Accounting

Finance for Non-Finance Professionals Accounting Fundamentals 1. ACCOUNTING FUNDAMENTALS Accounting Defined Accounting has been defined by the American Institute of Certified Public Accountants, as “The art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof” Books of Account Accounting transactions are recorded in a set of books. The following are referred to as the principal books of account: 1) Journal: The Journal contains details of transactions (other than those relating to receipts or payments in cash or through bank), recorded in chronological order. Date Particulars L/F Debit (Rs.) Credit (Rs.) Journal 2) Ledger: The Ledger contains separate accounts for every type of income, expense, asset, liability and every person/ organisation with whom any transactions have taken place. An account is a summary of all transactions taking place under that head. Dr. Date Particulars J/F Amount (Rs.) Date Particulars J/F Cr. Amount (Rs.) Ledger 3) Cash and Bank Book: The Cash and Bank Book combines the features of the Journal and Ledger, and records transactions involving receipts or payments in cash or through bank. Dr. Date Particulars L/F Cash (Rs.) Bank (Rs.) Date Particulars L/F Cash (Rs.) Cr. Bank (Rs.) Cash and Bank Book -1- Finance for Non-Finance Professionals Accounting Fundamentals General and Subsidiary Ledgers Most large organisations maintain separate Ledgers and Cash and Bank Books for different types of transactions. For example, the Ledger may be split into General Ledger, Customers’ Ledger (Accounts Receivable) and Suppliers’ Ledger (Accounts Payable), and separate books may be maintained for Cash and each Bank Account instead of the Cash and Bank Book. Subsidiary Books Generally, a set of subsidiary books is also maintained. Subsidiary books are registers in which frequently occurring transactions are recorded, such as the Purchase Register, Sales Register and Petty Cash Book. The totals of transactions recorded in the subsidiary books are periodically posted to the principal books. Voucher Each accounting entry has an underlying document – called ‘Voucher’ in accounting terminology – in support of its validity. The term ‘Books of Account’ generally includes the primary and subsidiary books, as well as the vouchers. Voucher No.: Date: Particulars Debit (Rs.) Credit (Rs.) TOTAL Prepared by: Authorised by: Voucher (General Format) Types of Accounts Accounts are classified into: • • • Personal – relating to an individual or firm Nominal – relating to a head of income or expenditure Real – relating to an asset or a liability Chart of Accounts The Chart of Accounts is a list of all accounts created in the ledger of the entity, arranged under the following four principal groups: • • • • Liabilities Assets Income Expenditure Each of the groups has several sub-groups and every such sub-group either has accounts or sub-groups as its sub-units, forming a tree structure. -2- Finance for Non-Finance Professionals Debit and Credit Accounting Fundamentals All amounts recorded in the books of account are placed either to the debit or credit of an account. For any transaction, which account(s) should be debited and which should be credited is determined by the following rule: DEBIT what comes in, CREDIT what goes out DEBIT the receiver, CREDIT the giver DEBIT all expenses and losses, CREDIT all incomes and gains The implications of amounts being placed to the debit or credit of an account are as follows: Type of Account Debit a) Personal b) Income/ Expenditure c) Asset/ Liability The individual/ firm has received some money or other tangible benefit An expense or a loss has been incurred An asset has been acquired or a liability has been paid/ reduced Implication Credit The individual/ firm has given some money or other tangible benefit An income or a profit has been earned An asset has been disposed or a liability has been incurred Accounting Systems Two systems exist for recording accounting transactions, viz.: 1) Single Entry System Under this system, only one aspect of each transaction is recorded. This is not a scientific method of accounting and is prone to error and manipulation. 