Introduction to Financial Accounting

READING MATERIAL FOR WEEK 1 Introduction to Financial Accounting 1.1 Introduction All organizations, irrespective of the legal status proprietorship, partnership, incorporated company, statutory corporation or trust and whether they exist for profit or not for profit, are formed with a view to achieve certain goals (objective, purpose or vision as you may choose). In order to impart direction and greater certitude to achieving the result, organizations prepare plans. It is said that all plans, in order to succeed, have to be controlled and all controls, in order to be effective, have to be planned. This implies that the actual performance should be measured, compared with the plans and deviation suitably dealt with. The action taken may involve either correcting the performance or modifying plans or both. Further, there are several stakeholders of business who will need financial information for decision making. For this purpose, organizations have to measure the performance and this is achieved through the accounting system. The objective of financial accounting is to provide relevant, reliable and timely information for decision making. 1.2 What is accounting? Accounting is a systematic process that is concerned with measurement and reporting of transactions and events occurring in an organization. Financial reports that are generated provide information that will enable the stakeholders to take decisions. 1.3 Users of Accounting Information Who are the users of accounting information? What information will the stakeholders look for? Let us understand through a small situation. John, a young graduate, wants to start a laundry service. He needs $100,000 to buy the equipment. He has $50000. For the remaining capital, he decides to take a loan from a bank and approaches ABV Bank. When approached by John, the bank manager says that in order to process the application, he needs details of the project and the return expected at the end of every year during the life of the car. Why did the bank manager ask John for the project details? The bank manager will sanction the loan only if he is convinced of the financial viability of the project. These stakeholders need information about the firm in order to decide whether to deal with it and if so, to what extent. There are several users of accounting information. Let us briefly discuss them. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

Investors: They provide capital to the firm. Hence, they need information to assess the inherent risk of loss of capital and the return their investment in the firm is likely to yield. They also need information to buy, sell or hold these investments. Lenders: They are interested in ascertaining the ability of the firm to service their loans over the entire term of the loan by paying interest and repaying installments on the due dates. Suppliers and other creditors: They would like to assess the ability of the firm to pay amounts owed to them within the credit period allowed to the firm. Normally, the interest of the trade creditors is over shorter periods as compared to lenders. Customers and employees: They would like to know if the firm represents a stable source of supply/employment. Government: The government is interested in information that will help it to assess the taxes that can be collected from the firm, regulate the businesses in general, draft tax and economic policies, and prepare national income statistics. Public: Members of the public are interested in assessing the economic benefits and costs arising from factors such as employment of people from the locality, patronage to local suppliers and hazards to environment. 1.4 Accounting System Is there a formal process or a system to do accounting? Let us explain. Accounting System is similar to any other information system and has three components, namely input, process and output as outlined below. The Accounting System INPUT OUTPUT PROCESS MONETARY TRANSACTION AND EVENTS DOUBLE ENTRY SYSTEM OF ACCOUNTING Financial Reports All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

The accounting system in detail: Input All business phenomena, which can be expressed in monetary terms, constitute the input for the accounting system. Certain non-monetary data is used as additional information. When a cash sale is made, monetary events such as the cash received and the value of the sale involved constitute the input for the accounting system. Non-monetary events such as the description of the item and the units sold are also considered by the system since this input is required for additional information. Particulars regarding the customer such as name, address and profile may or may not be treated as an input. However, if the sale is on credit basis, the name and address will be treated as a needed input. The non-monetary phenomena can vary from simple events as stated above to highly involved data on employee performance and customer preferences. The monetary phenomena or transactions which constitute the input can arise either from transactions with third parties such as purchase/sale of goods/services or from other monetary events not involving third parties such as depreciation/amortization/depletion. Process As a rule, the double entry bookkeeping mechanism can process an event only after the event becomes eligible for processing. Rather than attempting to answer the above questions, we will make out a case here for establishing rules of measurement and reporting for carrying out the double entry bookkeeping process. We do not cover the double entry process in this course. More important are the rules we should follow. Rules for measurement and reporting Accounting rules or Accounting standards are a set of rules, guidance or principles governing the way the elements of financial statements should be recorded and reported in the financial statements. They provide the principles for recognition, measurement and disclosures in the financial statements. They set the rules the way specific transactions should be reported and disclosed in the financial statements. Financial statements are prepared in accordance with the accounting standards make them uniform and comparable. Accounting standards impart consistency to financial reports. The investors and analysts can compare the financial statements across different companies and countries if they are prepared as per the same accounting standards. Accounting standards improve the quality of reporting. These standards bring out the most appropriate, fair and legitimate way of recording and disclosing the complexities of any transaction. Accounting standards play a key role in removing the number of alternatives available to present a particular item in the financial statements. Though there are still different ways of reporting transactions depending on the circumstances, to a great extent, these ambiguities have been resolved to present a clean and clear picture of the organization. The standards ensure that the materiality of the transaction remains intact. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

