Accounting Principles and Financial Statements

Introduction to Financial Management

• Financial management is a broad field.
• Accounting is the language of business.
• Finance includes corporate, investment, personal, international, and behavioral finance.

Broad Categories

• Accounting
  • Financial Accounting: Records financial transactions for external users.
  • Cost Accounting: Measures cost of production.
  • Management Accounting: Aids in internal decision-making.
• Finance
  • Corporate Finance: Deals with financial decisions of a corporation.
  • Investment Finance: Involves investment decisions.
  • Personal Finance: Individual financial decisions.
  • International Finance: Global financial markets.
  • Behavioral Finance: Combines finance with behavioral psychology.

Accounting Language of Business

• Accounting is the recording, classifying, and summarizing of financial transactions.
• Transactions are recorded in terms of money.
• The results are interpreted and used for decision-making.

Accounting Process

• Source Documents: Initial records
• Journals: Summarized records of transactions.
• Ledger (T-accounts): Detailed account of transactions.
• Trial Balance: Summarizes all transactions.
• Financial Statements: End results of the accounting process.

Financial Statement

• Financial statements are the end products of the accounting process.
• They reveal financial results over a period and the position on a particular date.
• The statements are a business's formal, annual report to communicate financial information to users.

Definition of Accounting

• Accounting, per the American Institute of Certified Public Accountants, is the art of recording, classifying, and summarizing financial information in significant manner in monetary terms.
• It also involves interpreting the results.

Importance of Financial Statement

• Importance to management
• Importance to creditors, bankers
• Importance to employees
• Importance to investors
• Importance to government and regulatory authorities

Accounting Concepts

• Money measurement
• Separate entity
• Going concern
• Cost
• Dual aspect
• Realization
• Accrual
• Periodicity
• Matching cost and revenue

Accounting Conventions

• Materiality
• Consistency
• Conservatism
• Full disclosure

Accounting Equation

• An expression of equality between a firm's assets and claims against it.
• Total assets = Liabilities + Capital

Affecting Opposite Side

• Increase in one account causes an increase in a second account (inc in A, inc in L; inc in A, inc in OE; Dec in A, Dec in L)
• Decrease in same causes a decrease in second account (dec in A, dec in L, withdrwal made by owner).

Affecting Same Side

• Increase in one account causes a decrease in a second account (inc in assets, Dec in other assets ( collection from debtors)
• Decrease in one account causes a increase in a second account(dec in L, inc in other liability (issuing debentures for paying creditors).

Types of Business

• Proprietorship
• Partnership
• Company

Definition of a Company

• A company is an artificial person created by law, formed by a group of individuals for a common end (social or economic).
• Section 3(1)(i) of the Companies Act, 1956 defines a company: as a company that is formed and registered under the Act or an existing company.
• An existing company is a company that was formed and registered under earlier company laws.

Characteristics of a Company

• Separate Legal Entity: The businesses has an independent existence from its members.
• Any member can enter contracts
• Company's money owned by the company and not the shareholders
• Common Seal: The seal acts as the official signature.
• Transferability of Shares: Shares are transferrable.
• Limited Liability : Liability of members is limited.
• Perpetual Succession: The company's existence is unrelated to the members, it continues even if all members die.
• Separate Property: The company owns its own property.

Classification of Company

• Incorporation
• Liability of members
• Number of members
• Control

On the Basis of Incorporation

• Statutory Company: Formed per special act by parliament or state legislature
  • Reserve Bank of India (RBI Act, 1934), Life Insurance Corporation of India (LIC Act, 1956)
• Registered Company: Formed and registered under the Indian Companies Act.

On the Basis of Liability

• Limited by Shares: Liability of shareholders is limited to the extent of unpaid shares
• Limited by Guarantee: Liability of members is limited to the amount undertaken to contribute to the assets.
• Unlimited Companies: No limit on liability; members are liable for all debts and liabilities.

On the Basis of Number of Members

• Private Companies: Minimum paid-up capital of one lakh rupees; minimum 2 members, max 200. Shares usually restricted, invitations to public prohibited.
• Public Companies: Minimum paid-up capital of five lakh rupees; unlimited number of members.

On the Basis of Control

• Holding and Subsidiary Companies
• Associate Companies

Sources of Finance

• Shares (equity)
• Debentures (debt)
• Retained earnings

Shares

• Shares are a unit of ownership
• Owners of shares receive dividends.
• Shareholders can vote.

