FINANCIAL
ACCOUNTING
Ref Book
Accounting
By
Meigs, Williams, Haka,
Bettner
Need and Importance of Accounting
We live in a word where people need things from
the day they are born to the day that they die.
Some of these NEEDS are physical needs, like
food, shelter, clothing etc. some of these are
emotional WANTS, like education,
entertainment, recreation etc. In satisfying such
needs and wants businessmen perform useful
services to their fellow humans. In return they
expect to earn a reasonable reward for their
efforts in the form of profit.
Every individual will have to plan his expenditure
according to his income. Obviously the question
arises –why is this planning necessary? The need
for such planning arises as our needs ( and wants)
for goods and services are unlimited, while the
means i.e., the income with which to buy such
goods and services are limited. Where, however
goods and services are available free of cost i.e.,
gifts of nature such as air, water etc, there is no
question of economy. But the necessity of
economy is undeniable, where goods or services
are not available free of cost and their supply is
Limited.
A proper and fair planning of expenditure of
expenditure helps us to ensure proper use of our
income. Of course, it is true that the quantity of
goods or money cannot be increased by making a
proper planning. But certainly we can ensure
most economic use of goods or money at our
disposal.
Most of us do maintain some kind of written
record of our income and expenditure. The idea
behind maintaining this record is to know the
correct position regarding income and
expenditure. The need for keeping a record of
income and expenditure in a clear and systematic
manner has given rise to the subject of “Book
Keeping.”
It is necessary for an organization or a business
concern to keep proper accounts. At the end of
the year (or at a certain time) the true result of
the economic activities of a concern must be
made available otherwise it will not be possible
to run the organization or concern.
In case of a business concern the profit or loss at
the end of a year must be ascertained, because the
amount of profit must be adequate in relation to
that of investment made in the business. If it is
not so or if there is a loss, it is an indication of
some defects existing somewhere in the
management of the business. All such defects
need to be detected, analyzed and appropriate
measures taken for their rectification. But it is
only possible if proper Book Keeping of accounts
are maintained in the business concerns.
The proper recording of the financial
transactions in the book of accounts is known as
Book Keeping.
The function of accounting is more extensive. It
has many other functions to do except recording
transactions. Book keeping is confined to
recording aspect of accounting. Both represent
two different phases of the main subject
”accounting.” Book keeping is the first stage,
while Accounting is the final stage, that is why
it is said that accounting starts where book
keeping ends.
The function of book keeping ends with the
recording of transactions in the book of
accounts. But the function of accounting is to
classify the recorded transactions, summarize
them, interpret them and communicate
information to the management and other
important persons.
Accounting versus Accountancy
The two words “accounting” and “accountancy”
are often used to mean the same thing. But it is
not correct. Accountancy is the main subject
whereas accounting is one of its branches. The
word “accountancy” is far extensive i.e., the
scope of accountancy is far wide and extensive
compared to accounting. It covers the entire
body of theory and practice e.g., book keeping,
accounting, costing, auditing, taxation etc.
• Financial Accounting
The main purpose of f/accounting to ascertain
the true results(Profit or Loss) of the business
operations during a period of time and to state
the financial position of the business on a
Particular point of time. F/Accounting also
produces special purpose reports for use by the
great variety of people who are interested in the
organization but who are not actively engaged in
its day to day operation.
• Cost Accounting
The main object of cost accounting is to
determine the cost of goods manufactured or
produced by the business. It also helps the
management of the business in controlling the
costs by indicating avoidable losses and wastes.
• Managerial Accounting
The object of M/accounting is to communicate
the relevant information periodically to the
management of the business to enable it to take
suitable decisions.
Financial accounting is the oldest and other
branches have developed from it.
IDENTIFICATION
OF USERS
NEEDS OF
USERS
ECONOMIC OR
BUSINESS ACTIVITIES
USERS:
ACCOUNTING
SYSTEM
REPORTING
Owners, Investors, Creditors, Managers,
Agencies, Employees, Government,
DECISION
MAKING
•Business
Any profit oriented activity is called business.
• How Do We Measure Performance?
We should have certain facts about the
activities. These facts about business activities
pass through an system, known as Accounting
System, which performs two functions:
• To develop an Accounting information in
such a way that: Information is recorded.
 Information is classified.
 Information is summarized.
• To communicate this information to users
(decision makers)
Accounting is a basis for business decisions.
• What type of reports are generated?
Two types of reports are generated:
 Financial Statements
 Special Reports
• Financial Statements
A set of following four statements. These are
open documents.
