Chapter 1: Introduction to Financial Accounting

Accounting is the language of business. It requires the systematic record keeping of all that happens on a day to day basis in business and analyzing this information to aid business decision making. The primary intension of financial accounting is the preparation of the statement revealing the income and financial position of the business on the basis of the events. The major financial statements are Profit and Loss A/c, Balance Sheet, Cash Flow Statement etc I. UNDERSTANDING BUSINESS ORGANIZATIONS: Business organizations offer goods and services in order to earn a profit. Receiving and paying cash are central to the activities of business organizations. Business organizations that provide goods are of two kinds: Merchandising (Trading) Organizations: buy and sell goods without any processing. Manufacturing Organizations: buy materials, process them into finished products, and sell them. Service Organizations: are businesses that provide services. Unlike goods, services do not have either form or substance, and, therefore, the recipient of a service can only experience them and can not transfer them to another person.
Book-Keeping is mainly concerned with recording of financial data relating to the business operations in a significant and orderly manner. A book keeper may be responsible for keeping all the records of a business or only of a minor segment such as position of a customers accounts in a departmental store. A substantial portion of the book keeper work is of a clerical in nature and is increasingly being accomplished through the use of mechanical and electronical devices.

II. What is Accounting?

Accounting is often called the language of Business. Accounting, as an information system, is the process of identifying, measuring, and communicating the economic information of an organization to its users who need the information for decision making. The American Institute of Certified Public Accountants defines accounting as "the art of recording, classifying and summarizing in a significant manner and in terms of money transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. This definition brings out the following as attributes of accounting: Events and transactions of a financial nature are recorded while the events of a non-financial nature cannot be recorded.

The record should reflect the importance of the transactions so recorded both individually and collectively, which includes summarization, thereby making it amenable to analysis. The users of the financial statements should be able to obtain the message encompassed in such financial statements, and it is the knowledge of accountancy, which enables the user to understand the contents of the financial statements.

The Accounting Information System

INPUT PROCESS OUTPUT

Economic events measured in financial terms

Recording Classifying Summarizing Analyzing Interpreting

Communicatin g information to users ( P&L A/c, B/S, CFS, etc)

Accounting Process:
Recording: Recording commences when a business transaction occurs and it has been quantified. A record of all these transactions is maintained in the order in which they occur in the Journal Book. Classifying: It refers to the rational segregation of the recorded information into related groups so as to make the record useful. The book containing such classified information is called the Ledger Book consisting of a number of accounts each complete in its own way. For example, all the receipts forming inflows and the payments forming outflows are grouped to ascertain the net cash position of the firm. The arrangement in this case is better known as the Cash Book. Summarizing: After the Recording and Classification phases are complete the accounts containing relevant information in the Ledger Book are to be balanced and the balances listed. The Statement giving names of these accounts and their respective balances is called the Trial Balance. On the basis of the Trial Balance the summaries are generated to provide information about the Profit / Loss and the

Position of the firm. The reporting of these summaries is done through Financial Statements. Financial Statements can be defined to include the Balance Sheet, the Profit and Loss Account, Notes to the Accounts and other incidental statements and explanatory material which are identified as part of financial statements. Information and the Accounting Process Identificationwhats relevant? Measurementwhich yardstick? Classification and accumulationhow do you organize the results of thousands of events? Summarizationhow much information is enough, but not too much? Communicationhow often, when, and to whom? Qualities of Accounting Information Information should be useful, but what does that mean? The two primary qualities of useful information are: 1) Relevance--the information must pertain to the decision at hand. That suggests it will have predictive and feedback value and should be timely. 2) Reliability--the information must reasonably reflect the real-world situation that it represents. To do so, it must be free of bias and verifiable. Other Qualities of Useful Information Understandability--the information must be understood to be useful. Users are assumed to have a general knowledge of business and a very basic knowledge of accounting. Comparability--the information must be reported so that comparisons between similar entities can be made. Consistency--the same accounting methods must be used from period to period to evaluate results over time.

