Basics of Financial Accounting – Session 1 Summary notes:

The assessment of company’s financial performance as well as its current financial position is shown
using various financial statements. The importance of these statements is that they help various
stakeholders ranging from various departments within an organization like HR, Marketing etc. to top
management of the firm in decision making. They are equally important for government agencies,
regulators and investors as they carry various messages for each of them. Investors decide whether to
invest in the company or not? Or Creditors / Banks decide whether they should provide credit or loan to
the company.

So, what are the different financial statements which a company is required to produce:

1.Profit & Loss or Income statement

2.Balance Sheet
3.Cash Flow statement
4.Retained earnings statement
➢ Income statement shows the financial “performance” of the company for a given period and it
will always state “profit & loss for the period 1st April to 31st March”. It is usually assessed on
quarterly basis or half yearly or annually. They can also be compared with previous quarters &
also with same quarter in previous year. This gives an idea whether company is doing or better
than in previous period. The key message of this statement is that it provides whether company
is in net profit or loss? Also, some of the key information like Sales or revenue, operating profit,
other income or expenses, earnings per share etc. The outcome of income statement is carried
forward to the balance sheet in form addition of retained earnings being added to the equity
➢ Balance sheet is snapshot of the company’s financial “position” on a given date & hence it will
mention balance sheet as at 31st march and not the period. This statement consists of Assets on
one side and liabilities plus owner’s equity on the other side. This brings us to the most
important accounting equation:
➢ Assets (A) = Owner’s equity {E} + Liabilities (L)
o Assets are something which company can use for its own benefit in future like land, building,
machine, inventory etc.
o Liabilities are something which company is obligated to pay like bank loan or goods purchased
on credit etc.
o Owner’s equity is the fund which owner or investors provide as compared to a loan which
company gets from external sources like banks etc. on which it is obligated to pay interest
whereas on equity company is not required to pay interest but they get share of profit via
dividend and balance is added as retained earnings. Balance sheet provides the key information
as to whether company is having how much of fixed assets or what is amount of borrowing
compared to owner’s equity
o The above equation is will always be equal! Most important thing to understand is whether the
transaction is impacting the equation on the same side or on both sides?
o If the transaction is impacting on “One Side” say you are purchasing a building so it will go up
whereas the cash will go down. So, if it is impacting the same side the “+” & “- “are on same
side.
o If the impact is on both sides then one side is “+” and opposite side also must be a “+ “. Say if
the above building was purchase on credit then Building as an asset will be “+” but to balance it
 out either cash must go down which we saw in same side impact but since we purchased on
credit our “Liabilities” will go up on the opposite side hence again “+”. Below is the summary to
understand the impact of any transaction on the accounting equation.

Now that we have understood what each of the financial statements showcase let’s understand how
each of the accounting transactions are recorded and how they flow through the Income statement,
balance sheet & cash flow statement. But in order understand how the transaction is recorded we need
to understand the 3 golden rules of accounting or the system called as “Double – entry” accounting or
book keeping. Double entry means any transaction will always impact 2 accounts or more. Those
accounts can be from income statement or balance sheet or only from balance sheet.
Whenever there is financial transaction taking one needs to classify it under any of the following
accounting heads.

1. Personal accounts: This category of accounts consists of person related accounts like vendors,
customers, lenders etc.
• The golden rule of accounting for this category is “Debit” the receiver account and
“Credit” the giver account
2. Real Accounts: This consists of assets like machinery, building, cash, plant etc.
• The golden rule of accounting for this category is “Debit” what comes “in” and “Credit”
what goes “out”
3. Nominal Accounts: They consist of income and expenses accounts like Sales, Salary, Material
cost, rent etc.
• The golden rule of accounting for this category is “Debit” all expenses / losses & “Credit”
all incomes & gains

Now let’s try to convert an accounting transaction into an accounting entry or known as journal entry:

1. Sales of INR 10,000 to ABC ltd on credit:

a. ABC limited is a customer so it’s a “personal” account and is an also the “receiver”
hence will be Debited.
b. Sales is a “nominal” account which represents “income” which will be Credited.

The accounting entry will look as under:

Impact on the Accounting equation?

Assets = “+” because by selling on credit we are increasing asset which will pay us in future
Equity= “+” because increase in income will be added to owner’s equity via increased retained
earnings

Now that we have gone through the basic accounting entries let’s try to also understand the
inter relation of financial statements.