2) Double Entry System Under this system, both aspects of each transaction are recorded, ensuring that the sum of all debits is equal to the sum of all credits. This is the most scientific method of accounting and reduces the occurrence of errors and scope for manipulation. In either case, the books of account may be maintained either on cash basis (i.e. transactions are recorded only when money is actually received or paid) or on accrual basis (i.e. transactions are recorded when the income or expense accrues, irrespective of the time of actual receipt or payment of the money). The Companies Act, 1956 requires all companies to maintain books of account under the Double Entry System on accrual basis. Partnership firms and individuals have the option to follow either system. Capital and Revenue Expenditure Capital Expenditure is that expenditure which results in the acquisition of an asset (tangible or intangible) which can later be sold or which results in an increase in the earning capacity of a business. Expenditure incurred on acquisition of fixed assets is in the nature of Capital Expenditure. Items of expenditure whose benefit expires within the year or expenditure incurred for maintaining the business or keeping the assets in good working condition are referred to as Revenue Expenditure. Wages, salaries, electricity, etc. are items of Revenue Expenditure. However, certain expenses – such as expenses on formation of the company, the cost of issuing shares and debentures, etc. – although apparently revenue in nature, provide an enduring benefit. Such expenses are classified as Deferred Revenue Expenses. The classification of expenditure into capital and revenue expenditure is required in order to apply the Matching Concept. The general accounting treatment of capital and revenue expenses is as follows: Capital Expenditure The expenditure incurred is shown as an asset on the Balance Sheet. The asset is depreciated over its useful life, and the amount of depreciation debited to the Profit and Loss Account -3- Finance for Non-Finance Professionals Revenue Expenditure Deferred Revenue Expenditure Accounting Fundamentals The expenditure is debited to the Profit and Loss Account in the year it is incurred The expenditure is shown as an asset and debited to ythe Profit and Loss Account in annual instalments over the period for which it provides a benefit Financial Statements At the end of the reporting period – which is generally one year – the accounting transactions for the entire period are summarised into a few statements. The major Financial Statements are: 1) Balance Sheet: Statement of Assets and Liabilities as on a particular date, indicating the financial position of an entity at a given point of time. 2) Profit and Loss Account: Statement of Income and Expenditure for the reporting period, indicating the financial performance of the entity during the reporting period. Purpose of Financial Statements To inform the following persons of the financial performance and position of the entity: 1) Management – for reviewing their performance during the reporting period 2) Shareholders – for assessing the worth of their investments and reviewing the effectiveness of the Management 3) Investors – for judging the worth of the entity before deciding to invest 4) Suppliers and Lenders – for judging the creditworthiness of the entity before deciding to extend credit 5) Government – for calculating the amount of tax to be collected Accounting Concepts To ensure uniformity in preparation of accounts across entities, the following concepts are applied when recording accounting transactions: 1) Business Entity Concept: The business for which accounts are maintained is treated as an entity distinct from its owners and managers. 2) Money Measurement Concept: All transactions affecting the business are stated in money terms and recorded in the Books of Account. 3) Dual Aspect Concept: Every transaction has two aspects – a ‘debit’ and a ‘credit’ – and the sum of all debits will equal the sum of all credits. For example, when an asset is acquired, one of the following events will also take place: • another asset is forgone • a liability (obligation to pay) is undertaken • a profit has been earned 4) Cost Concept: Transactions are recorded at the actual cost. 5) Going Concern Concept: At the time of recording the transactions, it is assumed that the entity will continue to remain in business for as long as can be foreseen. 6) Accrual Concept: Income is recorded when goods are supplied or a service is rendered, even though the money may be received later; expenditure is recorded when goods are procured or a service is availed, even though the money may be paid later. 7) Realisation Concept: Transactions are recorded only when they occur and not in anticipation of their occurrence. 