S T E P 1 I d e n t if ic a t io n o f T r a n s a c tio n

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Figure 1.1: The Accounting Process III. ACCOUNTING INFORMATION AND ECONOMIC DECISIONS: Accounting information is useful in making a number of decisions that affect the income or wealth of individuals and organizations. Accounting reports are designed to meet the common information needs of most decision makers. Examples of decisions that are based on accounting information include the following: 1. Decide when to buy, hold or sell an equity investment. 2. Assess the stewardship or accountability of mgt. 3. Assess the ability of the enterprise to pay and provide other benefits to its employees. 4. Assess the security for amounts lent to the enterprise. 5. Determine distributable profits and dividends. 6. Determine taxation policies. 7. Prepare and use national income statistics. 8. Regulate the activities of enterprises. The decision maker who intends to use accounting information should have a reasonable understanding of business and economic activities and be willing to study

the information with reasonable diligence. A sophisticated understanding of accounting is an indispensable part of the tool-kit for most decision makers. IV. CLASSIFICATION OF ACCOUNTING: In order to satisfy needs of different people interested in the accounting information, different branches of accounting have developed. Accounting is generally classified into three different disciplines as shown in Figure.

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Figure 1.2 Classification of Accounting Financial Accounting: Its primary intention is to prepare the Statements revealing the Income / Loss and financial position of the business on the basis of events, which have happened in the period being reckoned. But this information, though of immense vitality does not adequately aid the management in planning, controlling, organizing and efficiently conducting the course of the business as a result of which Cost Accounting and Management Accounting are in place. Cost Accounting: It shows classification and analysis of costs on the basis of functions, processes, products, centers etc. It also deals with cost computation, cost saving, cost reduction, etc. Management Accounting: Management Accounting begins where Financial Accounting and Cost Accounting ends. It deals with the processing of data generated in financial accounting and cost accounting for managerial decision-making. It also deals with application of managerial economic concepts for decision-making. V. OBJECTIVES OF ACCOUNTANCY: Maintaining Accounting records: Systematic recording of the monetary transactions of the firm is the initial step leading to the creation of the financial statements. Once recording is complete, the records are classified and summarized to depict the financial performance of the enterprise. 2. Calculating the results of Operations: The Income Statement also known
1.

as the Profit and Loss Account is prepared to reflect the profits earned or losses incurred. All the expenses incurred in the course of conducting the business are aggregated and deducted from the total revenues to arrive at the profit earned or loss incurred during the relevant period. 3. Ascertaining the financial position: Financial health or position is ascertained with the help of the Balance Sheet. On the right hand side of the Balance Sheet are the Assets or the resources owned by the firm. On the left hand side are the Liabilities or the obligations of the business to the outsiders and the owners. The owners' portion is called the Capital and is to be distinguished from that of the other liabilities such as loans and creditors. All of them are grouped in the respective heads under the Liabilities. This information on the assets and liabilities, with the help of accountancy, provides control over the resources of the firm. 4. Accounting is the precursor to financial reporting: The vital liquidity / solvency position is comprehended through the Cash and Funds Flow Statement elucidating the capital transactions, obtaining of cash and the way it has been expended, loans and their repayment, cash dividends, etc. 5. Communicating the information to the users: Financial statements so compiled are of great use to a variety of users including the provision of a firm base for the computation of the statutory tax liability and the consequent filing of return of income. VI. ADVANTAGES OF ACCOUNTING: It facilitates: to replace memory. to comply with legal requirements. to ascertain Net results of operations. to ascertain Financial position. the users to take decisions. a compliance study. control over assets. the settlement of tax liability. the ascertainment of value of business. raising of funds. Acts as legal evidence VII. USERS OF FINANCIAL STATEMENTS: Investors and lenders are the most obvious users of accounting information. Their decisions and their uses of information have been studied and described to a much greater extent than those of other user groups. However, financial reports are also extensively used by other individuals and groups who have to rely on them as their major source of financial information. Potential users of accounting information include: Internal Users: They include Board of Directors, Partners, Managers, and Officers.

II.

