ACCOUNTING & ACCOUNTING PRINCIPLES

Dual Aspect of Transactions >>

Financial Statement Analysis-FIN621

Lesson-1

ACCOUNTING & ACCOUNTING PRINCIPLES

Accounting

Almost every organization and individual maintains accounts and deals with

accounting. In simple terms, it can be described as a record of Income and expenditure of a business

organization, or budget vs. utilization, in the case of a government non-commercial organization. In the

case of the business entity, accounting would deal with measuring, recording and communicating the

results of business activities. That is why; Accounting is often called "Language of Business".

Purpose of Accounting

Accounting provides decision-makers with sufficient, relevant information to make

prudent and intelligent business decisions. This information is provided through accounting reports

called financial statements. The whole process is called "financial reporting"

The purpose of accounting is to organize the financial details of business.

To identify the financial transactions.

To organize the financial data into useful information

To measure the value of these information in terms of money

To analyze, interpret, and communicate the information to persons or groups, both

inside or outside the business.

Financial Statements Generated by a Business

A business generates four financial statements at the end of its accounting period:-

Income statement: shows operational results of business during/over the accounting

period.

ii)

Statement of owners' equity: showing changes in owner's equity through

profit/additional investment or through losses/drawl by owner.

iii)

Balance sheet showing financial position at the end of the accounting period i.e. a

picture of what the business owns and what it owes.

iv)

Statement of cash flows giving a picture of cash inflows (receipts) and cash outflows

(payments) over/during the accounting period. It is prepared from the two major

financial statements viz Income Statement and Balance Sheet.

Notes to Financial Statements:

In addition to above, notes containing additional information (financial & non-

financial) about the business are also attached to financial statements.

Accounting Period

Accounting period is the period of time covered by an Income Statement. It is usually one

year. It can either be calendar year (Jan to Dec) or financial year (July to June). Financial Statements are

prepared at the end of accounting period and are the end product of accounting process/cycle.

Financial Statement Analysis-FIN621

Different Types of Business Organizations

1. Sole Proprietorship

According to D.W.T. Stafford, "It is the simplest form of business organization, which is owned and

controlled by one man"

Sole proprietorship is the oldest form of business organization which is owned and controlled by one

person. In this business, one man invests his capital himself. He is all in all in doing his business. He

enjoys the whole of the profit. The features of sole proprietorship are:

Easy Formation

Unlimited Liability

Ownership

Profit

Management

Easy Dissolution

2. Partnership

According to Partnership Act, 1932, "Partnership is the relation between persons who have agreed to

share the profits of a business carried on by all or any of them acting for all."

Partnership means a lawful business owned by two or more persons. The profit of the business shared

by the partners in agreed ratio. The liability of each partner is unlimited. Small and medium size

business activities are performed under this organization. It has the following features:

Legal Entity

Profit and Loss Distribution

Unlimited Liability

Transfer of Rights

Management

Number of Partners

3. Joint Stock Company

According to S. E. Thomas, "A company is an incorporated association of persons formed usually for

the pursuit of some commercial purposes"

A joint stock company is a voluntary association of persons created by law. It has a separate legal entity

apart from its members. It can sue and be sued in its name. In the joint stock company, the work of

organization begins before its incorporation by promoters and it continues after incorporation. The joint

stock company has the following feature:

Creation of Law

Separate Legal Entity

Limited Liability

Transferability of shares

Number of Members

Common Seal

Financial Statement Analysis-FIN621

Generally Accepted Accounting Principles (GAAP)

These are `Ground rules' i.e. Principles for preparing financial statements. These are

constantly evolving. These embody accounting concepts, measurement techniques and standards of

presentation of financial statements. These Accounting Principles enable comparability between various

enterprises and of the operational performance of the same enterprise over many years. These give

reliability to Financial Statements.

Following are some of the Generally Accepted Accounting Principles:

Entity principle:

specific business entity separate from personal affairs of the

owner(s).

ii)

Cost principle: valuation and recording of assets at cost.

iii)

Going-concern assumption: connected with cost principle, assets acquired for use and

not for resale.

iv)

Objectivity principle: definite, factual basis for assets valuation; measuring

transactions objectively.

Stable currency principle. The currency remains more or

less stable and rate of

inflation is almost zero.

vi)

Adequate disclosure concept: facts necessary for proper interpretation of statements;

"subsequent events", lawsuits against the business, assets pledged as

securities/collaterals, contingent liabilities etc; reflected in Notes.