Types of Preference Shares

• Participating Preference Shares: Shares can receive profit along with dividends.
• Non-Participating Preference Shares: Guaranteed dividend; no excess profit.
• Redeemable Preference Shares: Company can repay the shares after a certain time.
• Irredeemable Preference Shares: Shares do not have a repayment agreement.

Cumulative Preference Shares:

• Guaranteed dividend; unpaid dividends add during subsequent years.
• Non-cumulative Preference Shares, Guaranteed dividend; dividends not added per year
• Convertible Preference Shares, Can be converted into equity.
• Non-convertible Preference Shares, Cannot be converted into equity.

Debentures

• Debenture is a creditor security.
• Debenture holder is entitled to a fixed rate of interest.
• Companies Act defines debentures as stocks, bonds and any other securities.

Characteristics of Debentures

• Debenture holders are creditors not the owners.
• They do not vote in company meetings.
• Fixed rate of interest
• They do not share company profits

Types of Debentures

• Secured debentures: Secured by assets or collateral
• Unsecured debentures: General solvency of the company is the only guarantee.
• Redeemable debentures: Repayable after a stated time period.
• Perpetual debentures: Never Redeem
• Convertible debentures: Can be converted to shares
• Non-convertible debentures: Non-convertible to shares
• Coupon rate debentures: Fixed interest rates
• Zero coupon debentures: No coupon, discounted
• Registered debentures: Recorded in company's register
• Bearer debentures: Payable to bearer; transferable by delivery

Final Accounts Companies Act 2013

• Overrides previous legislation (Banking Regulation Act, Insurance Act, Electricity Act)
• Follows accounting standards by MCA
• The financial statements must present a true and fair view of the company's affairs.
• Annual general meeting of a company must have financial statements for the fiscal year.

Form of Balance Sheet & P&L Account

• Balance sheet, Schedule III Part I, Profit and Loss Account, Schedule III Part 2
• Vertical format
• Current and non-current categories

Salient Provisions of Companies Act 2013

• Vertical format for the balance sheet
• Vertical format for the statement of profit and loss
• Important information is stated in the Notes to Accounts"

Trade Receivables

• Replacement of "sundry debtors" for dues from goods sold/services rendered.
• Amounts from other contract obligations excluded.
• Separate disclosure of trade receivables outstanding for over six months.

Assets

• Assets are classified as current or non-current.
• Current assets must satisfy at least one criteria to be classified
  • Expected to be realized within one operating cycle.
  • Held for trading
  • Realized within 12 months after reporting date
  • Cash or cash equivalent not restricted

Liabilities

• Liabilities are classified as current or non-current.
• Current liabilities are to be settled within 12 months after the reporting date.

Balance Sheet Part I

• Equity and Liabilities
  • Shareholder Funds
    • Share Capital
    • Reserves and Surplus
    • Money Received against share warrants
  • Non-Current Liabilities
    • Long-term borrowings
    • Other long-term liabilities
    • Long-term provisions
  • Current Liabilities
    • Short-term borrowings
    • Trade payables
    • Other current liabilities
    • Short-term provisions

Balance Sheet Part II

• Non-current assets: fixed assets, intangible assets, capital work-in-progress, intangible assets under development.
• Non-current investments
• Deferred tax assets (net)
• Long-term loans and advances
• Other non-current assets
• Current Assets
• Current investments, Inventories, Trade receivables, Cash and cash equivalents, Short-term loans and advances, Other current assets

Materiality

• Disclosure of significant factors affecting financial statement.
• Large quantity of raw materials sold leading to either profit or loss.
• The cost of materials is deducted and the result recorded as a component of the Profit and loss account.

Below-the-Line Adjustments

• Profit and Loss Account is now Statement of Profit and Loss.
• Adjustments are disclosed under Reserves and Surplus.

Items to Be Disclosed Separately

• Items of income or expense
• Revenue from operations
• Companies other than finance companies

Prior Period Items

• Errors and other items that arose in the previous period must be stated separately
• The items are not to be clubbed unless not material
• Statement to be prepared below the line

Exceptional Items

• Exceptional items must be disclosed for their sheer size or frequency, even though they are part of ordinary business operations.

Extraordinary Items

• Expenses or incomes that do not normally arise in business operations, and are significant should be separately recorded in the profit and loss account. Examples:
• Loss on speculation
• Profit on speculation
• Subsidy received from the government

Discontinued Operations

• Discontinued operation refers to a segment of the business that has been abandoned.
• Reported separately in the income statement, separate from the continuing operations.

