Introduction To Financial Accounting

Financial Accounting and Analysis
Prof. Padmini Srinivasan

Week 1 Handout
READING MATERIAL FOR WEEK 1
Introduction to Financial Accounting
1.1 Introduction
All organizations, irrespective of the legal status – proprietorship, partnership, incorporated
company, statutory corporation or trust and whether they exist for profit or not for profit, are
formed with a view to achieve certain goals (objective, purpose or vision as you may choose).
In order to impart direction and greater certitude to achieving the result, organizations prepare
plans. It is said that all plans, in order to succeed, have to be controlled and all controls, in
order to be effective, have to be planned. This implies that the actual performance should be
measured, compared with the plans and deviation suitably dealt with. The action taken may
involve either correcting the performance or modifying plans or both. Further, there are
several stakeholders of business who will need financial information for decision making.
For this purpose, organizations have to measure the performance and this is achieved through
the accounting system. The objective of financial accounting is to provide relevant, reliable
and timely information for decision making.
1.2 What is accounting?

Accounting is a systematic process that is concerned with measurement and reporting of
transactions and events occurring in an organization. Financial reports that are generated
provide information that will enable the stakeholders to take decisions.
1.3 Users of Accounting Information

Who are the users of accounting information? What information will the stakeholders look
for?
Let us understand through a small situation.
John, a young graduate, wants to start a laundry service. He needs $100,000 to buy the
equipment. He has $50000. For the remaining capital, he decides to take a loan from a bank
and approaches ABV Bank. When approached by John, the bank manager says that in order
to process the application, he needs details of the project and the return expected at the end of
every year during the life of the car. Why did the bank manager ask John for the project
details?
The bank manager will sanction the loan only if he is convinced of the financial viability of
the project. These stakeholders need information about the firm in order to decide whether to
deal with it and if so, to what extent.
There are several users of accounting information. Let us briefly discuss them.
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Financial
Accounting and Analysis" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
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Week 1 Handout
 Investors: They provide capital to the firm. Hence, they need information to assess
the inherent risk of loss of capital and the return their investment in the firm is likely
to yield. They also need information to buy, sell or hold these investments.
 Lenders: They are interested in ascertaining the ability of the firm to service their
loans over the entire term of the loan by paying interest and repaying installments on
the due dates.
 Suppliers and other creditors: They would like to assess the ability of the firm to
pay amounts owed to them within the credit period allowed to the firm. Normally, the
interest of the trade creditors is over shorter periods as compared to lenders.
 Customers and employees: They would like to know if the firm represents a stable
source of supply/employment.
 Government: The government is interested in information that will help it to assess

the taxes that can be collected from the firm, regulate the businesses in general, draft
tax and economic policies, and prepare national income statistics.
 Public: Members of the public are interested in assessing the economic benefits and
costs arising from factors such as employment of people from the locality, patronage
to local suppliers and hazards to environment.
1.4 Accounting System

Is there a formal process or a system to do accounting? Let us explain.
Accounting System is similar to any other information system and has three components,
namely input, process and output as outlined below.
The Accounting System
INPUT PROCESS
OUTPUT
DOUBLE ENTRY Financial

MONETARY
SYSTEM OF Reports
TRANSACTION
AND EVENTS ACCOUNTING
Week 1 Handout
The accounting system in detail:

Input
All business phenomena, which can be expressed in monetary terms, constitute the input for
the accounting system. Certain non-monetary data is used as additional information.
When a cash sale is made, monetary events such as the cash received and the value of the sale
involved constitute the input for the accounting system.
Non-monetary events such as the description of the item and the units sold are also
considered by the system since this input is required for additional information. Particulars
regarding the customer such as name, address and profile may or may not be treated as an
input. However, if the sale is on credit basis, the name and address will be treated as a needed
input. The non-monetary phenomena can vary from simple events as stated above to highly
involved data on employee performance and customer preferences.
The monetary phenomena or transactions which constitute the input can arise either from
transactions with third parties such as purchase/sale of goods/services or from other monetary
events not involving third parties such as depreciation/amortization/depletion.
Process
As a rule, the double entry bookkeeping mechanism can process an event only after the event
becomes eligible for processing. Rather than attempting to answer the above questions, we
will make out a case here for establishing rules of measurement and reporting for carrying out
the double entry bookkeeping process. We do not cover the double entry process in this
course.
More important are the rules we should follow.
Rules for measurement and reporting

