities = Owner’s Brought in Capital less

Owner’s Drawings plus Income less Expenses
 Accounting Principles

• Money Measurement concept

• Going concern concept
• Cost concept
• Conservative concept
• Accounting Period
• Consistency principle
 Key points
• Balance sheet has two sides, namely, assets and liabilities. Assets are valuable
resources owned by the firm and liabilities are obligations payable by it.

• Liabilities are sources of financing assets.

• Liabilities are broadly classified into two categories, namely, external liabilities
(consisting of creditors and lenders) and internal liabilities (consisting of
owners’ contribution/equity).

• Owners’ equity consists of (i) initial capital provided by them and (ii) retained
earnings accumulated over the years from the firm’s profitable operations.
 Contd…
• Total assets are always equal to total liabilities. This is as per principle of
duality. Fundamental accounting equation, therefore, is

• Owners’ equity + Liabilities (external) = Assets

• Balance sheet is always with reference to a point of time (say 31st March).
Therefore, it is a snapshot of financial position of a firm at a specific date in
terms of assets owned and liabilities owed. Whereas income statement
indicates profits earned (or loss suffered) during the accounting period.

• Financial statements record only those facts which are plausible to be

expressed in financial terms.
 Contd…

• Going concern concept implies that the firm will continue to operate
in foreseeable future and, therefore, assets should be valued at
historical cost (cost concept) and not at liquidation value.

• Assets shown in balance sheet do not show their market valuation.

• Accounting period concept normally covers time span of twelve

months. Most of the companies follow financial year (April-March) or
calendar year (January-Dec) to determine income.
Objective type questions
 True/False
1. Balance sheet indicates market value of the firm’s total assets.
2. Total of two sides of balance sheet always tally.
3. Accounting is a record of all important business events.
4. Owner’s equity implies owner’s capital contribution.
5. Balance sheet will not tally if assets have been stolen.
6. Liabilities are claims against all the assets.
7. Revenues are recognized not at the time of credit sales but when
cash is realized from debtors.
8. Expenses are recognized as and when they incurred.
 Fill the correct option
• 1. Liabilities + __________(Capital/owner’s equity) = Total assets
• 2. Sales revenue minus cost of goods sold is _____________ (Gross
Profit/Net Profit)
• One who lends money is _______________(Creditor/debtor)
• Owner’s claims are referred to as ____________ (Owner’s
equity/liabilities)
• Assets are __________ (Sources/resources) of a business firm.
THANK YOU