Introduction to accounting

 

“Accounting is the art of recording, classifying and summarizing in a significant manner and terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the result thereof.”

 

Rules of Debit and Credit

1.      Personal Accounts – Accounts that show transactions with persons are called Personal Accounts. A separate account is kept in the name of each person to record the benefits received from or given to the person in the course of dealing with him. Personal Accounts also include accounts in the name of companies, firms or institutions.

Example for Personal Accounts – Radha A/c, Ravi A/c, SBI A/c, Raju & Sons A/c, ABC Finance Limited A/c etc.

Debit the receiver

Credit the giver

 2.      Real Accounts – Accounts related to assets and liabilities are called Real Accounts.

Examples for Real Accounts – Cash A/c, Bank A/c, Furniture A/c, Buildings A/c, Machinery A/c, Bills Payable A/c, Overdraft A/c etc.

Debit what comes in

Credit what goes out

3.      Nominal Accounts – Accounts related to expenses, incomes, losses and gains are called Nominal Accounts.

Examples for Nominal Accounts – Salaries A/c, Wages A/c, Rent A/c, Commission Received A/c, Interest Received A/c, Bad Debts A/c etc.

Debit all expenses and losses

Credit all incomes and gains

Reporting Period – 12-month period starting from 1st April and ends on 31st March.

 

At the end of each financial year, the balance of P&L A/c is transferred to the Retained Earnings A/c in the Balance Sheet (under equity). For each new financial year, a new P&L A/c is started.

 

Thus, Balance Sheet is continuous and P&L A/c is just for the current financial year.

 

Profit and Loss Statement (P&L)

The profit and loss (P&L) statement is a financial statement that summarizes the revenues, costs, and expenses incurred during a specified period, usually a fiscal quarter or year.

The P&L statement is synonymous with the income statement.

Items that appear in P&L Statement

Revenues – Amount earned through sale of goods or provision of services.

Expenses – Includes COGS (cost of goods sold), SG&A (Selling, General & Administrative expenses) and interest expenses.

Gains & Losses – Such as the sale of a non-current asset for an amount that is different from its book value

Net Income – Result of subtracting the company’s expenses and losses from the company’s revenues and gains.

è Corporations with shares of common stock that are publicly traded often refer to net income as earnings and their income statements must include earnings per share of common stock.

 

Income statement amounts are best calculated using the accrual basis of accounting. Under accrual basis the revenues are the amounts that were earned (not the cash received) and the expenses are the amounts that best match with the revenues or the amounts that were used up during the period (not the cash that was paid out).

 

Components of an Income Statement

The most common income statement items are;

·       Revenue/Sales

·       Cost of Goods Sold

·       Gross Profit

·       Marketing, Advertising and Promotion Expenses

·       Selling, General & Administrative Expenses (SG&A)

·       EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization)

·       Depreciation & Amortization Expense

·       Operating Income (or EBIT) (Earnings Before Interest and Taxes)

·       Interest

·       Other Expenses – Businesses often have expenses that are unique to their industry. Other expenses may include fulfilment, R&D (Research & Technology), SBC (Stock Based Compensation), impairment charges, technology, gains/losses on the sale of investments, foreign exchange impacts and many other expenses that are industry or company specific.

·       EBT (Pre-Tax Income) (Earnings Before Tax)

·       Income Taxes

·       Net Income

 

Balance Sheet

·       It shows a snapshot of a company’s net worth at a given point in time. It is a report that summarizes a company’s assets, liabilities and equity at a given point in time.

 

·       It is used by lenders, investors and creditors to estimate liquidity of a company.

 

·       Balance Sheet is stated as of the end of the reporting period.

 

·       Whereas, the income statement and cash flow statement cover the entire reporting period.

 

 

ACCOUNTING EQUATION

 (Assets = Liabilities + Owners’ capital)

è Assets – Tangible and Intangible Items of value which the business owns.

 

è Examples:

è Current Assets (shorter life span and easily transferable into cash) – Cash/cash equivalents, Receivables, Deposit accounts, Money orders, Cheques, Bank drafts, Marketable securities, Investments (short term), Inventory, Stock, Prepaid expenses

è Fixed Assets (for long-term use and unlikely to be converted into cash quickly) – Property, Plant, Equipment, Tools and machinery, Furniture, Investments (long-term)

è Tangible Assets (physical, material and financial resources of your business) – Cash, Stock, Buildings, Land, Office equipment, Machinery, Vehicles

è Intangible Assets (resources without material substance, but with clear business value) – Intellectual property, Trade secrets, Licences, Franchises, Reputation, Brand, Goodwill

 

è Liabilities – These are items owed by the business to bodies outside of the business.