– Balance Sheet
– Statement of Owner’s Equity
– Income Statement
– Statement of Cash Flow
• Special Reports
Special Reports are specific reports, other than
Financial Statements, like General Purpose
reports, Income Tax Returns etc. These reports
may be on daily, weekly, or quarterly basis etc.
• Why We Study the Financial Statement?
We study these reports to find out
– Solvency (ability to pay debts)
– Profitability
– Future Prospects (ability to grow)
• What is an Accounting System?
An accounting system consists of personnel,
procedures, devices, and record etc for the
sake of developing accounting information and
communicating it to users (decision makers).
• What are the basic qualities these Reports
should contain?
– Reliability (true, actual, reliable etc)
• Qualified and competent personnel
• Internal Control System
• External Audit
Generally Accepted Accounting
Principles (GAAPs)
Accounting Information, that is communicated
externally to users (investors, creditors etc) must
be prepared in accordance with the standards that
are understood by both the preparers and users of
that information. We call these standards as
GAAPs. These include broad principles of
measurement and presentation, as well as, detailed
rules that are used by professional accountants in
preparing accounting information and reports.
– Comparability
• To compare the performance
(profitability) of one organization and
the others, by following certain
uniform rules and regulations, which
are globally accepted.
The phrase GAAPs refer to the accounting
concepts in use in the USA. However the
principles in use in Canada, Great Britain and in
a number of countries are quite similar. Today
the most authoritative source of GAAPs is the
Financial Accounting Standard Board (FASB).
This is an independent rule making body
consisting of 7 members from the accounting
profession, industry, Govt. , and accounting
education. The FASB is part of the private sector
of the economy. It is not a government agency.
Securities & Exchange Commission (SEC) is a
government agency with a legal power to
establish accounting principles and financial
reporting requirements for publically owned
corporations. In the past the SEC has generally
adopted the recommendations of the FASB,
rather than developing its own standards. The
accounting principles continue to be developed
in the private sector but are given the force of
law when these are adopted by SEC. These two
organizations work together in developing new
accounting standards.
• Financial Statements:
Balance Sheet (Statement of Financial
Position):
The Balance Sheet is a position Statement that
shows where the company stands in financial
terms at a specific date.
Income Statement:
The Income Statement is an activity statement
that shows detailed and results of the
company’s profit related activities for a period
of time ( for example , a month, a quarter, or a
year).
Statement of Cash Flows:
The Statement of Cash Flows is an activity
statement that shows the details of the
company’s activities involving cash during a
period of time.
Statement of Owner’s Equity:
The Statement of Owner’s Equity is an
activity statement that shows the details of the
owner’s claim to the assets of the business
during a period of time.
Balance Sheet
Every business prepares a balance sheet at the
end of the year, and many companies prepare one
at the end of each month. It consists of listing of
the assets, the liabilities, and the owner’s equity
of a business.
Balance Sheet has two parts –Title & Body.
Title consists of three sub-sections:
(a) Name of Business entity
(b) Name of Financial Statement
(c) Date on which Balance Sheet is prepared
Body of the Balance Sheet consists of three
sections:
(a) Assets:
Assets are the economic (or business)
resources owned by the company. Cash is
listed first among the assets, followed by
Notes Receivables, Accounts Receivables,
Supplies, & other assets. Cash is a liquid
asset. Less liquid assets, such as Land, Bldg
& Equipment etc are written afterwards.
Receivables are any cash which we have to
receive from others. Notes mean Promissory
Notes (written promise)& if nothing exists in
writing & we do credit on understanding, such
Receivables mean Accounts Receivables.
Supplies mean the items which have been
purchased & these will be used subsequently in
the process of business. Payables are any cash
which we have to pay to others. Notes mean
Promissory Notes (written promise)& if nothing
exists in writing & we do credit on some
understanding, such Payables mean Accounts
Payables.
(b) Liabilities:
Debt or obligation of an entity that resulted
from past transactions. This represents the
claim of creditors on the
assets(
other
than the owner).
(c) Owner’s Equity:
This represents the claim of owner on the
assets
•
•
Claims of the Outsiders are Liabilities
Claims of the Owners are Owner’s
Equity
Accounting Equation is
Assets =
Liabilities + Owner’s Equity
The amount of total Assets is always equal to
the total amount of Liabilities and Owner’s
Equity. This is why it is called Balance Sheet.