8) Matching Concept: Income and expenses for a period are correlated to ensure that the accounts project an accurate picture. Therefore: • when an income is recorded, all expenses incurred to earn that income must be recorded. • related income and expenditure must be recorded during the same reporting period. Accounting Conventions To make the information contained in financial statements clear and meaningful, they are drawn up according to the following conventions: -4- Finance for Non-Finance Professionals Accounting Fundamentals 1) Consistency: Accounting practices should remain the same from year to year. 2) Disclosure: All information which is essential for fully understanding the financial statements should be disclosed in addition to the information required to be disclosed by law. 3) Conservatism: Financial statements should be drawn up on a conservative basis – i.e. anticipated income should not be recorded whereas likely losses should be provided for. Accounting Process After each transaction Transaction  Recording in Subsidiary Book (if applicable)  Generation of Voucher  Recording in Journal/ Cash and Bank Book  Posting into Ledger At the end of the year Balancing of Ledger/ Cash and Bank Book  Generation of Trial Balance  Adjustments and Finalisation Entries  Compilation of Profit & Loss Account and Balance Sheet -5- Finance for Non-Finance Professionals Balance Sheet Preparation 2. BALANCE SHEET PREPARATION (in the context of the requirements of the Companies Act, 1956) Balancing of Ledger At the end of the year, the balance in each ledger account is determined by totalling the debit and credit sides of the account and calculating the difference. The difference is the ‘balance’ in the account, which is then posted on the side which has a smaller total. This process is called balancing. Generation of Trial Balance The Trial Balance is a statement showing the balance in each account as on a particular date. It is generated by listing all the accounts in the Ledger with the balance in each account appearing against its name. Under the Double Entry System of Accounting, the totals of the Debit and Credit side of the Trial Balance will always be equal. Fictitious Limited Trial Balance Sheet as at 31st March 1998 Sr. Name of the Account L/F Debit (Rs.) Credit (Rs.) TOTAL Trial Balance Adjustments and Finalisation Entries Following are some adjustments to be made/entries to be passed at the time of finalising the accounts: 1. 2. 3. 4. 5. 6. 7. 8. Determination of income and expenses not relating to current year Calculation of Depreciation on Fixed Assets and amount of Deferred Revenue Expenses to be amortised Calculation of Provisions to be made for doubtful debts Calculation of Provision for Taxation Valuation of Closing Stock Calculation of Dividend and tax thereon Adjustments relating to prior years Journal Entry for transfer of all current income to the credit of the Profit and Loss Account, and all current expenditure to the debit of the Profit and Loss Account Compilation of the Profit and Loss Account and the Balance Sheet The Profit and Loss Account is constructed by simply posting all items of income and expense from the finalisation journal entry. The current year’s profit is determined by balancing the account and carried down to the appropriation section of the P&L Account. Entries for appropriations made out of the profit are posted in this section. All balances remaining in any ledger account after the P&L Account is drawn up are listed in the Balance Sheet. Generally, the assets and liabilities are stated in decreasing order of permanence. -6- Finance for Non-Finance Professionals Balance Sheet Preparation Fictitious Limited Profit and Loss Account for the year ended 31st March Dr. Particulars To Opening Stock of Finished Goods To Raw Materials Consumed To Wages and Salaries To Administrative Expenses To Interest and Bank Charges To Sales and Distribution Expenses To Provision for Doubtful Debts To Depreciation To Provision for Taxation To Net Profit c/d Total To Balance b/f To Net Loss for the year b/d To Prior Years’ Adjustments To Transfer to Reserves To Proposed Dividend To Tax on Proposed Dividend To Balance c/f Total 1998 (Rs.) 1997 (Rs.) Particulars By Sales By Interest Earned By Other Income By Closing Stock of Finished Goods By Net Loss c/d 1998 (Rs.) Cr. 1997 (Rs.) Total By Balance b/f By Net Profit for the year b/d By Prior Years’ Adjustments By Balance c/f Total Profit and Loss Account - ‘T’ Format -7- Finance for Non-Finance Professionals Balance Sheet Preparation Fictitious Limited Balance Sheet as at 31st March LIABILITIES Share Capital - Equity Share Capital - Preference Share Capital Reserves and Surplus - General Reserve - Profit and Loss Account 1998 (Rs.) 1997 (Rs.) ASSETS Fixed Assets Gross Block Less: Depreciation Net Block Capital Work-in-Progress Investments Government Securities Shares Debentures Current Assets, Loans and Advances - Inventory - Sundry Debtors - Cash and Bank Balance - Other Current Assets - Loans and Advances 1998 (Rs.) 1997 (Rs.) Secured Loans Unsecured Loans Current Liabilities and Provisions - Sundry Creditors - Outstanding Expenses - Provision for Tax Miscellaneous Expenses (to the extent not written off or adjusted) Profit and Loss Account Contingent Liabilities: Balance Sheet - ‘T’ Format -8- Finance for Non-Finance