Fundamentals of Accounting

By the end of this reading, you will answer

What Financial Accounting is What is its necessity How Financial Information is communicated using Basic Financial Statements

Topic Introduction Accounting Concepts The Income Statement The Balance Sheet Statement of Cash Flows Accounting Jargon Concept Checkers

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Introduction
Accounting is the language of business

It is the process of identifying, measuring, communicating economic information to aid in

decision-making. Accounting has two main divisions: Financial accounting: Primarily prepared for users external to the company.

Revenues, earnings, assets, etc.

Management accounting: Primarily for internal purposes Costing, budgeting, net present value, etc. Managers, investors, and other internal groups want the answers to two important questions: How well did the organization perform? Where does the organization stand?

Accountants answer these questions with three major financial statements: Income Statement Balance Sheet Statement of Cash flows
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Accounting Concepts
Money measurement: Accounting records are recorded in monetary terms at value at time

transaction is recorded. It provides a common unit of measurement

Entity: Accounting treats a business as distinct and separate from its owners. Any private and personal incomes and expenses of the owner(s) should not be treated as the incomes and expenses of the business

Going concern: It is assumed that an entity will complete its current plans, use its existing
assets, and meet its obligations in the normal course of business. This is an underlying concept necessary for many of the fundamental recording and reporting decisions that are made in accounting. Accrual Basis: The accrual basis of accounting recognizes revenues and expenses when they occur regardless of when cash is received or disbursed. Cost: Assets are recorded at cost, which equals the value exchanged at the time of their acquisition. In the United States, even if assets such as land or buildings appreciate in value over time, they are not re-valued for financial reporting purposes.

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Accounting Concepts
Dual aspect: This concept states that every transaction has a dual or two-fold effect and should

therefore be recorded at two places. In other words, at least two accounts will be involved in
recording a transaction. Assets = Liabilities + Capital. Dual aspect concept is known as "Double Entry Book Keeping System. Accounting period: Covers the period for which the income has been measured. It is the time

between the preparation and presentation of two successive statements of financial position by
an organization. Matching: Requires the identification and recording of expenses associated with revenue earned and recognized during the same accounting period. Accordingly, under the matching concept the expenses of a particular accounting period are the costs of the assets used to earn the revenue that is recognized in that period. It follows, therefore, that when expenses in a period are matched with the revenues generated for the same period, the result is the net income or loss for that period. Materiality: The requirements of any accounting principle may be ignored when there is no effect on the users of financial information.
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Income Statement
Indicates how the revenue (money received from the sale of products and services before

expenses are taken out, also known as the "top line") is transformed into the net income (the
result after all revenues and expenses have been accounted for, also known as the "bottom line"). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of

various assets) and taxes.

The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported. Revenue - Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major operations. Expenses - Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major operations. Revenues Expenses = Net Income
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Income Statement

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Balance Sheet
A balance sheet or statement of financial position is a summary of the financial balances of an

entity. A balance sheet has three parts: assets, liabilities and ownership equity.
Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. Often described as a "snapshot of a company's financial condition. Shows how assets were financed: either by borrowing money (liability) or by using the owner's

money (owner's equity). Balance sheets are usually presented with assets in one section and
liabilities and net worth in the other section with the two sections "balancing." Assets (what the entity owns): Economic resources tangible or intangible capable of being owned or controlled to produce value and that is held to have positive economic value Liabilities (what the entity owes to debt providers): An obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. Equity (what belongs to the owners of the entity): Equity consists of: Contributed Capital (cash raised from the issuance of shares), Earned Capital (Retained Earnings is updated each period) Assets = Liabilities + Equity
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Balance Sheet

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Statement of Cash Flows

Shows how changes in balance sheet accounts and income affect cash and cash equivalents,

and breaks the analysis down to operating, investing, and financing activities. Essentially, the
cash flow statement is concerned with the flow of cash in and cash out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the

short-term viability of a company, particularly its ability to pay bills.

Change in Cash Balance = Cash Flow from Operating Activities + Cash Flow from Financing Activities + Cash Flow from Investing Activities The cash flow statement is intended to: 1. provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances 2. 3. provide additional information for evaluating changes in assets, liabilities and equity improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods 4. indicate the amount, timing and probability of future cash flows.
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Statement of Cash Flows

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Accounting Jargon
Transaction: any event that affects the financial position of an organization and requires

recording
Debit: At least one component of every accounting transaction (journal entry) is a debit. Debits increase assets and decrease liabilities and equity. Credit: At least one component of every accounting transaction (journal entry) is a credit.

Credits increase liabilities and equity and decrease assets.

Debtor: A company or individual who owes you money. Creditor: A company or individual whom you owe money to. Journal: The chronological, day-to-day transactions of a business are recorded in sales, cash receipts, and cash payment journals. A general journal is used to enter period end adjusting and closing entries and other special transactions not entered in the other journals. Ledger: The general ledger is a collection of the group of accounts that supports the value items shown in the major financial statements. It is built up by posting transactions recorded in the sales daybook, purchases daybook, cash book and general journals daybook.

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Concept Checkers

What is the need for Financial Accounting? What is the difference between Income Statement and Balance Sheet?

What is the need for Statement of Cash Flows?

What is the difference between Credit and Debit? What is the difference between Creditor and Debtor?

Presented by EQUIT-I The Finance and Investment Club, IIM Indore. Email: equiti@iimidr.ac.in Anshul | Rajesh | Sailesh | Saurabh | Sushant