Financial Accounting

January 31, 2013 L&T MDC Vivek Krishnamoorthy

Todays Agenda
Understanding forms of business organization Understanding accounting Structure and components of financial statements

Starting a business
When an individual or group of individuals decide to start a business, what factors would they consider? Risk Appetite of the owner Scale of operations Amount of Capital Owners desire for control

Taking a step back

Whats a business entity? An organization that carries out some economic activity in order to make profits Economic/business activities are broadly speaking one of these three categories trading, manufacturing, services

Well discuss three key types of business entities

1.

Sole Enterprise (or Proprietorship)

A business enterprise owned and managed by a single individual She bears the risk of running the business and reaps the profits that are earned She contributes the capital required She has residual claims on the profits She has unlimited liability

Types of business entities contd.

2.

Partnership
Agreement between two or more people for undertaking some business activity Business organization is called firm Managed by all the partners as per the provisions of the Partnership Deed or Agreement Sharing of profits/losses as per the Agreement Partnership is NOT a separate legal entity Hence, partners face unlimited liability

Types of business entities contd.

3.

Limited Liability Company

An LLC is a business enterprise that is an association of a large number of entities who contribute towards the capital for business purposes Capital contribution in the form of shares theyre therefore called shareholders The owners are not involved directly in the management of the company An LLC is an artificial entity created by law (separate legal entity) Practical implication of this Shareholders have limited liability and personal property of equity holders cannot be used to fulfill the business debts

Limited Liability Company

In LLCs, each shareholder does not have the privilege of managing the business like in partnerships Shareholders collectively appoint a team of directors called the Board of Directors This BoD is responsible for managing the business affairs on behalf of the shareholders The equity shareholders have residual claims on the profits and assets of the company

Capital of a firm The backbone

In a limited liability company, capital is broadly speaking of two types

Owners Equity Share Capital Borrowings Debt Capital

Owners Equity
Includes the amount of paid-up capital contributed by the shareholders and retained profits held in the company Capital contributed by owners/general public Equity shareholders have voting rights and residual claim Sum total of capital contributed by shareholders and retained earnings is collectively called net-worth

Capital of a firmcontd

Borrowings or Debt Capital

Finances that are arranged by taking a loan or by issuing debentures/bonds Company has obligation to make interest payments, irrespective of profits/losses Debt holders do not have any voting rights They can be also called money lenders and have higher priority than shareholders

Corporate Financial Reporting

Due to separation of ownership and management in an LLC, it becomes necessary for the company to have a system of apprising the owners of the performance of the company Every business enterprise prepares financial statements But for an LLC, it is mandatory to publish such statements in the form of an annual report every year This annual report is a means to communicate the financial performance as well as policies/strategies of the company

Objectives of Financial Reporting

Financial statements/annual multi-utility documents

reports

are

Equity holders: Get apprised about profitability Lenders: Get an idea of long term solvency of the entity Customers/Suppliers: Understand about the liquidity position of the company Employees: Get an idea of the financial health of the company Management: For control Government: Can compute the taxes that will accrue based on the financial performance

Why does Accounting exist?

Why does a business exist?

To create value

Accounting exists because decision makers need information for decision making (to create value)

Types of Accounting
Financial Accounting To provide reporting to owners, creditors, tax authorities, prospective investors Management Accounting For internal reporting at top managerial levels for decision-making Cost Accounting To facilitate cost estimation, cost control and cost management. For lower/middle level management Not compulsory, however for big factories/businesses, it is Costing records are maintained as per accounting conventions/systems Similar to management accounting

Compulsory for every form of business organization All monetary transactions are recorded Generally, annual reporting system is adopted. Sometimes quarterly/half-yearly.

Not compulsory Only product/process/service related transactions are recorded Reporting is done according to need of department/situation. Sometimes daily/weekly also. Historical as well as future oriented, estimates are made for forecasting the future of business

Historical in nature as only historical data is present

What is Accounting?