Accounting rules or Accounting standards are a set of rules, guidance or principles governing
the way the elements of financial statements should be recorded and reported in the financial
statements. They provide the principles for recognition, measurement and disclosures in the
financial statements. They set the rules the way specific transactions should be reported and
disclosed in the financial statements.
Financial statements are prepared in accordance with the accounting standards make them
uniform and comparable. Accounting standards impart consistency to financial reports. The
investors and analysts can compare the financial statements across different companies and
countries if they are prepared as per the same accounting standards.
 Accounting standards improve the quality of reporting.

 These standards bring out the most appropriate, fair and legitimate way of recording and
disclosing the complexities of any transaction.
 Accounting standards play a key role in removing the number of alternatives available to
present a particular item in the financial statements. Though there are still different ways
of reporting transactions depending on the circumstances, to a great extent, these
ambiguities have been resolved to present a clean and clear picture of the organization.
 The standards ensure that the materiality of the transaction remains intact.
Week 1 Handout
 They ensure that the companies resort to the fair practice of recording and
reporting/disclosures.
Generally, every country has its own set of accounting standards. This authority is vested in a
professional accounting body – private, government or a combination of the two. Some of
the renowned accounting standards across the world are US GAAP and IFRS.
In the United States, the responsibility of setting accounting standards is with SEC, this
function is delegated to FASB (The Financial Accounting Standard Board”). The accounting
rules in the United States are called as US GAAP.
Internationally, the accounting standards are formulated by an independent body called the
IASB (The International Accounting Standard Board). The standards are referred to as IFRS
or the International Financial Reporting Standards. More than 100 countries across the
world have adopted or converged IFRS. The usage of accounting standards enables business
organizations to bring in the best accounting practices for preparing and reporting financial
statements.
Output
The basic accounting system produces financial reports. The reports are categorized into two
kinds, depending upon the intended user – internal or external. For the external users, there
are 3 important financial statements.
 Income Statement or the Statement of Profit and Loss, giving information on the
performance of the firm
 Balance Sheet, giving information on the financial position of the firm
 Cash Flow Statement, giving information on the cash generated/used by the firm
 Balance Sheet
A balance sheet is a statement prepared at a particular point in time that tells us what the
business owns as assets and how these have been funded.
Understanding the balance sheet through an example:

‘Mr. Von has been working for the last 15 years. What is your wealth as on date?’ Mr. Von
gives you information about his cash in bank and investments in other long-term saving
instruments. He also tells you that he owns a car and another house. Will this information be
enough to gauge the wealth held by Mr. Von? Think again, what has he left out? Loans or
Borrowings? Isn’t it important for you to know if he has taken any loan for buying the car
and the house? Isn’t it important for you to know if he has any other borrowings or liabilities?
Yes, in order to evaluate the wealth, or more specifically, the financial position of Mr. Von,
you must consider both the assets (car and house) and the money that he owes to others
(liability) and the balance contributed by him to buy the assets (equity).
What information does the Balance Sheet provide?
A balance sheet provides information about the assets (cash, investment in shares, vehicles,
machinery, land, etc.) held by a firm and the ways in which the acquisition of these assets
were financed by the owners and others. The balance sheet is measured with reference to a
Week 1 Handout
point of time and this point of time normally coincides with the end of the period with
reference to which the performance is measured (quarter, half, or financial year).
Since every transaction alters the financial position of the firm, the balance sheet, which is
measured with reference to a point of time, can be said to give a ‘snap shot view of a
continuously changing scene.
 Income Statement or Statement of Profit and Loss
The income statement depicts the incomes and expenses for a period of time, i.e., it depicts
the financial performance of the firm.
Let us come back to Mr. Von. You ask Mr Von about his income. Mr. Von tells you that he
earned $200,000 per year. What will be your next question to Mr. Von? You are bound to
have several questions, but what is the next most important question that you will ask? You
may also want to know his expenses and thus the net savings from his income.
Since incomes are earned and expenses are incurred over a period of time, performance of a
firm is measured with reference to a period of time. This is very similar to the flow of water
into and out of a dam – measured with reference to a period of time.
 Cash Flow Statement provides this information.
The cash flow statement provides details of the cash inflows and outflows during the year.
This statement would give information on how and where the cash was generated and how it
was spent.
1.5 Preparation of financial statements using the accounting equation

