Overview of Financial Accounting System

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What is Accounting?
It is an information system that...

It measures business activities,

It processes information, and... It communicates financial information.
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Accounting...
is called the language of business.

Assets Income
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Users of Accounting Information

External users
make decisions about the entity.

Internal users
make decisions for the entity.

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Users of Accounting Information

Government of India Lenders Suppliers Customers Market Analysts etc.

External users

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Users of Accounting Information

Shareholders Employees Managers etc.

Internal users

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Generally Accepted Accounting Principles

What is the primary objective of financial reporting?

To provide information useful for making investment and lending decisions

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Objectives of Accounting

For external users, Accounting reports are the source of information on the financial health of the company, its ability to generate adequate surplus, its quantum of actual surplus

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Objectives of Accounting

For internal users, Accounting reports provide information for managerial decision making, show its performance vis--vis the industry benchmark .

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Fields of Accounting

Financial Accounting

Management Accounting

Cost Accounting
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Types of Business Organizations

Proprietorships Partnerships Companies

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Proprietorships
What are some advantages? total undivided authority no restrictions on type of business must be legal What are some disadvantages? unlimited liability limitation on size fund raising power

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Partnerships
What are some advantages? better credit standing possibly more brain power, but consultation with partners required What are some disadvantages? unlimited personal liability for partners need for written partnership agreement

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Companies
What are some advantages? separate legal existence limited liability of stockholders transferability of ownership relatively easy What are some disadvantages? taxes possible double taxation extensive governmental regulation

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Accounting is ...

Recording

of Financial Transactions in Books of Accounts, and Preparation of Financial Statements

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What is a transaction?

It is any event that both affects the financial position of the business and can be reliably recorded.

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Books of Account

Journal

Cash Book Purchase Book Sales Book Purchase Return Book Sales Return Book, etc Journal Proper

Ledger
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Financial Statements
Trading

and Profit & Loss Account Balance Sheet Fund-Flow and Cash-flow Statements

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Recording Business Transactions

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Double-Entry Accounting

Double entry bookkeeping means to record the dual effects of each business transaction.

Assets

= Liabilities + Owners Equity

Assets are on the right (debit) side. Liabilities and Equity are on the left (credit) side.

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The Accounting Equation

Assets = Liabilities + Owners Equity

Fund required to Hold/Acquire Assets
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Economic Resources

Assets

What is an asset?
It is something a company owns which has future economic value. land building equipment goodwill
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Liability

What is a liability?
It is something a company owes. money service legal retainers product magazines

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Owners Equity
What is owners equity? It is whats left of the assets after liabilities have been deducted. the same as net assets the owners claim on the entitys assets

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Transactions that Affect Owners Equity

OWNERS EQUITY INCREASES OWNERS EQUITY DECREASES Owner Withdraws from the Business Owners Equity

Owner Invests in the Business

Revenues

Expenses
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Rules of Debit and Credit

Assets

Liabilities

Owners Equity

Debit +

Credit

Debit

Credit +

Debit

Credit +

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What are some asset accounts?

Cash Liquid Investments Accounts Receivable Prepaid Expenses Land Building Equipment
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What are some liability accounts?

Working Capital Loan Accounts Payable Accrued Liabilities (for expenses incurred but not paid) Long-term Liabilities (bonds)

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What are some owners equity accounts?

Capital or owners interest in the business Share Premium Reserves Surplus

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Rajus Petrol Pump Example

Assume that the business sold Rs. 5,000 worth of petrol on a given day and performed Rs. 3,000 of repair services. How much revenue did the business earn that day? Rs. 8,000

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Rajus Petrol Pump Example

Revenues increase Rajus equity in the business. The business had to pay mechanics and vendors Rs. 3,750 for the work performed that day.

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Rajus Petrol Pump Example

Expenses decrease Rajus equity in the business. How much was the net increase in Rajus equity that day? Rs. 4,250

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Owners equity in a Company

In a company, the owners equity account is called Stockholders Equity. Contributed Capital

Retained Earnings
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The Double-Entry System

Each transaction is recorded with at least:

One debit

One credit

Total debits must equal total credits.