They need information for planning and controlling operations, for making special decisions, and for formulating major plans and policies. Managers use accounting information to evaluate potential investment projects. Management examines the competition in the industry and makes financial comparisons of its performance against competitors performance. External Users: A). Financing Group: a) Investors: Accounting information enables investors to identify promising investment opportunities. They need information to decide which investments to buy, retain, or sell, as well as the timing of the purchases or sales of those investments. They also need information to monitor management performance and to assess the ability of the enterprise to pay dividends. b) Lenders: Lenders such as banks and denture-holders need to know about the financial stability of a business that approaches them for funds. They are interested in information that enables them to determine whether their loans, and the related interest will be paid when due. c) Suppliers: Present and potential suppliers are interested in the enterprise as an outlet for their products or services and, if the enterprise is a major customer, they will be interested in assessing the likelihood of the situation continuing. They are interested in information that enables them to determine whether amounts owed to them will be paid when due. B). Public Group: a) Government Agencies: The three levels of government in India central, state and local - are interested in the allocation of resources and, therefore, in the activities of enterprises. They also require information in order to regulate the business practices of enterprises, determine taxation policies, and provide a basis for national income and similar statistics. b) Employees: They are interested in information about the enterprise about the enterprise as well as its general operations, stability and profitability. c) Customers: Present, potential and past customers are interested in the financial affairs of an enterprise in deciding how much business to do with it, and in assessing the likely ability of the enterprise to service to the product or to honor warranty agreements. d) Security Analysts and Advisers: They serve the needs of investors by providing them with skilled analyses and interpretation of financial reports. Securities firms to recommend to their clients whether to buy, sell or hold their investments use Analysts reports.

Basic Terms

Assets - resources owned by a business Liabilities - debts and obligations of the business Common stock - stock representing the primary ownership interest in a corporation Expenses: Expenses are the costs of assets consumed or services used to generate revenues Examples... Store operating expenses, General and administrative expenses, Interest expense Auditor's Report General Guide for Financial Accounting Generally Accepted Accounting Principles Accounts Provide the the most useful financial information forDecision Making Primary Accounting Setting Body in the U.S. 1. Financial Accounting Standards Board GAAP Are the Rules, The FASB makes the rules. Accounting Concepts Basic assumptions or conditions upon which the science of accounting is based. Accounting Conventions Principles or theories based on which accounting is done.

Money Measurement Concept: In financial accountancy, an event is recorded, only if it can be expressed in monetary terms. Recording, classification and summarization of business transactions requires a common unit of measurement, which is taken as money. Hence, all transactions are recorded through a common denominator money. Thus, if a certain event, no matter how significant for the health or even existence of the business, cannot be measured in monetary terms, that event is not recorded in accounting. Money is expressed in terms of its value at the time an event is recorded in the accounts. Business Entity Concept: The business is distinctly different and separate from its owner. A business entity or a company is an artificial company created by law, who has a common seal, which has a perpetual existence and does not die natural death. Hence for accounting purpose, the owner and his business should be kept separate. Accounting records are kept from the point of view of the business unit and not the owner. So, if the owner contributes fund to the business, it will be treated as a liability of the business say the business owes this much to the owner. Going Concern Concept: A business entity is having a perpetual existence, which does not die a natural death. It is assumed to carry on its operations forever. It implies that the

resources of the concern would continue to be used for the purposes for which they are meant to be used. For instance, in a manufacturing concern, the land, buildings, machinery etc., are primarily required for carrying out the production and selling of certain products. This concept implies that these land, buildings, machinery etc., would continue to be used for this purpose. Cost Concept: Cost Concept implies that in accounting, all transactions are generally recorded at cost, and not at market value. For example, if a piece of land is acquired for Rs.1 lakh, it would continue to be shown in the balance sheet at Rs.1 lakh, even when the market value of the land rises to say Rs.10 lakhs. Why should this be so? This is because cost concept is in fact closely related to the going concern concept. Duality concept: This is the fundamental accounting equation, which is the formal expression of the dual aspect concept. To reflect the two types of equities, the equation is more commonly expressed as
ASSETS =LIABILITIES + OWNERSEQUITY OR TOTAL ASSETS =TOTAL LIABILITIES

The Accounting Identity

Each of the permanent accounts are affected by debits and credits.