Overnight Auto Services
Balance Sheet
Dec.31,2007
Assets
$
Cash
Notes Receivables
Accounts Receivables
Suppliers
Land
Building
Office Equipment
Total(Assets)
10,000
20,000
30,000
15,000
85,000
100,000
40,000
Liabilities & Owner’s equity
Liabilities
Notes Payable
Accounts Payable
Salaries Payable
Total Liabilities
$
25,000
70,000
5,000
100,000
Owner’s Equity
Rehman’s Capital
200,000
300,000
Total(Liabilities & Owner’s 300,000
Equity)
Income Statement
The Income Statement is a separate representation of
the company’s revenues & expense for a period of
time. Generally the time period is one year & is known
as accounting year. It actually explains how the
company’s financial position changed during the
period (Profitability)
Revenue is the price of goods & services which we
sell.
Expense is the cost of goods & services we use to
generate revenue.
Revenue
=
$ 2200
Expense
=
$ 1400
Net Income
=
$ 800
ABC Company
Income Statement
For the month ended November 30, 2008
$
Revenue
Repair Service Revenue
Operating Expense
Wages Expense
Utilities Expense
Net Income
$
2200
1200
200
1400
800
Statement of Cash Flows: This shows how
cash position changed during the period.
Revenue/
Operating Expenses
Operating
Activities
Assets
Investing
Activities
Capital / Loan
Financing
Activities
• Operating Activities (Revenue / Expense)
should be positive (generation of funds within
the organization).
• Investing Activities ( Assets)
means any cash which we pay for buying
assets or cash receivables because of selling
assets. This should be negative showing
expansion in the business ( Business is
expanding).
ABC Company
Statement of Cash Flows
For the month ended Nov.30, 2007
Cash flow from operating activities
$
$
Cash received from sales revenue
2,200
Cash paid for expenses
( 1,400)
Net cash provided by operating expenses
800
Cash flow from investing activities
Purchase of lands
(58,200)
Purchase of tools and machinery
( 6,600)
Purchase of tools(receipt)
600
Net cash used by investing activities
(64,200)
Cash flow from financing activities
Investment by McBryan
80,000
Net cash provided by financing activities
80,000
Net Cash Increase during Nov.30, 2007
Balance of cash on Nov.1, 2007
Balance cash on Nov.30, 2007
16,600
0
16,600
Event
Event means anything that happens. Human life
is full of events. So many events take place in
the family life, social life & business life of a
person. The events may be classified into two:
Monetary Events: Events which are related
with money i.e., which change the financial
position of a person or organization.
Non-Monetary Events: Events which are not
related to money i.e., which do not change the
financial position of a person or organization.
In business accounting only those events which
change the financial position of a business and
which call for accounting are recognized as events.
In other words, all monetary events are regarded as
“business transactions.”
An event (or a business transaction) must qualify
following conditions to become a transaction:
1. It is complete event
2. The effect of which can be expressed in terms of
money
3. It causes immediate change in the financial
position.
Double Entry System
Every business transaction causes at least two
changes in the financial position of a business
concern at the same time—hence both the
changes are recorded in the book of accounts.
Anything which is not a transaction must not be
recorded.
For example we buy machinery for Rs. 100,000,
obviously it is a business transaction. It has
brought two changes—machinery increases by
Rs. 100,000 and cash decreases by an equivalent
amount. Both the changes must be recorded. In
account language these two changes are termed
as “a debit change” and “a credit change.” Thus
we see that for every transaction there will be
two entries—one debit entry and another credit
entry. For each debit there will be a
corresponding credit entry of an equal amount.
Conversely for every credit, there will be a
corresponding debit entry of an equal amount.
Such system is known as Double Entry System.
Transaction is always in Past Tense.
• State with reasons whether the following
events are transactions to my business.
1. I started a business with Rs. 500,000.00
2. I bought furniture for Rs. 100,000.00 for
business.
3. I submitted a tender for goods worth Rs.
10(M).
4. I appointed a cashier on a salary of Rs.
20,000 per month.
5. I paid salary Rs. 35,000 p.m.to an accountant
of the firm.
6. I took away goods worth Rs. 10,000from the
business for my personal use.
7. Paid rent of my house from my own funds.
1. It is a transaction. It changed the financial
position of my business. Cash (assets)
increases by Rs.500,000 and Owner’s equity
also increases by an equal amount.
2. It is a transaction. It changed the financial
position of my business. Furniture (asset)
increase by Rs. 100,000 and cash (asset)
decreases by an equal amount.
3. It is not a transaction. It did not change the
financial position of my business.
4. It is not a transaction. Mere appointment of
the cashier did not change the financial
position of my business.