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Rajus Petrol Pump Example

On July 1, Raju invested Rs. 500,000 in cash and obtained a Rs. 300,000 loan to open a Petrol Pump. How much was the initial increase in cash? Rs. 800,000 Which accounts were affected?

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Rajus Petrol Pump Example

Cash

Liabilities
Owners Equity

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Rajus Petrol Pump Example

Rajus Petrol Pump Balance Sheet July 1, 2002

Assets
Cash Total assets Rs. 800,000 Rs. 800,000
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Rajus Petrol Pump Example

Rajus Petrol Pump Balance Sheet July 1, 2002
Liabilities
Loan Owners Equity Rajus capital Total liabilities and owners equity Rs. 300,000 500,000 Rs. 800,000
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Entering transactions in the journal

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Journals
What is a journal? It is a list in chronological order of all the transactions for a business. 1 Identify transaction from source documents. 2 Specify accounts affected. 3 Apply debit/credit rules. 4 Record transaction with description.

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Journals

What does a journal entry include? date of the transaction title of the account debited title of the account credited amount of the debit and credit description of the transaction

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Recording Transactions
On April 2, Owners invested Rs. 30,000 in business. What is the journal entry? April 2 Cash 30,000 Owners Capital 30,000 Received initial investment from owner

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Post from the journal to the ledger

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Ledger
What is a ledger? It is a digest of all accounts utilized by an entity during an accounting period.

Loose leaf pages Bound books

Computer printout Cards

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Posting
What is posting? It is the transfer of information from the journal to the appropriate accounts in the ledger.

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The T-Account
Account Title Debit Credit

LEFT SIDE

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The T-Account
Account Title Debit Credit

RIGHT SIDE

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Accounting Terms
Cash Individual asset accounts All individual accounts combined make up the ledger. Ledger

Accounts Payable

Individual liability accounts

Capital

Individual owners equity accounts

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Sales Cash Sales Debtor

(One who has to pay the purchaser) If a bill is drawn BILLS PAYABLE

Credit Sales Creditor

(One who is to receive the seller) If a bill is drawn BILLS RECEIVABLE 1 - 50

Example 1:
Mr X sells goods worth Rs 10 lac to Mr Y on January 1, 2006. Mr Y makes a cash down payment of Rs 2 lac. On Jan 2, Mr X draws a bill for the remaining amount, which is accepted by Mr Y. On the same day, Mr X gets the bill discounted by his Banker, who deducts a discount of 1% of the bill amount.
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Example 1:

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Example 2:
On Feb 2, the due date of the bill, Mr Y could pay only Rs. 5 lac. The balance amount is paid by Mr. X to the Bank.
On Mar 2, Mr Y pays this remaining amount to Mr X by means of a cheque towards full and final settlement of all dues.
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Example 2:

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Trial Balance
What is a trial balance? It is an internal document. It is a listing of all the accounts with their related balances. Before computers, it provided a check on accuracy by showing whether total debits equal total credits.

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Locating Trial Balance Errors

What if it doesnt balance ? Is the addition correct? Are all accounts listed? Are the balances listed correctly?

DEBITS

CREDITS

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Locating Trial Balance Errors

Divide the difference by two. Is there a debit/credit balance for this amount posted in the wrong column? Check journal postings. Review accounts for reasonableness. Computerized accounting programs usually prohibit out-of-balance entries.

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Normal Account Balances

Assets

= Liabilities + Owners Equity Debits = Credits

The side where we expect increases to be recorded is the normal balance side.

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Depreciation
Whenever a business organisation uses fixed assets, there is constant wear and tear of the items. Unless the impact of such wear and tear is considered suitably for the purpose of accounting, the profit or loss of the enterprise cannot be correctly estimated.

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Depreciation
When a fixed asset is purchased, the total amount is NOT an expense but we are creating an ASSET. Every year A PART of this asset is being used up. This part is tantamount to an EXPENSE. However, actual cash outflow takes place only during the purchase of the fixed asset and NOT every year when depreciation is charged.