A = L + OE
LIABILITIES Debit Credit for for Increase Decrease EQUITIES Debit Credit for for Increase Decrease Credit for Decrease

ASSETS Debit for Increase

Period Concept: A business entity is an artificial person having a perpetual existence. To measure income generated by the business or loss incurred by the business, the infinite life of the business is broken into small pieces called accounting periods. End of each such

period it is ascertained what income the business generated or what loss the business incurred and what the financial position of the business is? These small periods are known as accounting period. Generally accounting period is one year January 01 to December 31 as in US and April 01 to March 31 as in India. Matching Concept: In order to ascertain profit or incurred some loss in an accounting period, the expenses related to this period must be compared or matched with the revenues generated during this period. Realization Concept: Realization concept deals with the point in time at which revenue may be deemed to be realized or when a sale can be said to have taken place. Normally revenue is recognized at the time of transfer of goods or services when a return consideration is either obtained immediately or there exists a reasonable certainty of receiving a return consideration in future.
For example: If a customer buys Rs 500 worth of the items at grocery stores, paying cash, the stores realizes Rs 500 from sale. If a department stores sells a suit for Rs 3000 the purchaser agreeing to pay within 30 days, the store realizes Rs 3000(in receivables)from the sale, provided that the purchaser has a good credit record so that payment is reasonably certain.

Accrual Concept: The accrual basis of accounting recognizes revenues when sales are made or services are preformed, regardless of when cash is received. Expenses are recognized as incurred, that is, when goods are used or services are received, whether or not cash has been paid out. Net profit equals the revenues earned less expenses incurred during a period.

B) Accounting Conventions: The term convention denotes circumstances or traditions which guide the accountant while preparing the accounting statements. The following are the important accounting concepts: 1. Consistency 2. Full Disclosure 3. Conservatism 4. Materiality

 Conservatism Concept: This principle emphasizes that revenues and profits should be accounted only when there is a reasonable surety of recognizing it but any anticipated loss or expense should be immediately accounted for. Materiality Concept: It states that insignificant events may be disregarded, but there must be full disclosure of all important information. Consistency Concept: The consistency concept requires that once an entity has decided on one method, it will treat all subsequent events of the same character in the same fashion unless it has a sound reason to change the method of treatment of that transaction. For example, if a concern is valuing its inventory by a particular method in one year it is expected to value its inventory in the subsequent years also in the same method unless there is a strong reason to change the same. Full Disclosure: According to this convention all accounting statements should be honestly prepared and to that end full disclosure of all significant information should be made. On the other hand, if there is no detailed disclosure in the profit and loss account undisclosed reserves accumulated in the past periods may be used to swell the profits in the year when the company is failing badly and the shareholders may be misled into thinking that company is making profit.
FORMS OF BUSINESS ORGANISATION: 1. Sole Proprietorship: A single individual carries on a business. All the profits the business might earn go to him. The sole proprietors liability is unlimited, that is, shall the business fall into debt, and he is personally liable for paying off the debts. 2. Partnership: It comprises between two and twenty persons trading together as one firm and sharing in the profits. As well as sharing the profits, each partner shares unlimited liability for all the debts and obligations of the firm. 3. Limited Company: It is a legal entity and is treated by the law like a natural person. It must be run according to the rules laid down by the company law. Systems of Accounting Cash Basis: Revenue recorded only when cash is received.Expense recorded only when cash is paid. Cash Basis in not GAAP

Accrual Basis: Adheres to the: Revenue Recognition Principle, Matching principle

Revenue recorded only when earned not when cash is receivedExpense recorded only when incurred not when cash paid Accrual Basis adheres to... Generally Accepted Accounting Principles ACCOUNTING MECHANISM: 1. Recording

