Financial Accounting

Financial Accounting : It is the process of recording, summarizing and reporting the myriad of
transaction resulting from business operations over a period of time. The transactions are summarized
into financial statements.

Types of Accounts : There are mainly four types of accounts in accounting : Real, Personal, Nominal
accounts and Valuation accounts. Personal accounts are classified under three subcategories:
Artificial, Natural and Representative. Failure in identifying an account correctly as either a real,
personal or nominal, in most cases, will render journal entries incorrect.

Real Account : All assets of a firm, which are tangible or intangible fall under this category.
For Real Accounts, Golden Rule Debit what comes in, Credit what goes out.
Nominal Account : An account that is related to expenses, losses, gains and incomes. Debit all
expenses and losses, Credit all incomes and gains
Personal Account : Accounts that are related to individuals, firms and entities. Eg. Debtors,
Creditors of the Firm, Suppliers etc. Golden Rule Debit the receiver, Credit the Giver. Further
divided into :
o Natural : Deals with the creations of nature ie. humans
o Artificial : Entities created artificially under the law ie. firms
o Representative : Accounts representing a person or group directly or indirectly. Eg.
Prepaid Accounts are representative etc.
Valuation Account : Contra (Adjunct) Account. Valuation account offsets the gross amount of
an account to arrive at a net balance. Eg. Allowance for Doubtful Accounts, Accumulated
Depreciation etc.

Double Entry System : Every business transactions has an impact on two accounts simultaneously ie,
principle of debit and credit.

Accounting Principles :

Matching : Expenses should be recorded during the period in which they are incurred,
regardless of when the transfer of cash occurs.
Duality : Accounting principle that recognizes the dual nature of impact of a transaction on
the cash flow ledger of a balance sheet ie. the role of both debit and credit in any given
transaction. Eg. A company raises debt funding from a bank, cash (asset) is debited and loan
payable (liability) is credited.
Materiality : Materiality states that items that are large enough to impact financial decisions
in an organization may be considered for the purpose of financial reporting. All important
matters are to be disclosed as they impact the decisions of stakeholders who use the financial
statements.
Money Measurement : Only transactions that have a monetary impact are to be considered
for the purpose of financial reporting. Only record transactions that can be recorded in terms
of money.
Going Concern : A business is to be regarded as an entity that exists for perpetuity.
Conservatism : Record expenses and liabilities as soon as possible, but record assets and
incomes/revenues only when sure about them.
Consistency : Once an accounting principle has been adopted, it should be treated as the
benchmark, until a significantly better accounting principle comes along.
Accrual Principle : Accounting transactions should be recorded in the period in which they
occur, rather than the period in which their cash - flows are realized.
For detailed definitions and more principles : http://www.accountingtools.com/basic-accounting-
principles such as Cost Principle, Contingency Principle etc.

Journal : A log in which all the financial transactions of the organization are noted chronologically. The
journal uses a shorthand notation to record transactions, major columns being Date, Accounts (From
Debit Account to Credit Account ALWAYS), Debit Amount, Credit Amount. Eg. Below :

Ledger : Contains detailed accounting transactions, showing the net of debit, credit and balance for
various pages of the journal.

Trial Balance : It is a listing of ledger accounts with their respective debit and credit balances. It serves
as a self - check before transferring the final contents into the financial statement.

Flow in the accounting cycle : Journal Entry Ledger Trial Balance Financial Statement
Financial Statement : It is a form of record of an organizations financial results, financial condition
and cash flows. Financial Statements are useful as they :

Determine the ability of a business to raise capital and effectively utilize the capital
Determine whether a business can pay back its borrowings
Track financial results and determine profitability
Derive financial ratios that indicate financial health of the business
Disclosures and assumptions

3 Golden Rules of Accounting : The golden rules of accounting are as follows :

For Personal Accounts : Debit the Receiver, Credit the Giver

For Nominal Accounts : Debit all expenses and losses, credit all revenues/incomes and gains
For Real Accounts : Debit what comes in, Credit what goes out

Modern Rule of Accounting : In the modern approach, the accounts are classified into categories :

Assets Account Debit when Increase, Credit when Decrease

Liabilities Account - Debit when Decrease, Credit when Increase
Capital/Shareholders Equity Account - Debit when Decrease, Credit when Increase
Revenue Account - Debit when Decrease, Credit when Increase
Expense Account - Debit when Increase, Credit when Decrease