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Depreciation
There

are two depreciation:

methods

of

charging

Straight Line Method Reducing Balance / Written Down Value Method

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Depreciation

Straight Line Method

Let C be the cost price of a fixed asset, n be its effective economic life in years, r the rate of depreciation p.a. and S the salvage value of the asset at the end of n years. The amount of depreciation charged p.a. = r.C
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Depreciation

Straight Line Method

Same amount of depreciation is charged every year. Therefore, total amount of depreciation charged in n years = n.r.C, and the residual value of the fixed asset after n years = C n.r.C = C ( 1-n.r). This is equal to S. Therefore, C (1-n.r) = S or r = (1-S/C)/n
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Depreciation

Straight Line Method

Value of Fixed Asset
Salvage Value

S
Years n
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Depreciation

Written Down Value Method

Depreciation is charged every year at the same rate r. Therefore, total amount of depreciation charged in the first year = r.C WDV at the end of first year = C (1-r) Depreciation charged in the second year = r.C(1-r) WDV at the end of second year = C (1-r)2
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Depreciation

Written Down Value Method

This way, WDV at the end of n years = C (1-r)n

Therefore, C (1-r)n = S
or, r = 1 (S/C) 1/n

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Depreciation

WDV Method

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Example

For an equipment Original purchase price = Rs. 110000 Useful Life = 10 years Salvage Value = Rs. 10000
Compute the rate of depreciation under (a) Straight Line Method (b) Written Down Value Method
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Example
Original purchase price = Rs. 110000 Useful Life = 10 years Salvage Value = Rs. 10000
In Straight Line Method r = (1 S/C)/n = (1 10000/110000)/10 = 1/11
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Example
Original purchase price = Rs. 110000 Useful Life = 10 years Salvage Value = Rs. 10000
In Written Down Value Method
r = 1 (S/C) 1/n

= 1 (10000/110000)1/10 = 1 (1/11) 1/10 which is equal to 0.213

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Another Example
The original purchase price of a machine is Rs. 10 lac and depreciation is charged at 10% p.a. What will be the net (depreciated) value of the machine under SLM and WDVM after 2 years?

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Another Example
SLM (Straight Line Method) First Year Original Value Rs. 10 lac Depreciation Rs. 1 lac Net Value Rs. 9 lac
Second Year Original Value Rs. 9 lac Depreciation Rs. 1 lac Net Value Rs. 8 lac

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Another Example
WDVM (Written Down Value Method) First Year Original Value Rs. 10.0 lac Depreciation Rs. 1.0 lac Net Value Rs. 9.0 lac
Second Year Original Value Rs. 9.0 lac Depreciation Rs. 0.9 lac Net Value Rs. 8.1 lac

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The Entity Concept Example

Assume that Raju decides to open up a Petrol Pump and coffee shop. The Petrol Pump made Rs. 250,000 in profits, while the coffee shop lost Rs. 50,000.

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The Entity Concept Example

How much money did Raju make? At a first glance, we would assume that Raju made Rs. 200,000. However, by applying the entity concept we realize that the Petrol Pump made Rs. 250,000 while the coffee shop lost Rs. 50,000.

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The Reliability (Objectivity) Principle

Information must be reasonably accurate.
Information must report what actually happened.

Information must be free from bias.

Individuals would arrive at similar conclusions using same data.

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The Cost Principle

Assets and services acquired should be recorded at their actual cost.

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The Going Concern Concept

The entity will continue to operate in the future.

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Financial Statements...
are the final product of the accounting process. tell how the business is performing and where it stands.
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Financial Statements

income statement statement of owners equity or retained earnings balance sheet statement of cash flows

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Transaction
On Apr 2, 2006 Sushma, the owner of a business brings in cash of Rs. 30000 as Owners Fund or Capital.

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Journal Entry

Date

Particulars

Debit(Rs)

Credit (Rs)

April 2 Cash Owners Capital (Received initial investment from owner)

30,000
30,000

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Ledger Posting
Dr
To Capital A/c

Cash A/c
Rs 30,000

Cr Rs

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Ledger Posting
Dr

Capital A/c
Rs By Cash A/c

Cr Rs 30,000

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Life Goes On
1.
2.