Journalizing: The daily business transactions are recorded in the order of their occurrence in a book called Journal. Recording of entries in the journal is known as journalizing. Journals aid the recording process by Disclosing in one place the complete effect of a transaction; Providing a chronological record of transactions; Helping prevent or locate errors because debit and credit amounts can be easily compared. 2. Classifying Ledger preparation: The process of transferring entries from the journal to the ledger is called ledger posting. Ledger contains a classified summery of all transactions recorded in journal. 3. Summarizing: Balancing the ledger: means to make the total of amounts column appearing on the debit and credit side equal to each other. If debit side is bigger than the credit side, the difference between the two sides is known as debit balance and vice versa. Preparation of Trial Balance: Trial Balance is a statement of debit and credit totals or balances extracted from the various accounts in the ledger with a view to test the arithmetical accuracy of the books. Preparation of Profit and Loss A/c: It is prepared to know the operating efficiency of the firm in terms of profit made or loss incurred during an accounting period. Preparation of Balance Sheet: It is a statement prepared with a view to measure the financial position of a business on a certain fixed date. It gives a true and fair view of the states of affairs of the business. ENTRY SYSTEM:

II.DOUBLE

The method of writing every transaction in two accounts is known as Double entry System of Accounting. Of the two accounts, one account is given debit while the other account is given credit with an equal amount. Thus, on any date, the total of all debits must be equal to the total of all credits because every debit has a corresponding credit. Total Debits = Total Credits Rules of Double Entry System: There are separate rules of the Double entry system in respect of Personal, real and nominal accounts which are discussed below:

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Figure 2.1 Rules of Double entry III. CLASSIFICATION OF ACCOUNTS:

A) Personal Accounts: Personal account includes the account of persons with whom the business deals. These account can be classified into three categories

1. Natural personal Account Example: Mohans account, Sohans account. 2. Artificial personal account-An account recording financial transaction with an artificial person created by law. Example: Account of club, Government, Bank. 3. Representative Personal account-An account indirectly representing a person is known as a representative personal account. Example: Salaries outstanding account, prepaid Insurance account. B) Impersonal Accounts: 1. Real Account: It represents assets like plant and machinery, land and buildings goodwill, etc. As on a particular date, this account shows the worth of the asset. 2. Nominal Account: It consists of different types of expenses or incomes or loss of profit. These accounts show the amount of income earned or expenses incurred for a particular period say a month, a year, etc.
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Figure 2.2 Types of Accounts Opening Entry All previous years assets and liabilities of B/S are brought forward to the current year as an opening entry. All asset a/cs are debited All liability a/cs are credited. The excess of assets over liabilities are credited to capital account.

TRIAL BALANCE

Chapter 2: Final Accounts

A list of all the accounts and their balances at a given time. It serves to prove the mathematical equality of debits and credits after posting. It aids in the preparation of financial statements. FINANCIAL STATEMENTS: 1. Profit and Loss A/c: It summarizes the results of the operations of an enterprise for a given time period by disclosing the revenues earned and expenses incurred. It indicates the operating success of a business in a period by measuring the net profit earned by it. 2. Balance Sheet: It presents an enterprises assets, liabilities, and owners equity at a particular point of time. It summarizes the resources of an enterprise and the claims to those resources by owners and creditors of the enterprise on a certain date. 3. Statement of Cash Flows: It reflects the major sources of cash receipts and cash payments of an enterprise. It reports the cash effects during a period of not only the enterprises operations but also its investing and financing activities. CAPITAL AND REVENUE ITEMS Capital Expenditure:

The benefit of which is not fully derived in one year but spread over several periods. Eg: Acquisition of assets, additions to fixed assets

Revenue Expenditure:

The benefit of which is derived in the year in which the expenditure was incurred. Eg: Raw material, Rent, wages and salaries.

