FinancialAccounting_VK

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Financial AccountingJanuary 31, 2013

L&T MDC

Vivek Krishnamoorthy


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Understanding forms of businessorganization

Understanding accounting

Structure and components of financialstatements

Todays Agenda


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When an individual or group of individualsdecide to start a business, what factors wouldthey consider?

Risk Appetite of the owner Scale of operations Amount of Capital Owners desire for control

Starting a business


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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 areearned

She contributes the capital required

She has residual claims on the profits

She has unlimited liability

Taking a step back


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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 theprovisions 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 entitiescontd.


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3. Limited Liability Company An LLC is a business enterprise that is an association

of a large number of entities who contribute towardsthe capital for business purposes

Capital contribution in the form of shares theyretherefore called shareholders

The owners are not involved directly in themanagement 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 equityholders cannot be used to fulfill the business debts

Types of business entitiescontd.


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Limited Liability Company

In LLCs, each shareholder does not have theprivilege of managing the business like inpartnerships

Shareholders collectively appoint a team of

directors called the Board of DirectorsThis BoD is responsible for managing the

business affairs on behalf of the shareholdersThe equity shareholders have residual claims

on the profits and assets of the company


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In a limited liability company, capital is broadlyspeaking 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 retainedearnings is collectively called net-worth

Capital of a firm The backbone


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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 higherpriority than shareholders

Capital of a firmcontd


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Due to separation of ownership and management in anLLC, it becomes necessary for the company to have asystem of apprising the owners of the performance ofthe 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

Corporate Financial Reporting


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Objectives of FinancialReporting Financial statements/annual reports are

multi-utility documents 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 willaccrue based on the financial performance


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Why does a business exist? To create value

Accounting exists because decision makersneed information for decision making (tocreate value)

Why does Accounting exist?


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Types of AccountingFinancial Accounting Management Accounting Cost Accounting

To provide reporting to owners,creditors, tax authorities,prospective investors

For internal reporting at topmanagerial levels fordecision-making

To facilitate cost estimation,cost control and costmanagement. Forlower/middle levelmanagement

Compulsory for every form of

business organization

Not compulsory Not compulsory, however for

big factories/businesses, it isAll monetary transactions arerecorded

Only product/process/se-rvice related transactionsare recorded

Costing records aremaintained as per accountingconventions/systems

Generally, annual reportingsystem is adopted. Sometimesquarterly/half-yearly.

Reporting is done accordingto need ofdepartment/situation.

Sometimes daily/weeklyalso.

Similar to managementaccounting

Historical in nature as onlyhistorical data is present

Historical as well as futureoriented, estimates aremade for forecasting thefuture of business

-


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

for

Decision Making Value creation Control Purposes - Monitoring

What is Accounting?

Information


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Business transactions are the object ofmeasurement

Business transactions are economic eventsthat affect the financial position of abusiness entity Transactions are the raw material of accounting

reports

Transactions must relate directly to a business

entity

What is measured?


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Source Documents

Information

PurchaseInvoice

Bank AccountStatements

ShippingDocuments

Cheques

Sales Invoice

Payroll RecordsReceiving

documents


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Outputs of the measurementprocessThe Financial Statements

Income Statement

Balance Sheet

Cash Flow Statement


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Owners

Equity

LiabilitiesAssets

Economic events are the basis for recordingtransactions in an accounting system

For every transaction, it is essential to analyze its

effect on the accounting equation.

The Accounting Equation

A = L + OE

The Recording System


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An economic event/transaction always hasa dual effect on the basic accountingequation

The double-entry system is the accountingprocess of recording this dual effect

Double Entry System


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A =

Assets are the rights or resources withexpected future benefits for an entity

Examples: Cash

Accounts Receivable Buildings, machinery, equipment

Office supplies

Assets

Assets


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L =

Liabilities are obligations to providers ofgoods and services to the business

Examples: Bank Loans

Interest Payable Salaries Payable

Liabilities

Liabilities


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Owners Equity =

Assets = Liabilities + Owners Equity

A = L + OEOE = A L

Owners equity is the obligation to transferresidual resources to owners when thebusiness ceases.