3.

4.

After investing Rs. 30,000 to begin her business, Sushma purchases an office location, paying Rs. 20,000 in cash. She buys office supplies, agreeing to pay Rs. 500 in 30 days. She earns and collects Rs. 5,500 revenues.

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Life Goes On
Sushma performs services, and the client agrees to pay Rs. 3,000 within one month. 6 During the month, she pays Rs. 3,100 for expenses incurred. 7 Sushma pays Rs. 300 to the store from which she purchased Rs. 500 worth of supplies. What is the effect of these transactions on the accounting equation?
5
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Break-up of Expenses for Rs. 3,100

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Accounting for the Transactions

Assets 1) Cash 2) Cash Land 3) Supplies 4) Cash 5) Receivable 6) Cash 7) Cash Totals

Owners = Liabilities + Equity

+ Rs. 30,000

+ Rs. 30,000 20,000 + 20,000 + 500 + 5,500 + 3,000 3,100 300 + Rs. 35,600

+ 500 + + 300 + 200 5,500 3,000 3,100

+ Rs. 35,400
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Accounting for the Transactions

Notice that the equation always stays in balance. Each transaction affects at least two accounts, sometimes more. Some transactions affect only one side of the equation; some affect both sides.

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Life Goes On

Other transactions that took place were as follows: The business collected Rs. 1,000 from the client. She sold some land at cost for Rs. 9,000. She withdrew Rs. 2,100 from the business.
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Accounting for the Transactions

Cash
30,000 5500 9000 1000 20,000 3100 300 2100

Land
(2) 20,000 9000 Bal. 11,000

Office Supplies
(3) 500
Bal. 500
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Accounting for the Transactions

Accounts Payable
(4) 300 (3) 500
Bal. 200

Owners Capital
(1) 30,000
Bal. 30,000

Owners Withdrawals
(6) 2,100 Bal. 2,100
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Relationships Among the Statements: Income Statement

Revenue: Fees earned Rs. 8,500 Expenses: Salary expense Rs. 1,200 Utilities and telephone expense 400 Equipment rental expense 400 Office rent expense 1,100 3,100 Net income Rs. 5,400
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Relationships Among the Statements: Statement of Owners Equity

Sushma, capital, April 1, 20xx Contribution of capital Net income Cash distributions Sushma, capital, April 30, 20xx Rs. 30,000 5,400 2,100 Rs. 33,300

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Relationships Among the Statements: Balance Sheet

Liabilities Accounts payable Assets Rs. 200 Cash Rs. 20,000 Accounts receivable 2,000 Supplies Land Total assets 500 11,000 Rs. 33,500

Owners equity, Sushma, capital 33,300 Total liabilities and owners equity Rs. 33,500

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Relationships Among the Statements: Statement Of Cash Flows

Cash flows from operating activities: Cash receipts from services rendered Cash payments: Supplies Rs. 300 Operating expenses 3,100 Net cash flows from Operating activities Cash flows from investing activities Purchase and sale of land
Rs. 6,500

3,400

Rs. 3,100
(Rs. 11,000)
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Relationships Among the Statements: Statement Of Cash Flows

Cash Flows from Financing Activities: Beginning Balance Investment by Owner Withdrawals Net Cash Flows from Financing Activities Cash at Beginning of Year Cash at End of the Year

0 Rs. 30,000 2,100 Rs. 27,900 0 Rs. 20,000

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Accrual Accounting and the Financial Statements

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Revenue Principle
The revenue principle governs two things: When to record revenue and the amount of revenue to record.
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Updating the Accounts: The Adjustment Process

The adjustment process begins with the trial balance.

The unadjusted trial balance lists the accounts and their balances after the periods transactions have been recorded.

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Categories of Accounting Adjustments

Deferrals

Depreciation

Accruals
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Prepaid Expenses: Rent

What is the adjusting entry on April 30?