Preparation of financial statements is not a difficult task. We are not going to record the
transaction using the traditional method; rather we are going to use the accounting equation,
which is simpler to capture the transactions. The accounting equation is the foundation of the
accounting system and is captured through the equation.
Assets = Liabilities + Shareholder Equity

Let us illustrate how accounting statements can be prepared with the help of a few
transactions.
1. John starts ABC Corporation for trading widgets. John starts the business with
$300,000 in cash.
Our accounting equation now is as follows. figures in $ 000’

Assets = Liabilities + Equity
Cash ($300 ) = 0 + Equity share capital $(300 )
Week 1 Handout
2. We approach a bank for a loan and the bank, based on their assessment gives a loan
of $200,000. Interest rate is 1% per month.
Assets = Liabilities + Shareholders' Equity
Cash (500 ) = Borrowings (200 ) + Equity share capital (300 )
3. Rented an office space at $1000 per month payable on the last day of the month.
No transaction as we will record the transaction at the end of the month.

Cash (500 ) = Borrowings (200 ) + Equity capital (300 )
4. Bought furniture for $5000 for the office and paid cash. Furniture is an asset. Our
Cash (500 ) = Borrowings (200 ) + Equity share capital (300 )
accounting equation now is as follows.

Furniture (5) + Cash (495) = Borrowings (200) + Equity capital (300)
Note that cash comes down as we spend money.
5. Purchased widgets for $60000. Paid cash for $40000 and agreed to pay the balance in
60 days. Our accounting equation now is as follows.
Furniture (5) + Cash (455) +Inventory (60) = Borrowings (200) + Trade

Payables (20) + Equity capital (300)
6. Sold goods costing $40000 for $ 50000 in cash.

This is the first time we have encountered items that do not appear directly in the
accounting equation. To answer this, let us understand and answer the following
questions:
What is the profit made in the transaction? Answer: $10000
Whom does the profit belong to? Answer: Equity capital (Shareholders)
So, rightfully this has to be added to the equity capital.
We now modify the basic equation into:
Assets = Liabilities + Equity

Assets = Liabilities + Equity (Contributed + Retained Earnings)
Assets = Liabilities + Equity (Contributed + Income - Expenses)
Week 1 Handout
The accounting equation would be depicted as:

Furniture (5) + Inventory (20) + Cash (505) = Borrowings (200) + Trade
Payables (2) + Equity share capital (300) + (Revenue (50) - Cost of goods sold
expense (40))
The equation has undergone a few changes. Inventory stock has come down from 60
to 20 on account of inventory being sold. Cash is increased by $50,000 because we
made cash sale. Revenue/sales increased by $50,000 along with an expense of
$40,000 resulting in a profit of $10,000.
7. Since we have borrowed money to invest in the business, we have to pay the interest,
which is 1% of the borrowings, i.e. $2000. Our cash holding declines by $2000 and
expenses increase by $2000. Our accounting equation is as follows:
Furniture (5) + Inventory (20) + Cash (503) = Borrowings (200) + Trade

Payables (2) + Equity share capital (300) + (Revenue (50) - Cost of goods sold
expense (40) –Interest Expense (2)
1.6 Accounting Equation to Financial Statements

We can now prepare the financial statements with the help of our accounting equations. The
income statement would be reported as follows:
Income statement for the month ending 31 January xx

Income $
Revenue 50,000
Other Income -
Total Income 50,000
Expenditure
Cost of Goods Sold 40,000
Interest Expenses 2,000
42,000
Net Income / Profit 8000
Notice that this is the expanded version of the retained earnings.
Week 1 Handout
Balance Sheet as on 31 January xx

Equity + Liability $
Shareholders' Fund
Equity Share Capital 300,000
Retained Earnings 8,000 308,000
Liabilities
Borrowings 200,000
Trade Payables 20,000
Total 528,000
ASSETS
Property Plant & Equipment (Furniture)1 5,000
Current Assets, Loans and Advances