Changes in Accounting Policies

• Disclosure required for any changes to accounting policies (e.g. inventory valuation methods, depreciation methods).
• The effect on profit or loss.

Statement of Profit and Loss

• Revenue from operations
• Other income
• Expenses
  • Cost of materials consumed
  • Purchase of goods
  • Changes in inventories of finished goods
  • Work-in-progress and Stock
  • Employee benefits
  • Finance costs
  • Depreciation
  • Other expenses

Profit before exceptional and extraordinary items/tax

• Exceptional items
• Extraordinary Items

Profit before tax

• Tax expense
• Current tax
• Deferred tax

Profit in (loss) for the period from continuing operations

• Discontinuing Operations
• Tax expense from discontinuing operations,
• Profit in (loss) from continuing operations (after tax)

Earning per equity shares

• Basic EPS
• Diluted EPS

Analysis of Financial Statement (Ratio Analysis)

• Profitability and Efficiency
• Company managers, owners, investors, banks and creditors are concerned.
• Efficiency and performance are revealed through ratios.

Ratio Analysis: Profitability Ratios

• Operating margin: EBIT / Net Sales to measure efficiency in generating earnings from sales
• Gross margin: Gross profit / Net Sales to evaluate the cost control of production and inventory
• Net profit margin: Net Income / Net Sales to measure profitability considering all business costs including taxes, interest and depreciation
• Return on Assets (ROA): Profit after tax / Total Assets to evaluate efficiency in utilizing assets to generate earnings
• Return on Equity (ROE): Profit after tax-Pref.Dividend / Total equity which measures profitability against how much money shareholders put in the company
• Return on Capital Employed (ROCE): Profit after tax / Average Capital Employed to measure profitability against capital employed
• Earnings per share (EPS): Earnings after tax/ No. of shares a tool to gauge company's profit for each share.
• Dividend per share (DPS): Total Dividends Paid/No. of shares a tool to gauge company's profit for each share.
• Dividend Payout Ratio (DPR): DPS/EPS a tool to gauge company's profit for each share.

Gross Profit Margin

• Cost of goods sold as a percentage of sales.
• Controls the inventory costs.

Operating Profit Margin

• Earning before interest and taxes (EBIT).
• Percentage of sales.
• Overall operating efficiency; all ordinary expenses covered.

Net Profit Margin

• Net income after deducting all expenses including taxes, interests and depreciation
• Percentage of sales; how much of every sales dollar is profit

Ratio Analysis: Expense Ratio

• Operating expenses ratio
• Administrative expenses ratio
• Selling expenses ratio

Ratio Analysis: Return on Assets (ROA), Return on Equity (ROE)

• Efficiency of using assets.
• Profitability of the company against investor investment (shareholders' funds)

Ratio Analysis: Return on Capital Employed (ROCE)

• Measures profitability compared with capital employed which incorporates debt as well..

Ratio Analysis: Earnings per share (EPS)

• Portion of a company's profit allocated to each share.
• Important for measuring profitability.

Ratio Analysis: Dividend Per Share (DPS)

• Dividend distributed per share of a company for every share of the stock.

Ratio Analysis: Dividend Payout Ratio (DPR)

• Indication of how much cash flows are returned to shareholders compared to earnings.

Ratio Analysis: Efficiency and Turnover Ratios

• Fixed assets turnover ratio
  • Ratio of sales to the value of fixed assets
  • Efficiency in using fixed assets to generate sales
• Inventory turnover ratio
  • Number of times inventory is sold and replaced
• Debtors turnover ratio
  • Frequency of collection of receivables
  • Accounts receivable turnover ratio

Ratio Analysis: Liquidity Ratios & Solvency Ratios

• Liquidity ratios: short-term solvency; ability to pay short-term obligations
• Current ratio: Measures relationship between current assets and current liabilities.
• Quick ratio: Quick assets (current assets excluding inventories) and current liabilities.
• Super quick ratio: only cash and marketable securities / current liabilities
• Solvency ratios: ability to service debt (long-term).

Debt-Equity Ratio

• Measures relationship between long-term debt and equity

Test your knowledge on essential accounting concepts and financial statements. This quiz covers important principles like the accounting equation, company classifications, and the role of financial statements in management. Perfect for students looking to reinforce their understanding of accounting basics.