April 30 Rent Expense (Rs 3,000 /3) Prepaid Rent To record rent expense

1,000 1,000

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Prepaid Expenses: Supplies

On April 2, 20x3, Air & Sea Travel paid cash of Rs 700 for office supplies.

Supplies 700

Cash 700

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Prepaid Expenses: Supplies

An inventory at month end indicated that Rs 400 in office supplies remained.

Supplies 4/2 700 4/30 300 Bal. 400

Supplies Expense 4/30 300 Bal. 300

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Depreciation of Plant Assets

On April 3, the business purchased furniture on account for Rs 16,500. The furniture is expected to last 5 years.

Furniture 16,500

Accounts Payable 16,500

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Depreciation of Plant Assets

The straight-line method of depreciation gives an annual depreciation expense of Rs 3,300. Rs 16,000 5 years = Rs 3,300 per year Rs 3,300 12 months = Rs 275 per month
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Depreciation of Plant Assets

What is the adjusting entry on April 30?

April 30 Depreciation Expense Furniture Accumulated Depreciation Furniture To record depreciation on furniture

275

275

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Book Value
The net amount of a plant asset (cost minus accumulated depreciation) is the book value. Plant Assets of Air & Sea at April 30
Furniture Less Accumulated Depreciation Building Less Accumulated Depreciation Book value of plant assets Rs 16,500 275 Rs 16,225 Rs 48,000 200 47,800 Rs 64,025
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Accrued Expenses
The term accrued expense refers to a liability that arises from an expense that has not yet been paid.

Suppose Air & Sea Travel pays its employees a monthly salary of Rs 1,900, half on the 15th and half on the last day of the month.

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Accrued Expenses
April

15

Assume that if a payday falls on the weekend, Air & Sea pays the employee on the following Monday.
30
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Accrued Expenses
Salary Expense 4/15 950 Cash 4/15 950

Salary Expense 4/15 950 4/30 950 Bal. 1,900

Salary Payable 4/30 950 Bal. 950

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Accrued Revenues
An accrued revenue is a revenue that has been earned but not received in cash. Bank One hires Air & Sea Travel on April 15 to arrange travel services on a monthly basis. Bank One will pay the travel agency Rs 500 monthly, with the first payment on May 15.
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Accrued Revenues
April 30 Accounts Receivable (Rs 500 ) Service Revenue To accrue service revenue

250 250

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Unearned Revenues
An unearned revenue is an obligation arising from receiving cash before providing a service. Plantation Foods engages Air & Sea Travel agreeing to pay the agency Rs 450 monthly, beginning immediately.
Air & Sea Travel collects the first amount on April 20 and earns one-third the last 10 days.
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Unearned Revenues
April 20 Cash 450 Unearned Revenue Received cash for revenue in advance
April 30 Unearned Revenue (Rs 450 1/3) 150 Revenue To record unearned revenue earned

450

150

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Adjusting the Accounts

Accounts Needing Adjustments Accounts receivable Supplies Prepaid rent Accumulated dep. Salary payable Unearned revenue Income tax payable Service revenue Rent expense Salary expense Supplies expenses Depreciation expense Income tax expense Totals

Partial Trial Balance Adjustments Dr. Cr. Dr. Cr. 2,250 e) 250 700 b) 300 3,000 a) 1,000 c) 275 d) 950 450 f) 150 g) 540 7,000 e) 250 f) 150 a) 1,000 1,000 950 d) 950 1,900 b) 300 300 c) 275 275 g) 540 540 3,465 3,465

Partial Adjusted Trial Balance Dr. Cr. 2,500 400 2,000 275 950 300 540 7,400

2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren

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Air & Sea Adjusted Trial Balance April 30, 20x3

Account Title Cash Accounts receivable Supplies Prepaid rent Furniture Accumulated depreciation-furniture Accounts payable Salary payable Unearned service revenue Income tax payable Common stock Retained earnings Dividends Totals Adjusted Trial Balance Debit Credit 24,800 2,500 400 2,000 16,500 275 13,100 950 300 540 20,000 11,250 3,200 49,400 46,415

Balance Sheet

Retained Earnings

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Air & Sea Adjusted Trial Balance April 30, 20x3

Adjusted Trial Balance Debit Credit 7,400 1,000 1,900 300 275 400 540 4,415 7,400

Account Title Service revenue Rent expense Salary expense Supplies expense Depreciation expense Utilities expense Income tax expense Totals

Income Statement

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Financial Statements Prepare the financial statements.