Balance Sheet : Statement that showcases the assets, liabilities and shareholders equity at a
particular point in time. Its represents the financial condition of the company at a given point in time.
Shows a companys sources of funding (shareholders equity and liabilities) and the utilization of these
funds in terms of the assets that the company owns under various heads. Eg. Below :

Accounting Equation : Assets = Liabilities + Shareholders Equity

Income/P&L Statement : Consolidated statement of incomes and expenditures & profits and losses
of the organization over a given period of time (usually 1 year). Shows the companys ability to
generate profits by reducing costs and/or increasing revenues.

PBT : Profit before Tax

PAT : Profit after Tax

EBITDA : Earnings before Interest, Tax, Depreciation and Amortization

Expenses and Revenues : Expense is the cost a business occurs in order to earn revenue and
potentially, profits. Revenue is the amount that a company receives by means of its core operating
activities.

Cash - Flows Statement : Statement elucidating how the companys operations are being run, where
its money is coming from and how the money is being spent. Lists the cash inflow and outflow
elements into three categories :

Operating Activities : Activities that are fall under the purview of the core business activities
and are related to the provision of its offerings.
Financing Activities : Loans and Debentures raised, issue and sale of shares, paying off any
dues etc.
Investing Activities : Purchase of new equipment, shares bought, income from investments,
dividends etc.

Assets : A tangible or intangible economic resource that contributes to the companys revenue
generation, has a positive economic value and over which the company has complete control. Eg.
Cash, Machines, Inventory, Land etc.

Fixed Assets/Non-Current & Liquid/Current Assets : Fixed Assets are those that cannot be converted
into cash quickly ie. cannot be converted into cash (through sale of the asset) within a period of one
year. Eg. Land. Liquid Assets are those that can be converted into cash within a period of one year. Eg.
Marketable Securities, Trade Receivables, Prepaid Expenses etc.

Depreciation and Methods : Reduction in the value of an asset due to wear and tear. A particular
asset is allotted a useful life for the purpose of accounting. The assets value is allocated over the
useful life of the asset. Depreciation is deducted from the Asset Cost each year in the balanace sheet.
There are three methods of depreciating the value of a particular asset over its useful life :

Straight Line Method : Depreciation (constant for all years) = Asset Value at Cost/Useful Life.
Net asset Value at the end of useful life is zero.
Written Down Value Method : For Year 1, Depreciation for Year 1 = Asset Value at Cost/Useful
Life. For Year 2, Asset Value for Year 2 = Asset Value at Cost Depreciation for Year 1.,
Depreciation for Year 2 = Asset Value for Year 2/Useful Life.

Amortization : Depreciation of an intangible asset is called amortization (Allocation of the cost of an

intangible asset over its useful life). Eg. Patents, Copyrights, Intellectual Property, Goodwill etc.

Liabilities : One of the sources of funding a companys activities. It is the monetary obligations of the
company towards entities that have funded it without gaining a stake/share of ownership in the
company.

Loan & Debenture : Loan is the act of giving money against the promise of future repayment of that
sum of money along with an additional charge, known as interest. Debenture is a form of debt
financing that is not secured by collateral or physical assets. It is backed by the general
creditworthiness of the issuing party.

Bonds : It is a written promise by the issuer (similar to an IOU) that the creditor will be payed after a
certain period of time, known as maturity period. Periodic interest pay - outs are made to the creditor,
followed by repayment of the principle amount at the end of the maturity period.

Treasury Bills : Also known as T bills, they are short term debt obligations issued by the government
of a country, usually at a discount from the par value. It has a maturity period ranging from a few days
to a max of 1 year. The greater the maturity period of the T bill, the higher will be the interest payout
that it gives.

Marketable Securities : Securities that can be sold ie. converted to cash within a year, hence making
them a short - term debt obligation. They are unrestricted financial instruments that can be bought or
sold on the public stock or bond exchanges. Eg. T bills, Certificates of Deposits, Commercial Papers
etc.

Money Market vs Capital Market : Money market is where highly liquid assets and securities with
short maturity periods are traded. There are unorganized and organized money markets in India.
Unorganized Eg. Money Lenders, Indigenous Bankers etc. Organized Eg. Call and Notice Money
Market, Treasury Bill Market, REPO Market, DFHI etc.