5. It is a transaction. It changed the financial
position of my business. Cash(asset) decrease
by Rs. 35.000 and an expense (salary)
decreases by an equal amount.
6. It is a transaction. Goods decreases by Rs. 10,
000 and Equity also decreases by an equal
amount.
7. It is not a transaction.
The Accounting Cycle
Capturing Economic Events
Transaction is the starting point and producing
the Financial Statements is the End point. In
between there is an accounting process:
TRANSACTION
FINANCIAL
STATEMENYS
JOURNAL
TRIAL BALANCE
LEDGER
Rules of Debit & Credit
This explains that when we have to write
something in the debit side and when in the credit
side.
ASSETS
LIABILITIES
&
OWNER's EQUITY
BALANCE SHEET’s
ACCOUNTS
REVENUE
EXPENSE
INCOME STATEMENT
ACCOUNTS
&
Rules of Debit & Credit
This explains that when we have to write
something in the debit side and when in the
credit side.
ASSETS
EXPENSES
&
LIABILITIES
OWNER’s EQUITY &
REVENUE
Increases are Recorded
as Debits
Decreases are Recorded
as Credits
Increases are Recorded
as Credits
Decreases are Recorded
as Debits
The Journal
The information about each business transaction
is initially recorded in an accounting record
called the Journal. The journal is chronological
(day by day) record of business transactions. At
convenient intervals, the debit and credit
amounts recorded in the journal are transferred
(posted) to the Ledger. The journal is an internal
document.
Date
2008
Nov
1
Account Titles and explanation
Debit
Cash
80,000
McBryan Capital
Credit
80,000
McBryan invested cash
Nov
3
Land
52000
Cash
52000
Purchased land for cash
Nov
5
Building
36,000
Cash
6,000
Notes Payable
30,000
Purchased Building for cash 6000 & Notes
payable 36000
Nov
17
Tools & Equipment
13,800
Accounts Payable
Purchased Tool & Equipment on accounts
13,800
Date
2008
Nov
20
Account Titles and explanation
Debit
Accounts Receivables
18,000
Tools & Equipment
Credit
18,000
Sold some of tools & equipment on accounts
Nov
25
Cash
600
Accounts Receivables
600
Received Cash on Accounts
Nov
26
Accounts Payable
6,800
Cash
Paid Cash on Accounts
6,800
Remember that:
• No currency sign is to be shown in Journal,
Ledger and Trial Balance. Currency sign is to
be shown in all the four Financial Statements,
being the external documents.
• Every debit amount has an equal credit amount
• Posting simply means updating the ledger.
The Ledger
An accounting system includes a separate record
for each item that appears in the financial
statements. For example, a separate record is
kept for the asset “cash,” showing all increases
and decreases in cash resulting from the money
transactions in which cash is received or paid. A
similar record is kept for every other asset, for
every liability, for owner’s equity etc. The record
used to keep track of the increases and decreases
in the financial statement items is termed as
ledger account or simply account.
The entire group of accounts is kept together in
an accounting record called a Ledger.
An account has three sections:
1. a title;
2. a left side, called as debit side; and
3. a right side called as credit side;
This form of an account is called a T- account
because of its resemblance to the T-letter.
Title of Accounts
Debit Side
Credit Side
Receipts are recorded on the left side and
payments are placed on the right side and then
we see the net impact of these transactions.
Examples
Nov.1: McBryan invested cash $ 80,000 in OAS
Analysis: The cash is increased by $ 80,000 &
the McBryan Equity is increased by the same
amount.
Debit / Credit Rules: Increase in assets is
recorded by debits; Increase in owner’s equity is
recorded by credits.
Owner’s Equity
Cash
1/11 80,000
3/11
52,000
1/11
80,000
5/11 6,000
Nov.3: Purchased land for cash $ 52,000
Analysis: The asset land is increase by $ 52,000
and the asset cash is decreased by $ 52,000
Debit / Credit Rule: Increase in assets are
recorded by debits; Decrease in assets is
recorded by credits.
Building
Land
1/11
5/11
36,000
52,000
Nov.5: Purchased building for $36,000, paid
cash $ 6000 & Notes Payable $ 3,000.
Analysis: the asset building is increased: Cash is
decreased & Notes Payable is increased.
Notes Payables
5/11 30,000
We see that equality of debits & credits is
maintained in all transactions. Now we do Trial
Balance to check the arithmetical accuracy of
ledger and to further ensure that equality of debit
& credit is maintained.
