FINANCIAL ACCOUNTING

Ref Book

Accounting By

Meigs, Williams, Haka, Bettner

Need and Importance of AccountingWe 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 AccountancyThe 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 OFUSERS

ECONOMIC OR BUSINESS ACTIVITIES

ACCOUNTINGSYSTEM REPORTING

DECISIONMAKING

USERS: Owners, Investors, Creditors, Managers, Agencies, Employees, Government,

•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 StatementsA 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 SheetEvery 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

Assets $

Cash 10,000Notes Receivables 20,000Accounts Receivables 30,000Suppliers 15,000Land 85,000Building 100,000Office Equipment 40,000

Total(Assets) 300,000

Liabilities & Owner’s equityLiabilities

$Notes Payable 25,000Accounts Payable 70,000Salaries Payable 5,000Total Liabilities 100,000

Owner’s EquityRehman’s Capital 200,000

Total(Liabilities & Owner’s 300,000

Equity)

Balance Sheet

Dec.31,2007

Income StatementThe 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 = $ 2200Expense = $ 1400Net Income = $ 800

ABC CompanyIncome Statement

For the month ended November 30, 2008

$ $Revenue Repair Service Revenue 2200Operating Expense Wages Expense 1200 Utilities Expense 200 1400Net Income 800

Statement of Cash Flows: This shows how cash position changed during the period.

Assets

Revenue/Operating Expenses

Capital / Loan

Operating Activities

InvestingActivities

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 CompanyStatement of Cash Flows

For the month ended Nov.30, 2007Cash flow from operating activities $ $ Cash received from sales revenue 2,200 Cash paid for expenses ( 1,400) Net cash provided by operating expenses 800Cash 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 16,600Balance of cash on Nov.1, 2007 0Balance cash on Nov.30, 2007 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 CycleCapturing Economic Events

Transaction is the starting point and producing the Financial Statements is the End point. In between there is an accounting process:

TRANSACTION JOURNAL LEDGER

TRIAL BALANCEFINANCIAL STATEMENYS

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

REVENUE & EXPENSE

BALANCE SHEET’s ACCOUNTS

INCOME STATEMENTACCOUNTS

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 DebitsDecreases are Recorded as Credits

Increases are Recorded as CreditsDecreases are Recorded as Debits

The JournalThe 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.

Date2008

Account Titles and explanation Debit Credit

Nov 1 Cash 80,000

McBryan Capital 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 13,800

Purchased Tool & Equipment on accounts

Date2008

Account Titles and explanation Debit Credit

Nov 20 Accounts Receivables 18,000

Tools & Equipment 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 6,800

Paid Cash on Accounts

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.

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.

Cash

80,000

Owner’s Equity

1/11 80,0003/11 52,0001/11

5/11 6,000

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.

Land

1/11 52,000

Building

5/11 36,000

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.

Notes Payables

5/11 30,000

Overnight Auto ServiceTrial Balance

On November 26, 2009Debit Credit

CashAccounts ReceivablesLand BuildingTools & MachineryNotes Payable Accounts PayableMcBryan Capital

117,000 117,000

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 BusinessThere 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 OrganizationThere are three main forms of business organizations:

Sole ProprietorshipsThe 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.

PartnershipAn incorporated business owned by two, or more, persons voluntarily acting as partners (co-workers), 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-4Assume 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.