Module 1: Introduction to Financial Accounting and Accounting Mechanics PDF

Module 1 Introduction to Financial Accounting and Accounting Mechanics © All Rights Reserved. This document has been authored by Prof. Prof. M.S. Narasimhan and is permitted for use only within th e course "Financial Statements and Business Performance" deli...

Module 1 Introduction to Financial Accounting and Accounting Mechanics © All Rights Reserved. This document has been authored by Prof. Prof. M.S. Narasimhan and is permitted for use only within th e course "Financial Statements and Business Performance" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illu strations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author. Module 1 - Overview In this module, you will be introduced to the Financial statements of the company How financial statements are used to assess the performance of a business. Recording financial transactions in the accounting books, Summarizing the transactions and preparing financial statements. Scope and Purpose of Financial Accounting Financial accounting involves recording and summarising the effects of business transactions into financial reports – Balance Sheet, Profit and Loss Account and Cash Flow Statement. Accounting helps generate a one-stop information for Revenues Expenses Receivables Payables Cash balance Accounting enables a systematic recording and summarising of business transactions for informed decision-making. Purpose of Financial Accounting Recording financial transactions as and when they occur Summarises the financial transactions at the end of the period i.e., yearly or half-yearly or quarterly. Preparation of financial statements, namely, Balance Sheet, Income Statement and Cash Flow Statement. Financial accounting helps in answering questions - – The sources of capital and amount capital raised – How was the capital used? – How much does the business owes and to whom? – How much is owed to the business and from whom? – What is the amount of revenue earned and expenses incurred? – Did the business earn a profit or incur a loss during the period? Different Forms of Business Organisations Sole Proprietorship It is simple form of business organisation. It suitable for small ventures. It is owned by an individual. The owner enjoys profit and bears the losses. The owner and the business are assessed as the same entity i.e., in the eyes of law the business and owner are the same. The liability of the proprietor is unlimited. Different Forms of Business Organisations Partnership Partners enter into a partnership agreement through a partnership deed. The partnership deed mentions the percentage of profit or loss attributed to each partner. The profit or loss is equally distributed to the partners in the absence of any percentage. Partners are jointly and severally liable for the business obligations and losses, which means they are individually responsible for the full amount of any debt or loss, not just a portion. Partner’s transactions with the business, such as investments or profits, are recorded in the partner’s capital account, which serves as a running record of their financial involvement in the business. Any withdrawal from the business for personal use is accounted by debiting the partner’s capital account.  Different Forms of Business Organisations Limited Liability Partnership (LLP) The liability of partners is limited, i.e., personal wealth is not affected by business failure. Different Forms of Business Organisations Company Companies are registered under the Companies Act. Shareholders have limited liability i.e., only up to the face value of the share. Shares of the company can be easily traded on the stock exchanges. Joint stock companies can be classified into public and private limited companies. Public Limited Company - shares are easily traded on the stock exchange. Shares of a company are open for subscription to the public. Private Limited Company - shares cannot be easily traded on the stock exchange. Different Forms of Business Organisations Co-operative Society Company In a company, anyone with surplus funds can Those directly connected with the business invest and create a company. objective of the cooperative society. Shareholder’s voting rights depends on the Each members gets one vote irrespective of number of shares. his/her investment in the cooperative. Users of Accounting Information Investors Use information in financial statements to assess the business performance. Lenders Use the accounting information to assess the repayment capacity of the business Use the accounting information to assess the company’s