Professionals Balance Sheet Preparation Fictitious Limited Profit and Loss Account for the year ended 31st March PARTICULARS INCOME Sales Interest Earned Other Income TOTAL INCOME EXPENDITURE Raw Materials Consumed Cost of Finished Goods sold Wages and Salaries Administrative Expenses Interest and Bank Charges Sales and Distribution Expenses Provision for Doubtful Debts Depreciation Provision for Taxation TOTAL EXPENSES Net Profit/Loss for the year Add: Balance brought forward from previous years Add/(Less): Prior Years’ adjustment Amount available for appropriation Appropriations: Dividend for the year Transfer to Reserves Balance carried forward Total Appropriations 1998 (Rs.) 1997 (Rs.) Profit and Loss Account - Vertical Format (Income Statement) -9- Finance for Non-Finance Professionals Balance Sheet Preparation Fictitious Limited Balance Sheet as at 31st March PARTICULARS SOURCES OF FUNDS Shareholders’ Funds Share Capital - Equity Share Capital - Preference Share Capital Reserves and Surplus - General Reserve - Profit and Loss Account Loan Funds Secured Loans Unsecured Loans TOTAL SOURCES APPLICATION OF FUNDS Fixed Assets Gross Block Less: Depreciation Net Block Capital Work-in-Progress Investments Government Securities Shares Debentures Current Assets, Loans and Advances - Inventory - Sundry Debtors - Cash and Bank Balances - Other Current Assets - Loans and Advances Less: Current Liabilities and Provisions - Sundry Creditors - Outstanding Expenses - Provision for Tax Net Current Assets Miscellaneous Expenses (to the extent not written off or adjusted) Profit and Loss Account TOTAL APPLICATION Sche dule 1998 (Rs.) 1997 (Rs.) Balance Sheet - Vertical Format - 10 - Finance for Non-Finance Professionals Requirements of the Companies Act, 1956 Balance Sheet Preparation Following is a gist of the provisions of the Companies Act, 1956 relating to the maintenance of accounts by companies: 1. Every company must keep books of account giving details of: 1. money received and spent by the company 1. sales and purchases of goods by the company 1. assets and liabilities of the company 1. cost records in case of companies manufacturing notified products Accounts must be maintained such that they give a true and fair view of the state of affairs of the company. Accounts must be maintained on accrual basis and according to the double entry system of accounting. Books of accounts and vouchers must be preserved for eight years. The Balance Sheet must be drawn up at the end of the financial year according to the format prescribed in Schedule VI Part IA (horizontal format) or Part IB (vertical format) of the Act, and must also disclose: 1. details of utilisation of Share Premium 1. gross value of assets and accumulated depreciation 1. free reserves net of debit balance in Profit and Loss Account 1. Loans and Advances due from companies under the same management 1. details of investments in each company (statement to be attached to the Balance Sheet) 1. balances due from directors The Profit and Loss Account must comply with the requirements of Part II of Schedule VI of the Act and must disclose: 1. details of non-recurring or exceptional transactions 1. commission paid to sole selling and other selling agents 1. in case of a manufacturing company, the value of raw materials consumed and the opening and closing stocks of goods produced, and in case of a trading company, the purchases made and opening and closing stocks of goods 1. the value of work-in-progress at the beginning and the end of the reporting period 1. depreciation on fixed assets 1. interest on debentures and loans, stating separately the interest paid to directors 1. provision for income tax 1. amounts transferred to and from reserves 1. provisions made for meeting specific liabilities 1. expenditure incurred on certain items 1. income from investments and other sources 1. dividend paid and proposed to be paid 1. impact of changes in accounting policies 1. amounts paid as salaries, commission, reimbursement of expenses, etc. to Directors 1. amounts paid to the auditors 1. 1. 1. 1. 1. 1. - 11 - Finance for Non-Finance Professionals Financial Analysis Techniques 3. OVERVIEW OF FINANCIAL ANALYSIS TECHNIQUES Financial Analysis Techniques Ratio Analysis and Funds Flow Analysis are the two most widely-used techniques for analysing the financial position of businesses. Ratio Analysis A ratio is one quantity expressed as a proportion of another. Ratio Analysis is a simple and effective method of understanding some crucial facts about a firm’s operations and financial situation – viz. debt burden, operating efficiency and profitability. Ratios are computed from financial statements and may be used for inter-firm or inter-period comparison. The ratios used in analysing the financial position of a company are classified into four types: 1. 