FINAL ACCOUNTS OF MANUFACTURING FIRMS

Production / Manufacturing A/c: To know the production cost Trading A/c: To know Gross Profit / Loss Profit and Loss A/c: To know the Net Profit / Loss Balance Sheet: To know the financial position

FINAL ACCOUNTS OF SERVICE BUSINESS ORGANISATIONS

Receipts and Payments A/c: To know the Cash and Bank balances Income and Expenditure A/c: To know the Surplus made / Deficit incurred Balance Sheet: To know the financial position

FINAL ACCOUNTS OF A SOLE PROPRIETOR Trading A/c: To know the Gross Profit/ Loss

Profit and Loss A/c: To know the operating performance of the business i.e. Net profit / Net Loss Balance Sheet: To know the financial position of the firm on a particular

date. Trading Account Overall Result of trading Gives out Gross profit Gross Profit = Sales - Cost of Goods Sold Gross Profit = (Net Sales) (Opening stock +Net purchases+ Direct Expenses Closing Stock) Trading Account Opening Stock Closing Stock valuation Purchases Sales Direct Expenses Wages,Customs & Import Duty,Freight, carriage and cartage inwards,Royalty Gas, electricity, water, fuel,Packing materials Closing Entries Trading Account

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To Opening stock a/c To Purchases a/c To Sales returns a/c To Carriage a/c To customs duty a/c To direct expenses a/c 2. Sales A/c Purchase Returns a/c Closing stock a/c Dr To Trading a/c Trading Account - Importance Gross profit disclosed helps in controlling operating expenses Gross profit ratio is compared year after year to identify the fall in the figures Comparison of stock figures help in preventing lock-up of funds in stocks In case of new products, it is helpful to fix the sale price Dr Dr

P & L Account - Importance Net profit/Net loss is an index of profitability of business Comparison of profit over periods helps in assessing the business efficiency Analysis of expenses over periods help in effective control of expenses Profit and expense analysis helps in planning and forecasting the future course of action. Manufacturing Account Final Cost of production Stock Raw Materials Work in progress Raw Materials consumed Carriage inwards Direct wages Factory overheads Factory power Depreciation on factory machines Sale of scrap Accounts Adjustment Entries

Sometimes the accountant will come to know that he had not taken some significant information into the books of accounts. This apart it not too uncommon that certain transactions take place during or after the preparation of trial balance. In the above cases the transactions were not recorded in the books and hence they need to be adjusted in the books. This is done by passing some adjustment entries. Following the double entry system every adjustment will have a two-fold effect. Put in other words, the adjustment has to be carried out at two places. Normally the adjustment takes palace at any two of the following three places In Trading a/c and Balance Sheet (B/S) In Trading a/c and Profit & Loss a/c (P & L) In P & L a/c and B/S Adjustment Entries

1. 2. 3. 4. 5. 6. 7. 8. 9.

Closing Stock Outstanding expenses Prepaid Expenses Accrued Income Income received in advance or unearned income Depreciation Bad debts Provision for bad debts Provision for discount on debtors

Closing Stock Adjustment Taken on credit side of trading account Closing stock a/c Dr To Trading a/c Asset side of Balance Sheet Given in the Trial balance Means that the closing stock is already adjusted in the cost of sales and hence already accounted for - Asset side of Balance Sheet

Outstanding expenses Outstanding expenses are those expenses which are due during the accounting period but have not yet been paid Appears as adjustment Expense a/c Dr To Outstanding expense a/c Addition to the concerned expense either in trading or P&L a/c

 Liabilities side of balance sheet Appears in trial balance Liabilities side of Balance sheet Prepaid expenses Prepaid expenses are those expenses which have been paid in advance during the accounting period Appears as adjustment Prepaid Expense a/c Dr To expense a/c

Deduction to the concerned expense either in trading or P&L a/c Assets side of balance sheet Appears in trial balance Assets side of Balance sheet Outstanding Income & Accrued Income Outstanding income is that income which is due during the accounting period but has not yet been received Outstanding income & Accrued income Appears as adjustment Outstanding Income a/c Dr To Income a/c

Addition to the concerned income either in trading or P&L a/c Assets side of balance sheet Appears in trial balance Assets side of Balance sheet Income received in advance Income received in advance is that income which is received during the accounting period but is not being earned. Appears as adjustment Income a/c Dr To Income received in Advance a/c

Deduction to the concerned income either in trading or P&L a/c Liabilities side of balance sheet Appears in trial balance Liabilities side of Balance sheet Depreciation Depreciation denotes the decrease in the value of an asset due to the wear and tear, lapse of time, obsolescence, exhaustion etc., As an adjustment Depreciation A/c Dr To Fixed Asset A/c Debit side of P&L a/c