 

è Examples:

è Current liabilities (due within the present accounting year) – bank overdrafts, accounts payable (e.g., payments to your suppliers), sales taxes, payroll taxes, income taxes, wages, short term loans, outstanding expenses

è Non-current liabilities (not due for settlement within one year during the normal course of business) A.K.A long-term liabilities – bonds payable, capital leases, mortgage debt, long-term borrowing, pension liabilities, deferred revenues and taxes, securities, such as stock shares or bonds, notes payable

è Owners’ Capital (A.K.A Shareholders’ Equity) – The money attributable to the business owners, i.e., it’s shareholders.

 

è Examples: Stock, additional paid-in capital, retained earnings and treasury stock.

è By rearranging the Accounting Equation, you can see that the owners’ capital is made of assets and liabilities.

Owners’ Capital = Total Assets – Total Liabilities

It can also be expressed as follows;

Owners’ Capital = Capital Invested by owner + Profits (Losses) to date (A.K.A Retained Earnings)

From above we can derive the following;

Total Assets – Total Liabilities = Capital + Retained Earnings

 

Retained Earnings – Retained Earning are the net earnings a company reinvests in the business or uses to pay off debt; the rest is distributed to the shareholders in the form of dividends.

 

Assets = Liabilities + Owners’ capital

The equation above has assets on one side and claims against the assets on the other side. These claims arise from

1.      Credit extended to the business (liabilities).

2.      Capital invested by owners in the business (owners’ capital).

The claims of liabilities have priority for payment over the claims of owners.

Let’s say that company has Rs. 20 crores worth of assets. Now let’s assume that the company’s creditors supplied Rs. 11 crores of its total assets, then the remaining Rs. 9 crores is the owner’s capital.

In Business Accounting, both assets and sources of assets are accounted for, which leads to a double entry system of accounting.

 

Let’s analyse some accounting equations to see what we can take away from them

 

1. Rs. 23,50,000 Assets = Rs. 50,000 Liabilities + Rs. 23,00,000 Owners’ capital

The equation balances but the size of the liabilities is very small compared to the assets. This isn’t common in business. Usually, the liabilities are a larger percentage of its total assets.

 

2. Rs. 47,00,000 Assets = Rs. 43,00,000 Liabilities + Rs. Rs. 4,00,000 Owners’ capital

This equation balances but you should notice that the business is highly leveraged, which means that the ratio of debt to capital (liabilities divided by owners’ capital) is very high. It’s more than 10 to 1. This ratio is quite unusual.

(43,00,000/4,00,000 = 10.75)

 

3. Rs. 26,450 Assets = Rs. 6,75,000 Liabilities – Rs. 6,48,550 Owners’ capital

This equation balances, but the business has a huge negative owners’ capital. Such a huge negative amount of owners’ capital means the business has suffered major losses that have wiped out almost all its assets. You wouldn’t want to be one of this business’s creditors (or one of its owners).

 

4. Rs. 4,50,000 Assets = Rs. 2,00,000 Liabilities + Rs. 2,00,000 Owners’ capital

This equation doesn’t balance.

The Liabilities, owner’s capital or some combination of both is Rs. 50,000 too low

or

The two items on the right-hand side may be correct, in which case total assets are overstated Rs. 50,000.

In the case of an unbalanced equation such as this one, the accountant definitely needs to find the errors and make appropriate correcting entries.

 

We present the accounting equation in this way à (Assets – Liabilities = Owners’ capital) à when the purpose is to emphasise the net worth of a business.

 

Financial Ratios

Ratio analysis is used for determining financial health of an business in terms of its profitability, liquidity, solvency and capital adequacy.

Liquidity Ratios

These ratios measure a company’s ability to meet its short-term debts and obligations.

Profitability Ratios
These ratios measure profitability and financial performance. They give insight into how well an entity is using its resources to generate profit.

Leverage/Capital Structure Ratios
These ratios provide information on capital structure of a company. And also, the financial leverage used by a company.

Coverage Ratios
A company’s ability to meet its fixed debt obligations.

Operating Performance Ratios
These ratios measure overall operating performance of a company. It also helps to ascertain how well resources are being used by the management to increase stakeholders worth.

Capital Market Ratios
These are ratios that are used by investors and analysts to estimate potential and value of shares of a company. They have direct impact on investment decisions.