They ensure that the companies resort to the fair practice of recording and reporting/disclosures. Generally, every country has its own set of accounting standards. This authority is vested in a professional accounting body private, government or a combination of the two. Some of the renowned accounting standards across the world are US GAAP and IFRS. In the United States, the responsibility of setting accounting standards is with SEC, this function is delegated to FASB (The Financial Accounting Standard Board ). The accounting rules in the United States are called as US GAAP. Internationally, the accounting standards are formulated by an independent body called the IASB (The International Accounting Standard Board). The standards are referred to as IFRS or the International Financial Reporting Standards. More than 100 countries across the world have adopted or converged IFRS. The usage of accounting standards enables business organizations to bring in the best accounting practices for preparing and reporting financial statements. Output The basic accounting system produces financial reports. The reports are categorized into two kinds, depending upon the intended user internal or external. For the external users, there are 3 important financial statements. Income Statement or the Statement of Profit and Loss, giving information on the performance of the firm Balance Sheet, giving information on the financial position of the firm Cash Flow Statement, giving information on the cash generated/used by the firm Balance Sheet A balance sheet is a statement prepared at a particular point in time that tells us what the business owns as assets and how these have been funded. Understanding the balance sheet through an example: Mr. Von has been working for the last 15 years. What is your wealth as on date? Mr. Von gives you information about his cash in bank and investments in other long-term saving instruments. He also tells you that he owns a car and another house. Will this information be enough to gauge the wealth held by Mr. Von? Think again, what has he left out? Loans or Borrowings? Isn t it important for you to know if he has taken any loan for buying the car and the house? Isn t it important for you to know if he has any other borrowings or liabilities? Yes, in order to evaluate the wealth, or more specifically, the financial position of Mr. Von, you must consider both the assets (car and house) and the money that he owes to others (liability) and the balance contributed by him to buy the assets (equity). What information does the Balance Sheet provide? A balance sheet provides information about the assets (cash, investment in shares, vehicles, machinery, land, etc.) held by a firm and the ways in which the acquisition of these assets were financed by the owners and others. The balance sheet is measured with reference to a All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

point of time and this point of time normally coincides with the end of the period with reference to which the performance is measured (quarter, half, or financial year). Since every transaction alters the financial position of the firm, the balance sheet, which is measured with reference to a point of time, can be said to give a snap shot view of a continuously changing scene. Income Statement or Statement of Profit and Loss The income statement depicts the incomes and expenses for a period of time, i.e., it depicts the financial performance of the firm. Let us come back to Mr. Von. You ask Mr Von about his income. Mr. Von tells you that he earned $200,000 per year. What will be your next question to Mr. Von? You are bound to have several questions, but what is the next most important question that you will ask? You may also want to know his expenses and thus the net savings from his income. Since incomes are earned and expenses are incurred over a period of time, performance of a firm is measured with reference to a period of time. This is very similar to the flow of water into and out of a dam measured with reference to a period of time. Cash Flow Statement provides this information. The cash flow statement provides details of the cash inflows and outflows during the year. This statement would give information on how and where the cash was generated and how it was spent. 1.5 Preparation of financial statements using the accounting equation Preparation of financial statements is not a difficult task. We are not going to record the transaction using the traditional method; rather we are going to use the accounting equation, which is simpler to capture the transactions. The accounting equation is the foundation of the accounting system and is captured through the equation. Assets = Liabilities + Shareholder Equity Let us illustrate how accounting statements can be prepared with the help of a few transactions. 1. John starts ABC Corporation for trading widgets. John starts the business with $300,000 in cash. Our accounting equation now is as follows. figures in $ 000 Assets = Liabilities + Equity Cash ($300 ) = 0 + Equity share capital $(300 ) All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

2. We approach a bank for a loan and the bank, based on their assessment gives a loan of $200,000. Interest rate is 1% per month. Assets = Liabilities + Shareholders' Equity Cash (500 ) = Borrowings (200 ) + Equity share capital (300 ) 3. Rented an office space at $1000 per month payable on the last day of the month. No transaction as we will record the transaction at the end of the month. Assets = Liabilities + Shareholders' Equity Cash (500 ) = Borrowings (200 ) + Equity capital (300 ) 4. Bought furniture for $5000 for the office and paid cash. Furniture is an asset. Our accounting equation now is as follows. Assets = Liabilities + Shareholders' Equity Furniture (5) + Cash (495) = Borrowings (200) + Equity capital (300) Note that cash comes down as we spend money. 5. Purchased widgets for $60000. Paid cash for $40000 and agreed to pay the balance in 60 days. Our accounting equation now is as follows. Furniture (5) + Cash (455) +Inventory (60) = Borrowings (200) + Trade Payables (20) + Equity capital (300) 6. Sold goods costing $40000 for $ 50000 in cash. This is the first time we have encountered items that do not appear directly in the accounting equation. To answer this, let us understand and answer the following questions: What is the profit made in the transaction? Answer: $10000 Whom does the profit belong to? Answer: Equity capital (Shareholders) So, rightfully this has to be added to the equity capital. We now modify the basic equation into: Assets = Liabilities + Equity Assets = Liabilities + Equity (Contributed + Retained Earnings) Assets = Liabilities + Equity (Contributed + Income - Expenses) All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