Deduction from the concerned asset account on assets side of balance sheet Appears in trial balance Debit side of P&L a/c Bad debts Bad debt is a debt that cannot be recovered and is a loss As an adjustment Bad debts A/c To Debtors a/c - Debit side of P& L A/c - Deduction from debtors on the assets side of Balance sheet Appears in trial balance Debit side of P&L a/c Provision for Bad & doubtful debts Provision for the likely Bad and doubtful debts As an adjustment P&L A/c Dr To Provision for bad debts a/c - Add to the bad debts on the debit side of P& L A/c - Deduction from debtors on the assets side of Balance sheet Provision for Discount on Debtors Provision for discount is making a provision for the good debts As an adjustment P&L A/c Dr To Provision for discount on debtors a/c Add to the discount a/c on the debit side of P& L A/c Deduction from debtors on the assets side of Balance sheet Dr

All balance sheets are built up from 3 main categories, namely assets, liabilities and shareholders funds. The relationship between them can be looked at either from the point of view of shareholders (a proprietary approach) or from the point of view of the company as a whole (an entity approach). Two forms of the fundamental balance sheet identity can thus be derived: Proprietary: Entity: assets liabilities = shareholder funds assets = liabilities + shareholder funds

Very broadly, all that is being said is that, firstly, what a company owns less what a company owes is equal to the value of the shareholders funds invested in it and that, secondly, what a company owns is financed partly by the owners (the shareholders) and partly by outsiders (the liabilities). Either way, a balance sheet must by definition, balance.

A proprietary approach balance sheet will look like the following (vertical balance sheet).

Fixed assets + Current assets - Current liabilities =Net assets or capital employed - Long term liabilities = Share capital and reserves
A entity approach balance sheet will look like the following (Horizontal balance sheet).

LIABILITIES Equity capital + Long term liabilities + Current liabilities

ASSETS Fixed assets + Current assets

Assets Fixed assets & Current assets: Assets are something of value to the business, which can either be turned into cash or used to produce revenue.

Fixed assets

Those assets which are intended for use on a continuing basis in an undertakings activities. Examples are buildings, equipment, vehicles. Stocks, for example, are not regarded as fixed assets since they are acquired either for immediate resale (for example cigarettes as sold by a tobacconist) or as raw materials for use in manufacturing operations. It is intention that determines whether an asset is fixed or not. Plant and vehicles, for example, are the current assets of a company whose business it is to manufacture them for sale. Matching Fixed assets are an example of a good purchased for use over several periods and are not charged entirely against profits of year of purchase but spread over their years of use. Cost valuation (historical value) Going concern basis Fixed assets are typically included at whatever proportion of cost is still expected to yield useful benefits in the future. It is assumed that the business will last long enough for these to be realised, which is quite different from an approach which valued assets at scrap values. There are different kinds of fixed assets in the balance sheet such as tangible fixed assets, investments and intangible fixed assets. Investments Shares, loans, bonds and debentures held either as fixed tangible assets or current assets. These are usually valued at cost. Intangible fixed assets Non-monetary fixed asset which is without physical substance. This category of asset includes not only such identifiable intangibles as patents, trade marks and copyrights, but also goodwill. Goodwill A company is not just a collection of tangible assets. It is, or should be, a going concern whose total value, by reason of its proven ability to earn profits, is greater than the sum of its parts. It is the difference between the total value and the sum

Concepts involved in valuation of fixed assets:

of the parts which constitutes goodwill. It should not be regarded as in any way a fictitious asset: to be valuable, an asset does not have to be tangible. Goodwill is, however, very difficult to value objectively and company law does not permit it to be appear in the balance sheet unless it has been purchased, and even then it is usually written off immediately or quite quickly. In some group balance sheets an item appears entitled goodwill arising on consolidation or goodwill on acquisition. This represents the excess of the cost of shares in subsidiary companies over the book value of their net tangible assets at the date of acquisition; that is, the parent company was willing to pay more to purchase a company than the sum of its tangible and net current assets. Current assets