Working Capital = Current Assets – Current Liabilities

Small Concerns -> Transactions -> Journal -> Ledger -> Trial Balance -> Trading, P&L A/c -> Balance Sheet

 

Large Concerns -> Transactions -> Subsidiary Books -> Ledger -> Trial Balance -> Trading, P&L A/c -> Balance Sheet

 

Journal – It is the book of original entry or first entry or primary entry. It is a complete and chronological record of business transactions. It is recorded in a systematic manner. In case of a small business, all transactions are first recorded in a single Journal because the transactions are so limited in number.

 

Ledger – A Ledger Account is an item either in the P&L A/C and the Balance Sheet. A ledger account is either an asset, liability, equity, income or expense. A ledger helps to knows whether a particular account is showing debit or credit balance. It is the final and permanent record of all transactions. Thus, the ledger is called the main book of accounts. The process of transferring entries from Journal to Ledger is called Posting.

 

Trial Balance – It is a list of all the ledger accounts of a business. However, only the balances of these ledger accounts are shown in the Trial Balance. Debit Balances are shown as positive numbers and credit balances are shown as negative numbers. Thus, the Trial Balance should always be equal to zero.

 

Subsidiary Books – In the case of big businesses, the transactions are numerous so it is inconvenient to use a single Journal to record them all.

Therefore, we use smaller account books known as subsidiary books or subsidiary journals. These books are distributed across various sections of the business.

The original journal, i.e., the Journal Proper, is used only when a transaction cannot be recorded in any of the subsidiary books.

Types of Subsidiary Books – Purchases Book, Sales Book, Purchase Returns Book, Sales Return Book, Cash Book, Bills Receivable Book, Bills Payable Book and Journal Proper.

 

Cash Book – All transactions, whether cash or credit are settled in the form of cash payment or cash receipt at some point. So, all transactions eventually end up in the Cash Book.

Cash Book records receipts on left hand side & payments on right hand side.

The Receipts side is called the Debit Side (Receipt means cash is coming in – “DEBIT WHAT COMES IN”).

The Payments is called the Credit Side (Payment means cash is going out – “CREDIT WHAT GOES OUT”).

Types of Cash Book – Simple Cash Book, Double Column Cash Book, Three Column Cash Book, Petty Cash Book

 

Capital and Revenue Expenditures and Receipts

Capital Expenditure – It is the expenditure that contributes to the earning capacity of a business over more than one accounting period.

Revenue Expenditure – It is the expenditure that is incurred to generate revenue for a particular accounting period.

Deferred Revenue Expenditures – It is that expenditure for which payment has been made or a liability incurred but which is carried forward (c/f) on the presumption that it will be of benefit over a subsequent period or periods.

Revenue Receipts – Receipts which are obtained in the course of normal business activities are revenue receipts (e.g., receipts from sale of goods or services, interest income etc).

Capital Receipts – Receipts which are not revenue in nature are capital receipts (e.g., receipts from sale of fixed assets or investments, secured or unsecured loans, owners’ contributions etc).

 

Contingent Assets and Contingent Liabilities

Contingent Assets – A contingent asset may be defined as a possible asset that arises from past events and whose existence will be confirmed only after occurrence or non-occurrence of one or more uncertain future events that are not wholly within the control of the enterprise.

Contingent Liabilities – A contingent liability may be defined as a possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events that are not wholly within the control of the enterprise.

 

Rectification of Errors – Unintentional omission or commission of amounts and accounts in the process of recording the transactions are commonly known as errors.

These errors can happen at any stage.

It may happen -

1.      When you’re collecting financial information/data.

2.      When you’re recording this information/data.

3.      Mathematical mistakes.

4.      Mistakes in applying accounting policies.

5.      Misinterpretation of facts.

6.      Oversight

A Trial Balance is prepared to check the arithmetical accuracy of the Journal and Ledger accounts. If we are unable to tally the trial balance, it means that there are errors in the accounts which need to be rectified.

Some errors may affect the Trial Balance and some don’t. Although the errors that don’t have an impact on Trial Balance may affect the determination of P&L or Assets & Liabilities of the business. So, keep that in mind.

 

Bank Reconciliation Statement

A business makes numerous payments and gets a lot of receipts every day. So, to deal with this, a business opens a current account with a bank. When the current account has been opened, the bank gives the business a passbook.

This passbook records the transactions of the business with the bank. This passbook is written and updated by the bank.