Inventory 20,000
Cash 503,000
523,000 523,000
Total 528,000
The purpose of the above illustration is not to teach accounting process or preparation of
financial statement but to demonstrate that they are simple and easy to follow. Many of you
will find it exciting to see that your balance sheet is 'balanced' at the end.
To Summarize
ASSETS MATCH WITH SOURCE OF FINANCING THE ASSET

ie
ASSETS = LIABILITIES + EQUITY
Expanding
ASSETS = LIABILITIES + EQUITY CAPITAL + RETAINED EARNING
Expanding to next level

ASSETS = LIABILITIES + EQUITY CAPITAL + RETAINED EARNING (Income –
Expenses)*
*Note that we have not adjusted the equation for any dividend payment
1.5 Accounting concepts
Accounting concepts provide a basis to record the transactions in a particular way. These are
the basic assumptions and conventions, which have to be followed while recording any
transaction. Some of the concepts are discussed next.
Week 1 Handout
Entity Concept
The entity concept states that the business and its owner(s) are viewed as entities, separate
from each other. The transactions of business are to be recorded separately and the personal
transactions of the owner should not be mixed with business transactions.
It is because of the entity concept that the capital contributed by the owner is treated like a
liability owed to the owner. Based on this logic, capital or equity is shown on the same side
of the balance sheet as liabilities.
Going Concern Concept

The going concern concept assumes that the business is going to continue its operations in the
foreseeable future. In other words, the business is going to exist for an indefinite period of
time.
For example, depreciating assets is an example of the going concern concept. If the
assumption fails to hold, then all expenses including expenses incurred for purchased of
property plant and equipment (which are assets in the balance sheet) will be shown as
expenses.
Cost Concept
Under the cost concept, all expenses, assets or liabilities should be recorded at their purchase
or acquisition price initially. Cost concept offers a sense of reliability to the accounting
records. The cost or purchase is reliable since it has proper evidence. For example, the
company purchased a piece of land on May 1, for $50,000. The same will be recorded at
$50,000
Money measurement concept:

Money measurement concept requires the accounting system to record transactions only if
such transactions can be measured on a monetary basis. In other words, events that cannot be
measured in money terms cannot be entered in the books. There is no way to measure
customers' satisfaction or production excellence or human resources value in accounting. In
that sense, accounting is not integrating itself with other functions and a typical performance
measurement includes several other non-monetary measurements. However, it can be counter
argued that if a firm’s production facility is excellent or customer satisfaction levels are high,
then they will be reflected in the form of additional revenue. Though it is true that ultimately
they will be reflected in incremental revenue or profit, there could be a considerable time gap.
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Introduction To Financial Accounting

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Introduction To Financial Accounting

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Financial Accounting and Analysis

Prof. Padmini Srinivasan

READING MATERIAL FOR WEEK 1

Introduction to Financial Accounting

1.2 What is accounting?

1.3 Users of Accounting Information

 Government: The government is interested in information that will help it to assess

1.4 Accounting System

The Accounting System

DOUBLE ENTRY Financial

The accounting system in detail:

Rules for measurement and reporting

 Accounting standards improve the quality of reporting.

Understanding the balance sheet through an example:

 Income Statement or Statement of Profit and Loss

 Cash Flow Statement provides this information.

1.5 Preparation of financial statements using the accounting equation

Assets = Liabilities + Shareholder Equity

Our accounting equation now is as follows. figures in $ 000’

No transaction as we will record the transaction at the end of the month.

Assets = Liabilities + Shareholders' Equity

Assets = Liabilities + Shareholders' Equity

Note that cash comes down as we spend money.

Furniture (5) + Cash (455) +Inventory (60) = Borrowings (200) + Trade

6. Sold goods costing $40000 for $ 50000 in cash.

We now modify the basic equation into:

Assets = Liabilities + Equity

Assets = Liabilities + Equity (Contributed + Income - Expenses)

The accounting equation would be depicted as:

Furniture (5) + Inventory (20) + Cash (503) = Borrowings (200) + Trade

1.6 Accounting Equation to Financial Statements

Income statement for the month ending 31 January xx

Balance Sheet as on 31 January xx

Property Plant & Equipment (Furniture)1 5,000

Current Assets, Loans and Advances

ASSETS MATCH WITH SOURCE OF FINANCING THE ASSET

Expanding to next level

1.5 Accounting concepts

Going Concern Concept

Money measurement concept:

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