➢ We can see the below relations among the accounting statements.

o All the income & expenses are recorded in income statement starting with sales then
direct expenses like COGS or cost of goods sold. Direct expenses include direct raw
material cost, direct labor and direct expenses. The we deduct other expenses like
salary, administration and rent. Finally, we deduct depreciation, interest cost &
taxation to arrive at Profit after tax (PAT). Dividend is part of profit which is paid out
to the owner’s and the remaining profit or the retained earnings will be added to
owner’s equity in balance sheet. You can see 3.8 being result of income statement
getting added to share capital on liabilities side.
o Cash flow statement is prepared on cash basis which means as and when payments
are made or income is received they get recorded in the cash flow statement. This is
the main difference between income statement and CF. In income statement
recording is done based on when the transaction takes place rather than when cash
comes in and goes out. Hence profit and cash flow don’t match. As it can be seen in
 the above that closing cash balance of 39 is reflecting on asset side of balance sheet.
Also, the bank loan of 20 is a cash inflow but it creates a liability on the balance sheet
or purchase of furniture results in cash outflow but also creates asset on the balance
sheet.
o Balance sheet as discussed earlier is a snapshot of Liabilities on one side and the
amount of assets on other side. They are both always equal. Logic being that for all
the assets being bought we have funded it either by creating liabilities or brining in
owner’s equity. As one can see that when owners bring in equity or capital then it
also recorded as cash inflow in CF statement
➢ Accounting process:

The net result of profit or The Balance sheet items

Transaction recorded via Transaction Impact on
loss is recorded & added to will have closing balance of
Journal entires based on Income statement or
owner's equity in balance assets & liabilities (Opening
golden rules of Accounting balance sheet
sheet + Changes = Closing)

The entire accounting process is based on various “assumptions” & accounting “principles” which we will see in next section

➢ Accounting “Assumptions”, “Principles” & “Standards”:

1. Accounting assumptions are some of the basic assumptions which one makes while recording the
transactions and preparing the accounting statements which can been in the below screenshot:
o Separate entity concept is about assuming that company is a separate entity from its owners.
Hence when Equity is provided by the owner it is shown as liability of the company because it is
considered as separate from its owners. So, both owner’s & company’s transaction should be
recorded separately
o Money measurement concept is about assuming that all the statements will be recorded in the
monetary units like say INR or USD etc.
o Going concern concept is an assumption that company will be in operation over the period for
which accounting statements are being prepared & also for foreseeable future. It implies that
the business entity will continue its operations in the future and will not liquidate or be forced
to discontinue operations due to any reason.
o Accounting period concept - An accounting period is the span of time covered by a set of
financial statements. This period defines the time range over which business transactions are
accumulated into financial statements, and is needed by investors so that they can compare the
results of successive time periods. In India, the financial year from April to March is considered
for preparation of financial statements whereas in US it’s January to December
2. Once these basic assumptions are understood we move on to understanding the various
“principles” or “rules” based on which accounting transactions get recorded.
o Full Disclosure: This principle means that companies need to provide full disclosure of all the
information in accounting statements which will help various stakeholders take decisions. The
information provided via schedules and footnotes to the statements. For e.g. if any case is
pending against the company it should be disclosed in footnotes along with possible liabilities
which will help investors and other’s judge the impact
o Materiality: The materiality concept is the principle in accounting that trivial matters are to be
disregarded, and all-important matters are to be disclosed. Items that are important enough to
 matter are material items. E.g. – Loss of $100 million because of fire is more important than not
recording purchase of $10 worth of purchase of stationary items.
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o Conservatism: The conservatism principle is the general concept of recognizing expenses and
liabilities as soon as possible when there is uncertainty about the outcome, but to only
recognize revenues and assets when they are assured of being received. The idea is not to
recognize the future revenues or assets when not sure of receiving but making provision for any
possible liabilities etc. So to become as conservative as possible.
o Accruals & Cash basis: Cash based accounting is when cash is paid or received rather than
timing when transaction takes place. This is usually for small businesses and personal finance.
On the other hand, the accrual method accounts for revenue when it is earned and expenses
goods and services when they are incurred. The revenue is recorded even if cash has not been
received or if expenses have been incurred but no cash has been paid. Accrual accounting is the
most common method used by businesses.
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o Revenue Recognition: It is an accounting principle which provides a set of conditions which
needs to be fulfilled for revenue or sale to be recognized in the books of accounts. It is one of
those major events or milestone when fulfilled leads to revenue recognition. Hence Sales would
be recorded even when cash is not received but when those conditions are satisfied.
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o Matching Concept: This again is very important principle in accrual accounting. Matching here
means that expenses & revenue for the period should be matched. Let’s look at it logically if the
company made a sale of $100,000 in 12 months period at cost of $80,000 then cost of only
those goods should be recorded to arrive at a correct profit which is be $20,000. The objective
of matching concept is that companies should not misstate the earnings or profit / loss. Suppose
for the above company has paid $90,000 during the period but of which cost of goods sold is
$80,000 then if company can book all $90K it will wrongly show profit at $10K instead of $20k as
calculated above.
3. Accounting “Standards” – The accounting standards are laid out by various authorities in a
country to standardize the reporting formats of all accounting statements so that they can be
comparable across the firms. They also prescribe the principles and rules for recording of various
transactions like criteria for revenue recognition or treatment of goodwill or depreciation
accounting. For e.g. International Financial Reporting Standards (IFRS) are a set of international
accounting standards stating how particular types of transactions and other events should be
reported in financial statements. IFRS are issued by the International Accounting Standards Board
(IASB), and they specify exactly how accountants must maintain and report their accounts. IFRS
were established in order to have a common accounting language, so business and accounts can
be understood from company to company and country to country.

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