Capital markets usually cater to the raising of capital by sale and purchase of securities with long
maturity periods. Eg. National Stock and Bond Exchanges etc.

Deferred Tax : Can either be an asset or a liability. Deferred Tax is an Asset when the company has
paid more taxes to the monetary authority than it was supposed to during the previous accounting
period. Deferred Tax is a Liability when a company has not paid the full amount of taxes owed to the
monetary authority during the previous reporting period.

Current & Non Current Liabilities : Current Liabilities are those debts and obligations of a firm that
can be repaid within a period of one year. Eg. Trade Payables, Short Term Loans etc.

Non Current Liabilities are those debts and obligations of a firm that can be repaid only after a period
of one year. Eg. Long Term Loans, Long Term Debentures, Bonds with high maturity period etc.

Shareholders/Owners Equity : The difference between the assets and liabilities of the firm. It is the
amount invested in the company by its owners ie. the net amount that would be returned to all
shareholders of the company if the company were liquidated (meaning all its assets were sold to repay
its debts).

Order of pay - outs in the event of liquidation : (Max Preference) Bonds Debentures Secured Loans
Unsecured Loans Preferred Stock Equity Shares (Min Preference)

Shareholders Wealth vs Shareholders Capital : Shareholders wealth is the market price of the share
of the company. Shareholders Capital is the amount invested by all shareholders in the company.

Common vs Preferred Stock : Common Stock and Preferred Stock are securities that represent
ownership in a firm. Differences :

Voting Rights : Common Stock holders have voting rights in the Annual general meeting of the
firm. They get to vote on any aspect related to management of the company, including
election of the board of directors.
 Dividend Pay - Outs : Preferred Stockholders are given fixed dividend pay - outs, whereas
common stockholders are given dividend pay outs at rates determined at the time of
dividend declaration by the company, at a certain percentage of the face value of the share.
Also preferred stockholders are paid prior to common stockholders.
Liquidation : In the event of liquidation of a firm, preferred stockholders get paid prior to
common stockholders.

Share : A unit of ownership in the firm. A person possessing a share of a company is entitled to a
proportion in the profits of the firm.

Reserves & Surplus : A provision of the profits appropriated to specific purpose, or withheld to
counteract an eventuality. Surplus is the amount that is left in the profit and loss account after
providing for dividends, bonus, taxation, reserves etc.

Retained Earnings : Retained earnings refers to the portion of net earnings of the firm (ie. Profit After
Tax) that is not paid out as dividend and is hence either re-invested in the core business of the
company, or used to repay debt.

Dividend vs Bonus vs Stock Split : Dividend is a pay out that is issued to the shareholders of the
company from the net earnings of the firm. It is declared as a percentage of the face value of the firms
share. Bonus is the issue of free additional shares to the shareholders of the company. A certain
number of additional shares are given as a proportion to the number of shares currently held by the
shareholder. Stock Split is a corporate decision that divides the existing shares of a firm into multiple
shares. Eg. The number of shares outstanding doubles ie. Stock split as 2:1. This would halve the
market price of the share and thus makes the shares more affordable for potential investors in the
market. Thus it would potentially lead to a greater demand for shares of the company in the market,
thus leading to an increase in the share price of the firm and the value of the investment.

Yield : The income return on an investment. Eg. Interest earned from investing in bonds, Interest
earned from investing in government T bills etc.

IPO/FPO : Initial Public Offering/Follow - on Public Offering. Initial public offering is the first time that
a company lists itself in the stock market for public equity financing. Follow on public offering is
when a company that is already listed in the stock exchange issues shares again to investors, usually
for the purpose of expanding the business.

Share Premium : Difference between the trading price of the share and its face value.

Issue Price : The initial price that the share of the share of a firm is issued in the stock market.

Face Value : The original cost of the stock as shown on the stock certificate.

Market Price : The price at which the share of the company is trading in the market. Determined by
supply and demand.

Financial Ratios : Please find the Capital Club PPT on Financial Ratios embedded below. Double click
to begin the slideshow :

Capital Club
Session 3
Basics of Accountancy

Presented By-:
Manan Chaudhary
Sachin Gopalakrishnan
Shorya Gupta