The accounting equation would be depicted as: Furniture (5) + Inventory (20) + Cash (505) = Borrowings (200) + Trade Payables (2) + Equity share capital (300) + (Revenue (50) - Cost of goods sold expense (40)) The equation has undergone a few changes. Inventory stock has come down from 60 to 20 on account of inventory being sold. Cash is increased by $50,000 because we made cash sale. Revenue/sales increased by $50,000 along with an expense of $40,000 resulting in a profit of $10,000. 7. Since we have borrowed money to invest in the business, we have to pay the interest, which is 1% of the borrowings, i.e. $2000. Our cash holding declines by $2000 and expenses increase by $2000. Our accounting equation is as follows: Furniture (5) + Inventory (20) + Cash (503) = Borrowings (200) + Trade Payables (2) + Equity share capital (300) + (Revenue (50) - Cost of goods sold expense (40) Interest Expense (2) 1.6 Accounting Equation to Financial Statements We can now prepare the financial statements with the help of our accounting equations. The income statement would be reported as follows: Income statement for the month ending 31 January xx Income $ Revenue 50,000 Other Income - Total Income 50,000 Expenditure Cost of Goods Sold 40,000 Interest Expenses 2,000 42,000 Net Income / Profit 8000 Notice that this is the expanded version of the retained earnings. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

Balance Sheet as on 31 January xx Equity + Liability $ Shareholders' Fund Equity Share Capital 300,000 Retained Earnings 8,000 308,000 Liabilities Borrowings 200,000 Trade Payables 20,000 Total 528,000 ASSETS Property Plant & Equipment (Furniture) 1 5,000 Current Assets, Loans and Advances Inventory 20,000 Cash 503,000 523,000 523,000 Total 528,000 The purpose of the above illustration is not to teach accounting process or preparation of financial statement but to demonstrate that they are simple and easy to follow. Many of you will find it exciting to see that your balance sheet is 'balanced' at the end. To Summarize ASSETS MATCH WITH SOURCE OF FINANCING THE ASSET ie ASSETS = LIABILITIES + EQUITY Expanding ASSETS = LIABILITIES + EQUITY CAPITAL + RETAINED EARNING Expanding to next level ASSETS = LIABILITIES + EQUITY CAPITAL + RETAINED EARNING (Income Expenses)* *Note that we have not adjusted the equation for any dividend payment 1.5 Accounting concepts Accounting concepts provide a basis to record the transactions in a particular way. These are the basic assumptions and conventions, which have to be followed while recording any transaction. Some of the concepts are discussed next. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial

Entity Concept The entity concept states that the business and its owner(s) are viewed as entities, separate from each other. The transactions of business are to be recorded separately and the personal transactions of the owner should not be mixed with business transactions. It is because of the entity concept that the capital contributed by the owner is treated like a liability owed to the owner. Based on this logic, capital or equity is shown on the same side of the balance sheet as liabilities. Going Concern Concept The going concern concept assumes that the business is going to continue its operations in the foreseeable future. In other words, the business is going to exist for an indefinite period of time. For example, depreciating assets is an example of the going concern concept. If the assumption fails to hold, then all expenses including expenses incurred for purchased of property plant and equipment (which are assets in the balance sheet) will be shown as expenses. Cost Concept Under the cost concept, all expenses, assets or liabilities should be recorded at their purchase or acquisition price initially. Cost concept offers a sense of reliability to the accounting records. The cost or purchase is reliable since it has proper evidence. For example, the company purchased a piece of land on May 1, for $50,000. The same will be recorded at $50,000 Money measurement concept: Money measurement concept requires the accounting system to record transactions only if such transactions can be measured on a monetary basis. In other words, events that cannot be measured in money terms cannot be entered in the books. There is no way to measure customers' satisfaction or production excellence or human resources value in accounting. In that sense, accounting is not integrating itself with other functions and a typical performance measurement includes several other non-monetary measurements. However, it can be counter argued that if a firm s production facility is excellent or customer satisfaction levels are high, then they will be reflected in the form of additional revenue. Though it is true that ultimately they will be reflected in incremental revenue or profit, there could be a considerable time gap. ================================================================= All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial