SESSION: 1
Introduction to financial accounting
1.1
Learning objectives
•
Understand various types and uses of accounting
•
Understand accrual accounting and its importance vis-à-vis cash accounting
•
Understand the revenue recognition principle.
•
Understand the difference between expensing vs capitalization
•
Prepare an income statement and a balance sheet.
1.2
Quick recap of basics of accounting
What are the 3 major types of accounting and who uses them ?
• Financial accounting– Shareholders, lenders, suppliers, customers and other external users
• Managerial accounting– internal users
• Tax accounting –Government to levy taxes
Why is accounting needed ?
• People who provide capital and people who run the company are different. The information asymmetry
between the two parties leads to – adverse selection (potential investors not able to distinguish good
companies from bad) and moral hazard (managers might work towards their benefits rather than that of
shareholders’). Accounting is a mechanism that can alleviate information asymmetry
What is the main output of financial accounting ?
Financial statements -Income statement, Balance sheet, Statement of cash flows, Statement of shareholders’
equity, other information contained in annual report
Who prepares financial statements ?
Managers (CEO , CFO) bear the ultimate responsibility
1.3
What is the role of auditors and that of an audit committee?
To make sure that financial statements are prepared as per the prescribed accounting standards
Why are rules needed in financial accounting ?
Accounting rules ensure that information about a firm’s performance is presented to
stakeholders in a manner that is consistent over time and across different businesses
What are these rules called ?
India – Ind AS; US A – US GAAP; Many other countries -IFRS
Who makes these rules?
Ind AS – NFRA (MCA)
US GAAP– FASB (SEC)
IFRS - IASB
1.4
What are the main elements of an income statement?
Income –(i) Sales or revenue , (ii) other income / gains
Expenses –(i) Operating expenses , (ii) other expenses / losses
What are the main elements of a balance sheet?
Assets
Liabilities
Shareholders’equity
1.5
Accrual accounting
▪
Most of the firms (except very small) prepare financial statements on accrual basis
▪
This method focuses on the economic characteristics of transactions rather than their
cash flows. In simple words,
▪ Not all cash inflows are revenue
▪ Not all cash outflows are expenses
▪
Accrual accounting is based on revenue recognition principle and matching
principle
1.6
Revenue recognition:
A firm can recognize revenue when:
⚫
⚫
It has earned the revenue by doing what it’s agreed to do (i.e. when the company has
performed the service or transferred control of the goods)
It is realized or realizable. [ Realized = When cash is received; Realizable = When
assets received are readily convertible to known amounts of cash or claims to cash]
US GAAP and IFRS have recently come up with more detailed guidelines, but the core
principles outlined above still remain same.
1.7
To achieve these core principles, companies need to apply the following 5 steps –
1. Identify the contract(s) with a customer. The parties to the contract should be identifiable and the
terms of the sale should be specified (including the items sold, the delivery terms, and the payments
required).
2. Identify the performance obligation(s) in the contract. A performance obligation is the
company’s contractual promise to transfer a good or service to the customer. If the contract involves
the transfer of more than one good or service to the customer, the company needs to account for
each promised good or service as a separate performance obligation and recognize revenue
separately for each.
3. Determine the transaction price. If the purchase price is variable, say dependent upon
contingencies, the company should estimate revenue using the expected purchase price.
4. Allocate the transaction price to the performance obligation(s). For contracts with more than
one performance obligation, the company must allocate the transaction price to each performance
obligation at its fair value.
5. Recognize revenue when the performance obligation is satisfied. Performance obligations that
are satisfied over a period of time should be recognized as revenue over time.
1.8
Illustration 1.1
⚫
Case 1: ABC Corp. delivers ₹10,000 of goods to XYZ Inc now. XYZ Inc. promises to pay cash
next month.
⚫
Case 2: ABC Corp. delivers ₹10,000 of goods to XYZ Inc now. XYZ Inc. promises to pay once
their quality control department approves of the quality within 30 days. Quality control approves
the quality next month after 20 days.
⚫
Case 3: ABC Corp. receives a purchase order from XYZ Inc. ordering goods valued at ₹10,000 to
be delivered next month. ABC Corp requires that XYZ Inc. pay 20% of the purchase order value
at the time of ordering and XYZ Inc. pays ₹2,000 in cash.
⚫
Case 4: ABC Corp. delivers 1,000 units of goods to XYZ Inc now and each unit costs $10. The
contract is that XYZ will pay only for the units that it can sell to the eventual customers. ABC
will send XYZ Inc. an invoice for payment after 30 days when XYZ Inc. knows how many units
it has sold. At that time, XYZ must pay the amount mentioned on invoice within 60 days.
1.9
Case #
When is performance
obligation met ?
What is transaction
value?
When is Revenue recognized
and how much?
1
Now , when goods are
delivered
10,000
10,000 is recognized as revenue at the
time of delivery
2
Only after QC team approved,
performance obligation is met
because obligation is to
provide “good quality” stuff
10,000
10,000 is recognized as revenue on the
20th day when the QC team approves
3
Next month , when goods are
delivered
10,000
10,000 is recognized as revenue at the
time of delivery
4
Now , when goods are
delivered
Not known.
Depends on how many
units XYZ is able to sell to
eventual customers
Depends on the term of contracts
If XYZ owns the inventory – ABC can
estimate (based on historic experience)
revenue at the time of delivery
If ABC owns the delivery, ABC will have
to wait till the goods are sold to eventual
customers
1.10
Matching principle
To match expenses with revenue, the following aspects should be kept in mind –
1. Product vs period costs
⚫
⚫
Product costs, i.e. those that can be directly associated with revenues. These are recognized as
expenses in the period when the firm recognizes the revenue. E.g. Raw material, wages of
labor, etc
Period costs, i.e. those that are not directly associated with revenues. These are recognized as
expenses in the time period benefitted. E.g. – Salary of admin staff, utility bills of corporate
HQ
2. Expensing vs capitalization
⚫
⚫
1.11
If the benefits of a cost are expected to be realized in future periods to when the cost is
incurred, then the cost is capitalized in that period. Capitalizing means the entire amount of the
cost is shown as an asset in the balance sheet. Capitalized costs are eventually charged as an
expense to income.
If the benefits of a cost are realized in the same period when the cost is incurred, then the cost
is expensed in that period. By expensing we mean that the entire amount of the cost is charged
as an expense in the income statement to determine income for that period.
Expenses arise as resources (assets)are consumed to generate revenue, EG:
BIG TAKE AWAY: Expenses are recognized in the same period that the associated
revenue is recognized (MATCHING PRINCIPLE)
1.12
Impact of accrual accounting on financial statements
Recognition of revenue and expenses may or may not happen in the same time period in
which there is a cash inflow / out flow. Various scenarios are as follows • Cash is received before revenue is earned. Example – We pay cash at the time of
booking tickets. Airline company receives cash but can recognize revenue only when it
flies us.
• Cash is paid before expense is incurred. Example – companies pay rent / insurance
premium etc in advance
• Cash is received after revenue is earned. Example – typical credit sale where goods
are delivered to customer and payment is received later
• Cash is paid after expense is incurred. Example – employees work for a month and
get paid next month
1.13
1. Cash is collected before revenue is recognized
• Even though cash is received, no revenue is recorded (DEFERRED) since no services have been
performed or no goods have been delivered. A liability called Deferred Revenue (or Unearned
Revenue) is created because an obligation exists to provide future services or assets (such as
inventory or a refund of cash). Eventually, when the goods are delivered or services provided,
revenue is recognized and liability does not exist anymore.
• E.g. On Jan 1, 20X1 HM pays Rs10,000 to Indigo Airlines to buy a ticket for New Delhi. The
departure dates in May 1, 20X1. How does this transaction affect Indigo’s financial statements.
Indigo will make the following JEs
On Jan 1, 20X1
Cash Dr 10,000 (A+)
Deferred revenue Cr 10,000 (L+)
On May 1, 20X1
Deferred revenue Dr 10,000 (L-)
Revenue Cr 10,000 (R+ → SE+)
1.14
2. Cash is paid before expense is recognized
• Even though cash is paid, no expense is recorded (DEFEREED). An ASSET is created because such
cash paid in advance will generate benefits in future and often more than one period. Subsequently,
when the asset is used or time elapses, the value of asset reduces and the expense is recognized
•
E.g. On Jan 1, 20X1 Indigo Airlines to buy an airplane from Airbus for $120M. The entire amount is
paid upfront. Indigo plans to use the flight for 10 years after which the airplane becomes worthless.
How does this transaction affect Indigo’s financial statements.
Indigo will make the following JEs
On Jan 1, 20X1
PP&E Dr 120M (A+)
Cash Cr 120M (A-)
On Dec 31, 20X1
Depreciation expense Dr 12M (E+ → SE-)
Accumulated depreciation Cr 12M (XA+)
1.15
3. Cash in received after revenue is recognized
• Even though cash is not received, revenue is recognized (ACCRUED) since the company has done
its job and is sure of collections. An asset titled Accounts Receivables (AR) is created. When the
cash is subsequently collected the asset AR gets converted into cash
•
E.g. On Jan 1, 20X1 Airbus sells an airplane to Indigo Airlines for $120M. The entire amount is
paid after 6 months (ignore any interest related issues) . How does this transaction affect Airbus’
financial statements.