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Air & Sea Travel, Inc. Income Statement

Month Ended April 30, 20x3 Revenue: Service revenue Expenses: Salary expense Rent expense Utilities expense Supplies expense Depreciation expense Income before tax Income tax expense Net income

Rs 7,400
Rs 1,900 1,000 400 300 275

3,875 Rs 3,525 540 Rs 2,985

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Air & Sea Travel, Inc. Statement of Retained Earnings

Month Ended April 30, 20x3 Retained earnings, April 1, 20x3 Add: Net income Less: Dividends Retained earnings, April 30, 20x3 Rs 11,250 2,958 Rs 14,235 3,200 Rs 11,035

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Air & Sea Travel, Inc. Balance Sheet

April 30, 20x3

Assets Cash Rs 24,800 Accounts receivable 2,500 Supplies 400 Prepaid rent 2,000 Furniture Rs 16,500 Less: Accumulated depreciation 275 16,225

Total assets

Rs 45,925

Liabilities Accounts payable Rs 13,100 Salary payable 950 Unearned revenue 300 Income tax payable 540 Total liabilities Rs 14,890 Stockholders Equity Common stock Rs 20,000 Retained earnings 11,035 Total Rs 31,031 Total liabilities and stockholders equity Rs 45,925
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Ethical Issues in Accrual Accounting

Managing earnings to meet established goals or budgets.

Misrepresenting company assets, liabilities, revenues, and expenses to financial statement users.
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Which Accounts Need To Be Closed?

Closing the books means to prepare the accounts for the next periods transactions. Temporary accounts (revenue, expense, and dividends) are closed at the end of the accounting period.

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Which Accounts Need To Be Closed?

Permanent accounts (assets, liabilities, and stockholders equity) are not closed at the end of the period because their balances are not used to measure income.
Closing entries transfer the revenue, expense, and dividends balances to Retained Earnings.
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Journalizing the Closing Entries

April 30 Service Revenue 7,400 Retained Earnings April 30 Retained Earnings 4,415 Rent Expense Salary Expense Supplies Expense Depreciation Expense Utilities Expense Income Tax Expense April 30 Retained Earnings 3,200 Dividends
7,400 1,000 1,900 300 275 400 540 3,200
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Posting the Closing Entries

Rent Expense 1,000 1,000 Salary Expense 950 950 1,900 1,900 Other Expenses 1,515 1,515 Retained Earnings 4,415 11,250 3,200 7,400 11,035 Service Revenue 7,000 250 150 7,400 7,400

Dividends 3,200 3,200

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Classifying Assets and Liabilities

Liquidity measures how quickly an item can be converted to cash. A balance sheet lists assets and liabilities in the order of their relative liquidity.

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Classifying Assets and Liabilities

Current assets Long-term assets Current liabilities Long-term liabilities
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Balance Sheet Format

Account Format

Report Format

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Income Statement Format

Single-Step Income Statement

Revenues

Expenses

= Net income

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Income Statement Format

Multi-Step Income Statement
Sales revenues Selling and Cost of goods sold administrative = Gross profit expenses

Operating income

Add: Other revenues and gains Less: Other expenses and losses
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Income Statement Format

Multi-Step Income Statement

Earnings before taxes

Income taxes

Net earnings

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Current Ratio
The current ratio measures the companys ability to pay current liabilities with current assets.
Current ratio = Total current assets Total current liabilities
Rule of thumb: A strong current ratio is 2.00.
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Debt Ratio
The debt ratio indicates the proportion of assets that is financed with debt. Debt ratio = Total liabilities Total assets This ratio measures a businesss ability to pay total liabilities A low debt ratio is safer than a high debt ratio.

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