The business records it’s transactions with the bank in a Bank A/c opened in the ledger or in the bank column of his cash book.

Sometimes, disagreements between Business’s Cash Book and Bank’s Passbook may arise because of some mistake or due to time-lag between the entries made by the bank in the Passbook and the entries made by the business in it’s Cash Book.

So, a statement called the Bank Reconciliation Statement is prepared to reconcile the difference in the balances shown by the Cash Book and Passbook.

 

Inventories – Inventory is generally second largest item after fixed assets in the financial statements, particularly in the case of manufacturing organizations.

The term inventory includes 3 components, i.e., raw materials, semi-finished goods (work-in-progress) and finished goods. Inventory (these 3 components) comprises a significant portion of the current assets.

(Accounting Standard – 2) Inventories are a tangible property:

1.      Held for sale in the ordinary course of business.

2.      In the process of production for such sale, or

3.      To be consumed in the production of goods or services for sale.

The value that is attached to inventories can materially affect the operating results and financial position of an enterprise. Also, different businesses use different methods of inventory valuation.

 

Depreciation Accounting – Cost of a fixed asset is nothing but the price paid for a series of future services that can be rendered by said fixed asset. It is necessary to spread it’s cost over a number of years during which benefit of the asset is received. This process of spreading cost is called Depreciation. Thus, depreciation is the gradual decrease in the value of an asset.

 Methods of providing depreciation:

1.      Fixed Instalments Method (A.K.A Straight-Line Method) (A.K.A Original Cost Method)

2.      Diminishing Balances Method (A.K.A Reducing Instalment Method)

3.      Annuity Method

4.      Depreciation Fund (A.K.A Sinking Fund Method)

5.      Insurance Policy Method

6.      Sum of Digits Method

7.      Depletion Method

8.      Revaluation Method

9.      Machine Hour Rate Method

10.  Mileage Method

 

Consignment – When a manufacturer or a wholesaler wants to sell goods in far away places, they send their goods to agents and ask them to sell these goods on their behalf. The person sending goods is the consignor and the person or agent selling the goods on their behalf is called the consignee. This is called a consignment business where goods are sent on consignment by the consignor to the consignee.

 

Joint Ventures – A joint venture is an association of two or more than two persons who come together for the execution of a specific transaction and then divide the profit or loss thereof in the agreed ratio.

There is a slight difference between partnership and joint venture. According to Indian Partnership Act, partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all. Thus, both in case of joint venture and partnership there is some business activity, the profit or loss of which is agreed to be shared by two or more persons. In fact, joint venture is also a type of partnership.

The main difference between these two is that joint venture is limited to an activity taken up by the co-venturers, whereas the partnership is a continuous activity. Thus, joint venture can be called as ‘temporary partnership’ or ‘partnership for a specific venture’ or ‘particular partnership’.

 

Bills of Exchange – Section 5 of the Negotiable Instruments Act defines a Bill of Exchange as, “an instrument in writing containing an unconditional order, signed by the maker, directing a certain person, to pay a certain sum of money only to, or to the bearer of a certain person or to the bearer of the instrument.”

Important terms in Bills of Exchange –

1.      Drawer

2.      Drawee/Acceptor

3.      Payee

4.      Holder

5.      Holder in due course

6.      Endorsement

7.      Maturity of bill

8.      Dishonour

9.      Noting

10.  Retiring of a bill

11.  Renewal of bill

12.  Discounting the bill

13.  Promissory note

 

Sale of Goods on Approval or Return Basis – Goods are sent to the customers on sale or approval basis to push up sales or for introducing a new product in the market.

Goods sent on 'approval' or 'on sale or return' basis mean the delivery of the goods to the customers with the option to retain or return them within a specified period.

Generally, these transactions take place between a manufacturer (or a wholesaler) and a retailer.

The goods are transferred from the wholesaler to the retailer under a sale or return basis.

This only implies a change in the possession of goods and not the transfer of the ownership of goods.

The ownership is passed only when the retailer gives his approval or if the goods are not returned within that specified period.

The retailer (customer) does not incur any liability when the goods are merely sent to him.

As per the definition given under the Sale of Goods Act, 1930, in respect of such goods, the sale will take place or the property in the goods pass to the buyer:

(1) When he signifies his approval or acceptance to the seller

(2) When he does some act adopting the transaction

(3) If he does not signify his approval or acceptance to the seller but retains the goods without giving notice of rejection, on the expiry of the specified time (if a time has been fixed) or on the expiry of a reasonable time (if no time has been fixed).

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