performance for granting the loan. Leasing companies want to assess if the potential lessee can pay the lease rental. Users of Accounting Information Credit Rating Agencies Use the financial statements to assess the creditworthiness of the business. Assign credit rating to the company. Example: AAA rating implies stable financials and high creditworthiness Suppliers Use the accounting information to assess the financial viability of the business. Users of Accounting Information Government Agencies Tax authorities use the financial statements to assess the amount of the tax. Planning authorities check the financial information to make policy decisions. Employees Assess the performance of the business to check their future employment prospects. Customers Use accounting information to assess the operating and financial viability of the company. Double Entry System of Bookkeeping Bookkeeping Bookkeeping is the process of systematic recording of transactions in the books of accounts. Transactions are recorded based on supportive (source) documents. Transactions A firm buys raw materials from its suppliers – supportive documents – invoice from supplier, stores receipt Double Entry System of Bookkeeping Recording transactions Transactions are recorded on the basis of source documents. E.g., invoice, contracts, bills, receipt etc. Transactions are recorded as and when they occur in a chronological order. Transactions are recorded using the double-entry system of bookkeeping. Each transaction has two-fold effects; Every debit has a corresponding credit. Double Entry System of Bookkeeping Double entry system ensures cross-checking and identification of mistakes and proper recording of transactions. Transactions are recorded as journal entries in the books of accounts as and when they occur. Each entry is posted to their respective accounts in the ledger. The balances of the ledger accounts can be summarized in trial balance to check the arithmetical accuracy The balance in the accounts is used to prepare the financial statements. Types of Accounts An account is a systematic record of all transactions relating to a particular head – an asset, liability, equity, revenue or expense. Types of Accounts - Personal Account - Real Account - Nominal Account  Accounts Personal Account Real Account Nominal Account Artificial Personal Representative Natural Personal Account Account Personal Account Example., Example., Example., SBI Account Asian Paints Limited Creditors and Debtors Account Account Types of Accounts Personal Account Personal account refers to the of individuals and organizations. Artificial Personal Accounts are related to other businesses. Representative Personal Accounts are the accounts of a group of individuals or organisations like creditors and debtors accounts. Real Account Real accounts include tangible and intangible assets used by the business. Real accounts can be classified into – Tangible Real Accounts and Intangible Real Accounts.  Real Account Tangible Real Account Intangible Real Account Example., Example., Software and spectrum Building and machinery license fee Types of Accounts Nominal Account Nominal accounts include income, profit, expenses, and losses.  Nominal Account Incomes, profit Expenses and losses Example., Example., Sales account (income) rent account (expenses) Understanding Debit and Credit The traditional accounting system requires transactions to be recorded with a two-fold aspect of debit and credit. Accounting process Recording of transactions in Posting of journal entries Preparing trial balance Journal to Ledger Preparing the financial statements Recording adjustments Understanding Debit and Credit Debit and credit have Latin origins. Debit originated from ‘debitum’, meaning "what is due." Credit came from ‘creditum’, meaning "something given to someone or a loan.  Golden Rules of Accounting Personal Debit the Credit the Account receiver giver Debit what Credit what Real Account comes in goes out Nominal Debit all Credit all expenses and incomes and Account losses gains  Recording transactions through debit and credit rules Transaction 1: Bought raw material worth of Rs. 100 lakhs from Sun Limited and agreed to pay the amount at the end of 90 days. Date Particulars L.F. Debit (Rs.) Credit (Rs.) xxx Raw materials A/c Dr. 100,00,000 To Sun Limited 100,00,000 Subsidiary Books Subsidiary book summarises the sales, purchases, purchase returns, sales returns etc. over a period. They are also called Day books. Sample Specimen- Purchase Book Date Name of Suppliers L.F. Inward Invoice No. Amount (Rs.) 2024 Jan 1 Ramesh & Co. R-421 10,000 Jan 5 Kamlesh & Sons K-564 15,000 Jan 10 Rama R-24 2,000 Jan 12 Ketan & Co. K-255 5,000 Total 32,000 Ledger A ledger is a register (book of accounts) keeping details of all the accounts over a period. Ledger Account Dr Cr Date Particulars J.F. Amount Date Particulars J.F. Amount Left-hand side is Right-hand Side is the debit side the credit side Ledger Transaction 1: Purchased goods worth Rs. 30,00,000 on credit LEDGER Dr. Goods Account Cr. Date Particulars J.F. Amount Date Particulars J.F. Amount To Grasim a/c 30,00,000 Dr Grasim Account Cr. Date Particulars J.F. Amount Date Particulars J.F. Amount By Goods a/c 30,00,000 Subsidiary Ledgers The main ledger is called the General Ledger or GL. Subsidiary Ledgers are used when there are large volumes of similar transactions. Sundry Creditors Ledger Sundry Debtors Ledger Includes the accounts of all the suppliers from Includes the accounts of all the customers to whom goods or services have been purchased on whom goods or services have been sold on credit credit Sundry Creditors Account Sundry Debtors Account Summarizes all the suppliers’ accounts Summarizes all the customers’ accounts Summarizes all the credit purchases and payments Summarizes all the credit sales and receipts from to the suppliers the customers Subsidiary Ledgers General Ledger Subsidiary Ledger PQR & Co. Sundry Creditors A/c Date Particulars Debit Credit Balance Date Particulars Debit Credit Balance Debit Credit Debit Credit Jan 1 Purchases 10,000 10,000 Jan 31 Purchases 30,000 30,000 Jan 10 Cash 5,000 5,000 Jan 31 Cash 10,000 20,000 MAX & Co. Date Particulars Debit Credit Balance Debit Credit Jan 3 Purchases 20,000 20,000 Jan 9 Cash 5,000 15,000 Accounting Equation Assets = Liabilities + Owner’s Equity Use of capital Source of capital Accounting Equation (Expanded form) Assets = Liabilities + Owner’s Equity Assets = Liabilities + Owner’s Capital + Revenue - Expenses Profit/(Loss) Accounting Equation (Expanded form) Assets = Liabilities + Owner’s Equity Assets = Liabilities + Owner’s Capital + Revenue – Expenses - Dividends Accounting Equation Transaction 1: Mr. Ram started the business by investing Rs. 100 lakhs Figures in Rupees lakhs Asset Amount = Liabilities account Amount Equity share Revenue Amount Expense Amount accounts name capital accounts accounts Cash 100 = 100 account Transaction 2: The business borrowed Rs. 50 lakhs from State Bank of India Figures in Rupees lakhs Asset Amount = Liabilities account Amount Equity share Revenue Amount Expense Amount accounts name capital accounts accounts Cash 50 = SBI’s Loan a/c 50 account Module 1 - Summary Purpose of Financial Accounting Financial accounting enables the systematic recording of transactions Summarises the financial information through Income Statement, Balance Sheet and Cash Flow Statement. Income Statement - Also, called Profit and Loss Account Or Statement of Profit and Loss. It shows how much revenue the business earned and how much the business has spent to earn the revenue. The difference between these two values shows its profit or loss. Balance Sheet shows sources of capital and utilisation of capital. Cash Flow Statement summarises all cash inflow and outflow.  Module 1 - Summary Forms of Business Organisations Sole Proprietorship Partnership – Limited Liability Partnership Company – Public Limited Companies and Private Limited Company Co-operative Society  Features of Different Forms of Business Organisations Sole The liability of the The owner and business are proprietorship proprietor is unlimited considered the same entity The liability of partner is Partners are jointly and severally Partnership unlimited liable for the acts of the firm The liability of the shareholders is Public limited company and Company Private limited company limited to the amount of the share capital they have subscribed Co-operative Members with common interests They work to promote their join together and form a co- Society business operative society  Managers Shareholders Government Agencies Tax Users of Lenders Authorities Accounting Information Customers Suppliers Trade Unions Employees Summary – Users of Financial Statements Managers and shareholders assess business Lenders and suppliers use accounting information to profitability using accounting information. assess the solvency position of the business Customers use the accounting information Employees and trade unions use the accounting to assess the stability and survival of the information to assess the profitability of the business business to ensure continued service for to ensure their wage negotiations and job security. products requiring long-term support.