ACCOUNTING EQUATION

ASSETS = LIABILITIES + OWNER'S EQUITY

Balance Sheet is based on Accounting Equation. It is in fact, a detailed statement of the

Equation. The Equation in a way shows, utilization of Funds and Sources of Funds. In other words, it

shows what a business OWNS and what it OWES. Alternately, the Accounting Equation or Balance

Sheet is a description of Total Assets of a business against the claimants of these Assets. Therefore, this

Equation shows financial position on a specific date. The three titles in the Equation are Elements of

Balance Sheet. Similarly Elements of Income Statement would be Revenues & Expenses and their net

affects Owner's equity.

Within the Elements, there would be sub-elements, for example, the Element or Account

"Assets" would consist of cash, Accounts Receivable, Land, and Building etc. Each financial

transaction affects two or more elements or sub-elements of the Accounting Equation. Therefore, we

can say that each financial transaction affects Balance Sheet i.e. financial position of the business. This

would be clear from the following illustration.

Khizr property dealer:

The proprietor starts business with deposit of Rs.180, 000. On July 1, 2006

Financial Statement Analysis-FIN621

Financial Position as on July 1, 2006

Assets (Rs)

Owner's equity (Rs)

Deposit in business by proprietor/ Cash 180,000

Khizr, Capital 180,000

owner.

Jul 3, 06

Land Valuing Rs. 141, 000 is purchased for cash on July 3.

Financial Position on that date would be

II) Purchase of land for cash

Cash

39,000

Khizr, Capital

180, 000

(Rs.141,000)

Land

141,000

Total assets

180,000

Total owner's equity

180,000

(Cash is reduced by

Rs.141, 000, but

correspondingly a new

asset land has come up)

Jul 5, 06

III) Purchase of building for

Cash

24,000

Liabilities & Owner's equity

(Rs.36,000) partly on cash

Land

141,000

Accounts/Notespayable21,000

Rs.15,000) and partly on credit

Building

36,000

Owner's equity

180,000

(Rs.21,000)

Total assets

2,01,000

Total

201,000

Rs.15, 000 is paid in cash for the building which further reduces cash from Rs.39, 000 to Rs.24, 000.

For remaining amount of Rs.21, 000, a liability in the form of accounts or notes payable involve

interest, where as accounts payable are without interest.

July 10, 2006: A part of land valuing Rs.11, 000 was sold on credit. A new asset "Accounts

Receivable" has been introduced. The new financial position as a result of this transaction would be:

24,000 Accounts Payable

21,000

iv)

Sale of part of Cash

11,000 Owner's equity

180,000

land on credit for Accounts Receivable

Rs.11,000

Land

130,000

_______

Building

36,000

201,000

Total

201,000

July 14, 2006: Office equipment for Rs.5400/- was purchased on credit. A new liability of Rs.5400 has

accrued, raising Accounts Payable from Rs.21, 000 to Rs.26, 400.

Purchase of Office Cash

24,000

A/C Payable

26,400

Equipment

for A/Cs Receivable

11,000

Owner's equity

180,000

Rs.5400 on credit.

Land

130,000

Building

36,000

Office equipment

5,400

206,400

Total

206,400

Financial Statement Analysis-FIN621

July 20, 2006. Accounts receivable which were Rs.11, 000 on July 14, have been converted into cash to

the extent of Rs.1, 500. Cash has therefore increased from Rs.24, 000 to Rs.25, 500 and accounts

receivable have correspondingly decreased to Rs.9, 500

(VI)

Partial collection of

Cash

25,500

A/Cs payable

26,400

Accounts (Rs.15,00)

A/C receivable

9,500

owner's equity

180,000

Land

130,000

Building

36,000

Office equipment

5,400

Total

206,400

Total

206400

July 31, 2006

(VII)

Payment of liability

Cash

22,500

A/Cs payable

23,400

(A/C payable) Rs.3,000

A/C receivable

9,500

owner's equity

180,000

Land

130,000

Building

36,000

Office equipment

5,400

Total

203,400

Total

2,03,400

It is thus clear from the above illustration that each financial transaction affects financial

position, (which in effect is the balance sheet). Accounting period in the example was one month. It

must also be noted no business activity (commissions/ fees/ Revenues & Expenses) was involved in

above example. Only setting up of business was involved and therefore owner's equity remains the

same.

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