OwnersEquity


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Four types of transactions affect Owners Equity

Increases Decreases

Owners Owners

Investments Withdrawals

OE

Revenues Expenses

A = L + OE


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OwnersEquity

LiabilitiesAssets

The accounting equation must remain balancedafter each transaction

Principles of Transaction Analysis


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1. Selva invests INR 10,000 of his savings inthe new company

2. He rents a boat and pays rent of INR 1000

3.

He purchases fish nets for INR 4,200 withcash.

4. He purchases a second hand boat for INR3,000. Pays INR 1,500 in cash and agrees

to pay the rest next month

Transaction Analysis


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5. He purchases fish feed for INR 1,800 andstorage buckets for INR 800 from MustafaSuppliers on credit

6. He pays INR 1,000 to Mustafa Suppliers

7. He pays INR 480 for a one-year insurancepolicy with cash

8. He sells fish for INR 1,400 in theneighbourhood market

9. He sells fish for a total of INR 2,800 to a three-star restaurant. Money to be collected nextmonth.

Transaction Analysis contd.


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10. He accepts INR 1,000 for the two lobstersthat have to be supplied later that month

11. He pays his assistant two weeks wages ofINR 600

12. He receives and pays utility bill of INR 100

13. He receives (but has not paid) a mobile billof INR 70

14. He is running short of cash for somepersonal expense he has to incur, andwithdraws INR 1,000 for it

Transaction AnalysisContd.


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Excel Sheet

Transaction Analysis ASummary


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Note that the accounting equation ALWAYSremains in balance after each transaction


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Separate Entity Assumption

This implies that the entity of owner and that ofthe business organization are considered

separate from each otherThere 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 businessorganization

Assumptions underlying accountingmeasurement and recording


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This implies that once a business hasstarted, the owner will continue to run it foran infinitely long period of time

This assumptions helps in the classificationof different assets into fixed and currentassets

Going Concern Assumption


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Financial accounting is a mechanism forrecording only historical monetarytransactions in the books of accounts

All transactions are recorded therefore atthe cost, irrespective of market price/value

of the transaction

Cost Assumption


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Purpose of accounting is to calculateprofit/loss and make as far as possible thecorrect presentation of assets and liabilitiesin the books of accounts

The economic life of a business is dividedinto artificial time periods

Accounting Period Assumption


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Only transactions that capable of beingexpressed in terms of money should beincluded in the accounting records of theeconomic entity

Monetary Unit Assumption


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This dictates that revenue be recognized inthe accounting period in which it is earned

It is considered earned when the servicehas been provided or the goods have beendelivered

Revenue Recognition Concept


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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 thesame period

Matching Concept


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This concept implies that the final accountsshould incorporate expenses and revenuethat is relevant for the current accountingyear whether settled in cash or not

Accordingly adjustments are made foroutstanding expenses, prepaid expense,

unearned income and accrued income

Accrual Concept


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These are certain accounting policies andprocedures that are followed in a businessorganization

Different from accountingconcepts/assumptions in the sense thatthey might not be followed as universally as

accounting concepts are followed

Accounting Conventions


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It implies that an accountant should foreseefuture losses and provide for such losses inthe book of accounts

She should nor anticipate and provide forexpected/future profits in the books ofaccounts

Conservatism


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Once an accounting policy or procedure isadopted, it should be followed continuouslyfor a long time period without anysignificant change

Consistency


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Circumstances and events that make adifference to financial statement usersshould be disclosed

Full Disclosure


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Information is material if its omission ormisstatement could influence the economicdecision of users taken on the basis of thefinancial statements.

Materiality depends on the size of the itemor error judged in the particularcircumstances of its omission ormisstatement.

Materiality
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Decision_theoryhttp://en.wikipedia.org/wiki/Decision_theoryhttp://en.wikipedia.org/wiki/Economics


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Thank You!