Airbus will make the following JEs
On Jan 1 20X1
Accounts receivable Dr 120M (A+)
Revenue Cr 120M (R+ → SE+)
On Jul 1 20X1
Cash Dr 120M (A+)
Accounts receivable Cr 120M (A-)
1.16
4. Cash in paid after expense is recognized
• Even though cash is not paid, expense needs to be recognized (ACCRUED) based on accrual concept.
A liability titled PAYABLE is created because there is an obligation to pay in the future. Subsequently,
when the cash payment is done, the liability does not exist any more
•
E.g. The total employee salary for Indigo Airlines is $300M for the month of Jan 20X1. The salaries
are paid on the 2 Feb 20X1. How does this transaction affect Indigo’s financial statements.
Indigo will make the following JEs
On Jan 31, 20X1
Salary expense Dr 300M (E+ → SE-)
Salary payable Cr 300M (L+)
On Feb 2, 20X1
Salary payable Dr 300M (L-)
Cash Cr 300M (A-)
1.17
Illustrating difference between cash and accrual accounting
Illustration 1.2 HM Apparel Co.
[Source- Adapted from Financial Statement Analysis, K.R. Subramanyam, McGraw Hills 11E ]
HM Co. starts a business of selling printed T-shirts in June 2020. The company is started with an
initial capital contribution of $1,200 by the promoters. HM Co. also borrows $800 from the bank. The
following transactions took place during the month 1. HM Co got 100 plain T-shirts for $5 a piece by making full cash payment to a supplier
2. A design is printed on all these 100 plain T-shirts. For printing, HM Co buys a printer for $1,200.
This printer can be used for 12 months after which it is worthless.
3. Wages of $100 is paid to worker who operates the printer.
4. During the first month, the company sold 60 T-shirts for $10 a piece. But, of the 60 T-shirts picked
up, only 20 paid cash. For the other 40, HM agrees to accept payment next month.
5. Salary of $100 is paid to employee who provides admin and sales support.
At the end of the month, you were dismayed to find you had only $ 300 in cash remaining. Given that
you started with a cash of $2,000, does this suggest that you had lost $ 1,700 during the month?
REQUIRED
1. Show how your cash balance had dwindled to $ 300 at the end of the month
2. Prepare the income statement and balance sheet for the month
1.18
Keeping track of the cash
1
2
3
4
5
Payment to supplier
Payment for machine
Payment to worker
Collection from customers
Payment to sales staff
∆ Cash
Opening cash
Closing cash
(500)
(1,200)
(100)
200
(100)
(1,700)
2,000 [Capital 1,200 + Bank borrowing 800]
300
Can we say that the business lost $1,700 during the month?
1.19
HM Apparel Co
Income statement for the month ending June 30, 2020
Revenue
600
Cost of goods sold (COGS)
(420)
Selling general and admin
expenses (SG&A)
(100)
Net income
[$10×60 = 600]
Total direct cost is 700* but this is to produce 100 T-shirts.
Revenue is recognized only for 60 T-shirts. So expense for 60
T-shirts will be recorded. COGS = 700×60/100
80
*Direct costs = Plain T-shirts 500 [100*5] + depreciation 100 [ 1,200/12] + salary to worker operating printer 100 = 700
1.20
HM Apparel Co
Income statement for the month ending June 30, 2020 ( alternate way of presenting)
Revenue
Less:
Raw material consumed
Depreciation
Employee salaries
Net income
600
300
60
[= 500×60/100]
[= 100×60/100]
160
80
[= 100×60/100 + 100]
*Direct costs are Plain T-shirts 500 [100*5]; depreciation 100 [ 1,200/12] ; salary to worker operating printer 100
1.21
HM Apparel Co
Balance sheet as on June 30, 2020
Assets
Cash
Accounts receivables
Inventory
300
400
280
[Refer to the cash statement]
PP&E
Total assets
1,100
2,080
[1,200 – 100]
[$10×40 = 400 the amount to be collected from customers]
[700 – 420= 280, the value of T-shirts that remains unsold]
Liabilities & Shareholders’ equity
Liabilities
Bank borrowing
800
Shareholders’ equity (SE)
Capital
Retained earnings
1,200
80
Total SE
1,280
Total liabilities & SE
2,080
1.22
Balance from income statement
Exercise – Prepare these income statement and balance sheet in a more formal way by
posting journal entries, creating T-accounts, drawing trial balance and then preparing
financial statements.
[AA will help you with this in the office hour]
1.23
Next session
• Financial statement analysis – part 1
1.24