Comprise those assets which are not intended for continuing use in the business. Expected to be turned into cash or used in course of trading which can normally be expected to be turned into cash within one year from the date of the balance sheet. Examples include bank balance, prepayments, amount owing from debtors, cash, stocks. Stocks are another example of matching concept - just how far to take it depends upon the materiality concept. Liabilities

Obligations arising from past transactions or other events and involving a company in a probable future transfer of cash, goods or services. Can be classified as current or long term liabilities. Current liabilities Obligations which have to be settled within a relatively short space of time. Examples include amounts owing to creditors, bank overdraft, tax liability Current assets- Current liabilities = Net Current Assets or Working Capital (a measure of liquidity). Fixed assets + current assets - current liabilities = Capital Employed or Net Assets or Net Worth

Long term liabilities Long term liabilities represent the extent to which the firm, not wishing to borrow further long term funds from shareholders, has borrowed from outsiders. The major parts consist of both long term loans (not wholly repayable within 5 years) and medium term loans (repayable within 5 years). Banks are an obvious source of outside finance and many firms long term liabilities are in the form of bank loans. These are not the only form of borrowings. There are also debentures and debenture stocks which may be secured by fixed or floating charges or may alternatively be unsecured debentures. Shareholders funds The shareholders funds section of the group balance sheet is subdivided into Share Capital and Reserves. Shareholders differ from debenture holders in three important ways; they are owners of the company, not lenders; they receive dividends (a share of the profits), not interest; and, except in special circumstances, the cost of their shares will not be repaid (redeemed) to them by the company. Shares can be either ordinary or preference. The latter is usually entitled only to a dividend at a fixed rate, but has priority of repayment in the event of the company being wound up. Preference shares may be cumulative or non-cumulative.

Every share has a par value but this is not necessarily the same as the issue price of the shares or their market price. Shares can be issued at more than their par value: this gives rise to a share premium reserve. Once a share has been issued, its market price fluctuates from day to day, but this has no effect on the firms balance sheet. A company does not have to issue all its shares at once, nor does it have to request full payment on the shares immediately. Companies normally have authority to issue (i.e. have authorised capital of) shares even though they have not issued them. Also shares can be partly paid. For example, a 25p share could be payable 5p on application for the shares, a further 5p on allotment, when the directors decide to whom the shares are going to be issued (or allotted), and the remaining 15p in calls. Thus, in summary, one can distinguish authorised, issued, called up and paid-up share capital.

Reserves

Reserves consist of the retained profit (or loss), the share premium account and other reserves such as a revaluation reserve. This is created as a result of the revaluation of fixed assets on the other side of the balance sheet. It is very important not to confuse reserves with cash. To say that a company has large reserves is not the same thing as saying that it has plenty of cash. If a company has reserves it must have net assets of equal amount, but these assets may be of any kind (e.g. machinery, stock in trade). Thus it is perfectly possible for a company to have both large reserves and a large bank overdraft.

An example of a balance sheet

(, 000) FIXED ASSETS Net fixed assets Investments CURRENT ASSETS Stocks Debtors Cash TOTAL ASSETS CURRENT LIABILITIES Creditors TOTAL ASSETS LESS CURRENT LIABILITIES Long term liabilities CAPITAL AND RESERVES Called up share capital Share premium Profit and loss account SHAREHOLDERS FUNDS 100 50 150 25 25 25 225 50 175 50 125 25 75 25 125

Relation between the P&L statement and the balance sheet It is worth looking more closely at the link between the profit and loss account and the balance sheet. How can a company grow that is, how can it increase its assets? Look again at the identity

Entity:

assets = liabilities + shareholder funds

It is clear that the only ways to increase the assets are to increase the liabilities (to borrow) or to increase the shareholders funds. How can a company increase the latter? There are two possibilities: it can issue more shares or it can plough back profits (assuming of course that it is making some). Ploughing back profits is the simplest but not necessarily the cheapest source of long term finance for a company. Also the more a company ploughs back the less, in the short run at least, there will be available for paying dividends.