It is the process of recognizing, measuring, recording, disclosing and attesting to

Information

for

Decision Making Value creation Control Purposes - Monitoring

What is measured?
Business transactions are the object of measurement Business transactions are economic events that affect the financial position of a business entity

Transactions are the raw material of accounting reports Transactions must relate directly to a business entity

Source Documents
Purchase Invoice Sales Invoice

Bank Account Statements

Information
Shipping Documents

Cheques

Payroll Records

Receiving documents

Outputs of the measurement process

The Financial Statements

Income Statement Balance Sheet Cash Flow Statement

The Recording System

Economic events are the basis for recording transactions in an accounting system For every transaction, it is essential to analyze its effect on the accounting equation. The Accounting Equation
Assets Liabilities Owners Equity

A = L + OE

Double Entry System

An economic event/transaction always has a dual effect on the basic accounting equation The double-entry system is the accounting process of recording this dual effect

Assets
A=

Assets

Assets are the rights or resources with expected future benefits for an entity Examples:
Cash Accounts Receivable Buildings, machinery, equipment Office supplies

Liabilities
L=

Liabilities

Liabilities are obligations to providers of goods and services to the business Examples:
Bank Loans Interest Payable Salaries Payable

Owners Equity = Assets

Owners Equity

Liabilities

Owners Equity

A = L + OE OE = A L Owners equity is the obligation to transfer residual resources to owners when the business ceases.

A = L + OE
Four types of transactions affect Owners Equity Increases
Owners Investments

Decreases
Owners Withdrawals

OE
Revenues Expenses

Principles of Transaction Analysis

The accounting equation must remain balanced after each transaction

Assets

Liabilities

Owners Equity

Transaction Analysis
1.

2. 3.

4.

Selva invests INR 10,000 of his savings in the new company He rents a boat and pays rent of INR 1000 He purchases fish nets for INR 4,200 with cash. He purchases a second hand boat for INR 3,000. Pays INR 1,500 in cash and agrees to pay the rest next month

Transaction Analysis contd.

5.

6. 7.

8.

9.

He purchases fish feed for INR 1,800 and storage buckets for INR 800 from Mustafa Suppliers on credit He pays INR 1,000 to Mustafa Suppliers He pays INR 480 for a one-year insurance policy with cash He sells fish for INR 1,400 in the neighbourhood market He sells fish for a total of INR 2,800 to a threestar restaurant. Money to be collected next month.

Transaction AnalysisContd.
10.

11.

12. 13.

14.

He accepts INR 1,000 for the two lobsters that have to be supplied later that month He pays his assistant two weeks wages of INR 600 He receives and pays utility bill of INR 100 He receives (but has not paid) a mobile bill of INR 70 He is running short of cash for some personal expense he has to incur, and withdraws INR 1,000 for it

Transaction Analysis A Summary

Excel Sheet

Note that the accounting equation ALWAYS remains in balance after each transaction

Assumptions underlying accounting measurement and recording

Separate Entity Assumption

This implies that the entity of owner and that of the business organization are considered separate from each other There are two viewpoints here, viz. the accounting viewpoint and the legal viewpoint From the accounting viewpoint, the entity of owner is always separate from the business organization

Going Concern Assumption

This implies that once a business has started, the owner will continue to run it for an infinitely long period of time This assumptions helps in the classification of different assets into fixed and current assets

Cost Assumption

Financial accounting is a mechanism for recording only historical monetary transactions in the books of accounts All transactions are recorded therefore at the cost, irrespective of market price/value of the transaction

Accounting Period Assumption

Purpose of accounting is to calculate profit/loss and make as far as possible the correct presentation of assets and liabilities in the books of accounts The economic life of a business is divided into artificial time periods

Monetary Unit Assumption

Only transactions that capable of being expressed in terms of money should be included in the accounting records of the economic entity

Revenue Recognition Concept

This dictates that revenue be recognized in the accounting period in which it is earned It is considered earned when the service has been provided or the goods have been delivered

Matching Concept

All resources consumed in earning revenues

Should be recorded as expenses when incurred (not when cash is paid) It must be matched with revenues recorded in the same period

Accrual Concept

This concept implies that the final accounts should incorporate expenses and revenue that is relevant for the current accounting year whether settled in cash or not Accordingly adjustments are made for outstanding expenses, prepaid expense, unearned income and accrued income

Accounting Conventions

These are certain accounting policies and procedures that are followed in a business organization Different from accounting concepts/assumptions in the sense that they might not be followed as universally as accounting concepts are followed

Conservatism
It implies that an accountant should foresee future losses and provide for such losses in the book of accounts She should nor anticipate and provide for expected/future profits in the books of accounts

Consistency

Once an accounting policy or procedure is adopted, it should be followed continuously for a long time period without any significant change

Full Disclosure
Circumstances and events that make a difference to financial statement users should be disclosed

Materiality
Information is material if its omission or misstatement could influence theeconomic decisionof users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.

Thank You!