1. Liquidity Ratios measure the firm’s ability to fulfil short-term commitments out of its liquid assets. Assets are ‘liquid’ if they are either cash or relatively easy to convert into cash. 1. 1. 1. 1. 1. 1. 1. 1. 1. Current Ratio 1. 1. Current Assets Current Liabilities Current Assets are relatively liquid (i.e. they can be converted into cash in a relatively short time period) and Current Liabilities are those liabilities which are due within one year. Quick Ratio or Acid Test Ratio Current Assets-Inventory Current Liabilities The Quick Ratio measures the firm’s ability to meet short-term obligations from its most liquid assets. In this case, inventory is not included with other current assets because it is generally far less liquid than the other current assets. 2) Leverage Ratios measure the extent of the firm’s total debt burden. They reflect the firm’s ability to meet its short- and long-term debt obligations 1. Debt to Total Assets Ratio Total External Liabilities Total Assets The Debt to Total Assets Ratio indicates how much of the investment in the firm’s business has been funded by outsiders. b) Debt Equity Ratio Long Term Debt Shareholders’ Funds The Debt Equity Ratio measures the extent of borrowing by the firm as a proportion of the investment of its owners. - 12 - Finance for Non-Finance Professionals Financial Analysis Techniques c) Interest Coverage Ratio Cash Profit Interest Expense The Interest Coverage Ratio reflects the firm’s ability to pay interest out of its earnings. 3) Activity Ratios show the intensity with which the firm uses its assets in generating sales. These ratios indicate whether the firm’s investments in current and long-term assets are too small or too large. a) Inventory Turnover Cost of Goods Sold Average Inventory The Inventory Turnover Ratio shows the speed with which the firm is able to sell its output. b) Average Collection Period Sundry Debtors x 12 Credit Sales The Average Collection Period indicates the firm’s efficiency in collecting receivables. A longer collection period will lead to an increase in the interest burden on the firm. c) Fixed Assets Turnover Sales Fixed Assets This ratio indicates how intensively the fixed assets of the firm are being utilised. A low fixed assets turnover ratio means that the value of the goods produced by the firm is low when compared to the investment made for producing those goods. d) Total Assets Turnover Sales Total Assets Total Assets Turnover reflects how well all the firm’s assets are being utilised to generate sales. 4) Profitability Ratios measure the success of the firm in earning a net return on sales or on investment. Since profit is the ultimate objective of the firm, poor performance here indicates a basic failure that, if not corrected, would probably result in the firm’s going out of business. a) Gross Margin Sales - Cost of Goods Sold Sales The Gross Margin reflects the effectiveness of pricing policy and of production efficiency. - 13 - Finance for Non-Finance Professionals b) Net Operating Margin Operating Profit Sales Financial Analysis Techniques The Net Operating Margin indicates the profitability of sales before taxes and interest. Non-operating revenues and expenses are excluded when calculating this ratio. c) Net Margin Net Profit Sales The Net Margin is simply the net profit earned by the firm expressed as a proportion of sales. It is similar to the Net Operating Margin, but is slightly distorted as nonoperating income and expenditure can impact it substantially. d) Return on Total Assets Net Profit + Interest Expense Total Assets The Return on Total Assets is the return earned by the firm for all investors (i.e. shareholders and lenders). It reflects the ability of the firm to earn profits without considering the financing pattern. e) Return on Equity Net Profit-Preference Dividend Net Worth-Preference Share Capital The Management’s objective is to maximise returns on shareholders’ investment in the firm. Return on Equity is the best indicator of the Management’s effectiveness in achieving this objective. Funds Flow Analysis Funds Flow Analysis involves the determination of the sources of cash flowing into the firm and the uses of that cash by the firm. While the Balance Sheet only shows the monetary value of each source and application of funds at the end of the year, an analysis of the flow of funds reveals the extent of changes in each source and application during the year. Inflow of funds will be indicated by: 1. 1. 1. a decrease in assets an increase in liabilities an increase in shareholders’ funds On the other hand, outflow of funds will be indicated by: 1. 1. 1. an increase in assets a decrease in liabilities a decrease in shareholders’ funds - 14 -