Overnight Auto Service
Trial Balance
On November 26, 2009
Debit
Credit
117,000
117,000
Cash
Accounts Receivables
Land Building
Tools & Machinery
Notes Payable Accounts
Payable
McBryan Capital
Trial Balance
Trial Balance is an internal document and not an
external document. Now if the total of two
columns agree, we say that we have done the
recording in the ledger correctly. From the
ledger, we prepare the Balance Sheet.
Types of Business
There are three main types of businesses: those
selling services (such as dry cleaners, auto
workshops, beauty saloons, airline companies
etc); those selling goods (such as food sellers,
automobile dealers etc);those manufacturing
goods (such as automobile manufactures, sugar
mills, textile mills etc).
A business entity is an economic unit which
enters into business transactions that must be
recorded, summarized and reported.
The entity (business organization) is regarded as
separate from its owner or owners; the entity
owns its own property; the entity has its own
debts.
The purpose of accounting is to provide useful
information about an organization (an entity) to
people who need such information but not about
the personal affairs of the owner or owners.
Forms of Business Organization
There are three main forms of business
organizations:
Sole Proprietorships
The simplest form of business organization “to
organize and operate "is a single or sole
proprietorship. This is the most common type of
ownership and is founded in businesses such as
small retail shops, service stations etc. This
unincorporated business, owned by one person,
is called a sole proprietorship. The owner is
personally responsible for the debts of the
business. If the business becomes insolvent,
creditors can force the owner to sell his or her
personal assets to pay the business debts.
The advantage is its simplicity whereas the
unlimited liability is a disadvantage to the owner.
Partnership
An incorporated business owned by two, or
more, persons voluntarily acting as partners (coworkers), who agree to share their property
and/or skills etc to operate the business is called
partnership. Like the sole proprietorship, a
partnership business is simple to organize. The
owners of a partnership are personally
responsible for all debts of the business.
Joint Stock Companies (Corporations)
This is the only type of business organization
recognized under the law as an entity separated
from its owners. Therefore the owners of a Joint
Stock Company are not personally responsible /
liable for the debts of the business. The owners
can loose no more than the amounts they have
invested in the business—a concept known as
limited liability. Because of this concept, the
corporations are the most attractive form of
business organizations to many investors.
Ownerships of a corporation is divided into
transferable shares of capital stock and the
owners are called stockholders. Stock certificates
are issued by the corporation to each stockholder
showing the number of shares that he or she
owns. The stockholders are free to sell some or
all of these shares to other investors at any time.
This transferability of ownership adds to the
attractiveness of the corporate form of
organization, because the investors can more
easily get their money out of the business.
Balance Sheet in case of Sole Proprietorship
Owner’s Equity
McBryan Capital
$ 80,000
Balance Sheet in case of Partnership
Partner’s Equity
McBryan Capital
$ 100.000
Smith Capital
80,000
Total Partner’s Capital
180,000
Balance Sheet in case of Corporation
Stockholder’s Equity
Capital Stock
80000 shares of $ 10 each
$ 800,000
Retained Earning
100,000
Total Shareholder’s Equity
980,000
Capital Stock
Capital Stock represents the amount that the
stockholders originally invested in the business
in exchange for shares of the company’s stock.
Retained Earning
Retained Earning represents the increase in
stockholder’s equity that has accumulated over
the years as a result of profitable operations.
Assignment-4
Assume that Michael McBrown, an experienced
auto engineer, opens his own automotive repair
business “Overnight Auto Service.” A distinctive
feature of overnight's operations is that all repair
work is done at night. This strategy offers
customers the convenience of dropping off their
cars in the evening and picking them up the
following morning.
McBryan started business on November 1,2008.
Following are the transactions:
Nov 1: McBryan started the business by
depositing $ 80,000 in a company’s bank
account.
Nov 3: Purchased Land for $ 5,2000 paying cash.
Nov 5: Purchased a building for $ 36,000 paying
$ 6,000 in cash and issuing a note payable
for the remaining $ 30,000.
Nov 17: Purchased tools & machinery on
accounts for $ 13,800.
Nov 20: Sold some of the tools & machinery on
accounts for $ 1,800.
Nov 25: Received cash $ 600 on account.
Nov 26: Paid cash on account $ 6,800.
Nov 30: Received cash $ 2,200 from customers
for repair service provided during the
month.
Nov 30: Paid cash $ 1400 for expense ($ 200 for
utilities & $ 1200 for salaries).
Develop a Balance Sheet showing the company’s
financial position, transaction wise.