Understanding Financial Statements Dr Gourav Vallabh XLRI Jamshedpur

Concept of Double Entry Every Transaction has two aspects and according to this system both the aspects are recorded. IfThen (Either / Or)Relation A is createdAnother A reduces L Increases E Decreases I Increases Vice Versa L is createdAnother L reduces A increases E Increases I decreases Vice Versa E is incurredA reduces L increases Vice Versa I is generatedA Increases L reduces Vice Versa

Classification of Accounts 1.Assets: Indicates the resources which the firm enjoys. 2.Liabilities: Indicates the amounts which the firm owes to the outsiders. 3.Expenses: Amount which has been spent or even lost in carrying on operations. 4.Income: Amounts earned by the firm

Thumb Rule for Debits and Credits DEBITSCREDITS Increase in AssetsDecrease in Assets Increase in expenses Decrease in expenses Decrease in liabilityIncrease in liability Decrease in incomeIncrease in income

Ledger On the basis of entries made in the journal, accounts are prepared in T form (as discussed earlier) The book which contains the accounts is called ledger. Ledger is also called the principal books of account.

Trial Balance After passing the accounts in ledger, a statement is prepared showing the debit and credit balances in two separate columns. These two columns agrees automatically. T B helps to establish arithmetical accuracy of the books of accounts. Financial statements are normally prepared on the basis of agreed T B. T B serves as a summary of what is contained in the ledger.

Introduction Business Transaction Inflow of Funds Revenues (I) Direct Income Indirect Income External Sources L (Capital and Loans) Outflow of Funds Purchase of Assets (A) Revenue Expenses (E) Accounting Equation: Assets + Expenses = Liabilities + Income A + E = L + I

Introduction ExpensesIncome EPEP I TOTAL = I Profit and Loss Account Balance Sheet LiabilitiesAssets LPLP A TOTAL = L + PTOTAL = A

Proof of the Accounting Equation LHS = L + P = L + (I – E) = L + I – E = A = RHS (applying the accounting equation)

Profit and Loss Account This is prepared for a certain period. The revenue incomes and revenue expenses pertaining to that year for which the Profit and Loss Account is being prepared are considered and the profit or loss is computed. All revenue expenses chargeable to that year is taken into consideration irrespective of the fact, whether it is actually paid or not. Similarly all revenue incomes are also considered irrespective of the fact whether it is actually received or not.

Balance Sheet This is prepared at a particular date. Balance Sheet reflects the financial position of the organization at that particular date. Balance Sheet depicts the assets and liabilities position of the organization at that particular date.

Fundamentals Concepts of Accounts 1.Entity Concept: The business of the owner and the owner himself are considered as two separate entities. It is due to this reason, that the owners fund (Capital plus accumulated Surplus is regarded as a liability of the business entity) 2.Going Concern Concept: The business entity to have perpetual existence. 3.Historical Cost Concept: Value of an asset is to be determined on the basis of the cost of acquisition.

Fundamentals Concepts of Accounts – Contd. 4.Accrual Concept: Recognition of revenue and costs as they are earned or incurred rather than money actually received or paid. 5.Consistency: Whatever may be the accounting policies adopted, these are to be followed consistently promoting comparability. 6.Conservatism: It is not prudent to account or provide for unrealised gain but it is desirable to guard or provide against all possible losses. 7.Matching Principle: If any income is recognised in the books of accounts then the simultaneous expenditure should also be booked.

Defining Certain Terms 1.Assets: Indicates the resources which the firm enjoys. 2.Liabilities: Indicates the amounts which the firms owes to the outsiders. 3.Expenses: Amount which has been spent or even lost in carrying on operations. 4.Income: Amount earned by the firm.

Defining Certain Terms – Contd. 5.Fixed Assets: Assets which are expected to be used for more than one accounting period. Not held for the purpose of sale in the ordinary course of business. 6.Current Assets: Those assets which can be liquidated or converted into cash within a period of 12 months. 7.Current Liabilities: Those liabilities which needs to be paid out within a period of 12 months.

A Standard Profit and Loss Account (In vertical form) Income Sales Other Income NotesRs. Expenses Cost of Goods Sold Manufacturing Expenses Establishment Expenses Depreciation Interest Profit before Tax Taxation Profit after Tax Distribution of Profits Transfer to Reserves Dividend Retained Earnings

A Standard Balance Sheet (In vertical form) Employment of Capital Fixed Assets Investments Preliminary Expenses Deferred Revenue Expenses NotesRs. Current Assets Inventories Receivables Loans and Advances Cash and Bank Balances Current Liabilities Trade Creditors Provisions Bank Overdraft Net Current Assets Capital Employed Capital Reserves and Surplus Long Term Loans

Qualities of well presented accounts Readability Transparency Comparability Reflecting a true and fair view of the state of affairs of the business. Informative Compliance with the fundamental principles and assumptions Supplemented with adequate disclosures for inconsistencies, non compliance with reasons thereof.

Why it is necessary to develop a good accounting system Proper reflection of the actual financial performance/results/position. Aids in evaluating the strengths and weaknesses of the organisation. The first word in MIS Information base for decision making by the management Compliance with various legal formalities and statutory regulations

Users of Accounting Information Internal User Management External Users Investors Employees Lenders Suppliers Customers Government Tax Authorities and other statutory bodies. General Public

Accounting as MIS A large portion of accounting information is prepared for management decision making. Accounting data is used as basic source document for MIS Management also depends on other data source for information. Accounting system can be moulded to serve requirements of management Accounting is an essential service function to management.

Accounting Accounting is the art of recording, classifying and summarizing 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.