Finance for Non-Finance ProfessionalsAccounting Fundamentals 1.

ACCOUNTING FUNDAMENTALS Accounting Defined Accounting has been defined by the American Institute of Certified Public Accoun tants, as The art of recording, classifying and summarising in a significant mann er and in terms of money, transactionsand 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 referr ed to as the principal books of account:1) Journal : The Journal contains details of transactions (other than those relating to rec eipts or payments in cash or through bank), recorded in chronological order. DateParticularsL/FDebit (Rs.)Credit (Rs.) Journal 2) Ledger : The Ledger contains separate accounts for every type of income, expense, asset , liabilityand every person/ organisation with whom any transactions have taken place. An account is asummary of all transactions taking place under that head. Dr.Cr. DateParticularsJ/FAmount (Rs.)DateParticularsJ/FAmount (Rs.) Ledger 3) Cash and Bank Book : The Cash and Bank Book combines the features of the Journal andLedger, and rec ords transactions involving receipts or payments in cash or through bank. Dr.Cr. DateParticularsL/FCash(Rs.)Bank(Rs.)DateParticularsL/FCash(Rs.)Bank(Rs.) Cash and Bank Book 1 Finance for Non-Finance ProfessionalsAccounting Fundamentals General and Subsidiary Ledgers Most large organisations maintain separate Ledgers and Cash and Bank Books for d ifferent types of transactions. For example, the Ledger may be split into Genera l Ledger, Customers Ledger (Accounts Receivable) and Suppliers Ledger (Accounts Pa yable), and separate books may bemaintained for Cash and each Bank Account inste ad of the Cash and Bank Book. Subsidiary Books Generally, a set of subsidiary books is also maintained. Subsidiary books are re gisters in whichfrequently occurring transactions are recorded, such as the Purc hase Register, Sales Register and PettyCash Book. The totals of transactions rec orded in the subsidiary books are periodically posted to the principal books. Voucher Each accounting entry has an underlying document called Voucher in accounting term inology insupport of its validity. The term Books of Account generally includes th e primary and subsidiary books, as well as the vouchers. Voucher No.:Date:ParticularsDebit (Rs.)Credit (Rs.)TOTALPrepared by:Authorised b y: 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 ent ity, arranged under thefollowing four principal groups: Liabilities Assets Income ExpenditureEach of the groups has several sub-groups and every such sub-group ei ther has accounts or sub-groupsas its sub-units, forming a tree structure.2 Finance for Non-Finance ProfessionalsAccounting Fundamentals Debit and Credit All amounts recorded in the books of account are placed either to the debit or c redit 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 outDEBIT the receiver, CREDIT the giver DEBIT all expenses an d losses, CREDIT all incomes and gainsThe implications of amounts being placed t o the debit or credit of an account are as follows:Type of AccountImplicationDeb itCredita) PersonalThe individual/ firm has receivedsome money or other tangible benefitThe individual/ firm has givensome money or other tangible benefit b) In come/ ExpenditureAn expense or a loss has beenincurredAn income or a profit has beenearnedc) Asset/ LiabilityAn asset has been acquired or aliability has been p aid/ reducedAn asset has been disposed or aliability 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 methodof 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 alldebits is equal to the sum of all credits. This is the most scient ific method of accounting andreduces the occurrence of errors and scope for mani pulation.In either case, the books of account may be maintained either on cash b asis (i.e. transactions arerecorded only when money is actually received or paid ) or on accrual basis (i.e. transactions arerecorded 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 t he DoubleEntry System on accrual basis. Partnership firms and individuals have t he option to follow either system. Capital and Revenue Expenditure Capital Expenditure is that expenditure which results in the acquisition of an a sset (tangible or intangible) which can later be sold or which results in an inc rease in the earning capacity of a business. Expenditure incurred on acquisition of fixed assets is in the nature of Capital Expenditure.Items of expenditure wh ose benefit expires within the year or expenditure incurred for maintainingthe b usiness or keeping the assets in good working condition are referred to as Reven ue Expenditure.Wages, salaries, electricity, etc. are items of Revenue Expenditu re. However, certain expenses suchas expenses on formation of the company, the c ost of issuing shares and debentures, etc. althoughapparently revenue in nature, provide an enduring benefit. Such expenses are classified as DeferredRevenue Ex penses.The classification of expenditure into capital and revenue expenditure is required in order to apply theMatching Concept. The general accounting treatmen t of capital and revenue expenses is as follows:Capital ExpenditureThe expenditu re incurred is shown as an asset on the BalanceSheet. The asset is depreciated o ver its useful life, and theamount of depreciation debited to the Profit and Los s Account-

3 -

Finance for Non-Finance ProfessionalsAccounting Fundamentals Revenue ExpenditureThe expenditure is debited to the Profit and Loss Account int he year it is incurredDeferred Revenue ExpenditureThe expenditure is shown as an asset and debited to ytheProfit and Loss Account in annual instalments over the periodfor which it provides a benefit Financial Statements At the end of the reporting period which is generally one year the accounting tr ansactions for theentire 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 thefin ancial 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 fi nancial 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 period2) Shareholders for assessing the worth of their investments and reviewing the effectiveness of the Management3) Investors for judging the worth of the entity before deciding to invest4) Suppliers and Lenders for judging the creditworthiness of the entity before deciding to extendcredit5) Government for calculating the amount of tax to be collected Accounting Concepts To ensure uniformity in preparation of accounts across entities, the following c oncepts are appliedwhen recording accounting transactions:1) Business Entity Concept : The business for which accounts are maintained is treated as an entitydistinct from its owners and managers.2) Money Measurement Concept : All transactions affecting the business are stated in money termsand recorded in the Books of Account.3) Dual Aspect Concept : Every transaction has two aspects a debit and a credit and the sumof all debits w ll equal the sum of all credits. For example, when an asset is acquired, one of thefollowing events will also take place: another asset is forgone a liability (obligation to pay) is undertaken a profit has been earned4) 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 entitywill c ontinue 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, eventhoug h the money may be received later; expenditure is recorded when goods are procur ed or aservice 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 thei r occurrence.8) Matching Concept : Income and expenses for a period are correlated to ensure that the accounts pr oject an accurate picture. Therefore: when an income is recorded, all expenses incurred to earn that income must be re corded. 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 upaccording to the following conventions:4 Finance for Non-Finance ProfessionalsAccounting 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 state mentsshould 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. anticipat edincome should not be recorded whereas likely losses should be provided for. Accounting Process After each transactionTransaction 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 Boo k Generation of Trial Balance Adjustments and FinalisationEntries Compilation of Profit & LossAccount and Balance Sheet5 Finance for Non-Finance ProfessionalsBalance 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 tota lling the debit andcredit sides of the account and calculating the difference. T he difference is the balance in theaccount, 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 par ticular date. It isgenerated by listing all the accounts in the Ledger with the balance in each account appearing againstits name. Under the Double Entry System of Accounting, the totals of the Debit and Credit side of theTrial Balance will always be equal.

Fictitious Limited Trial Balance Sheet as at 31 st March 1998 Sr.Name of the AccountL/FDebit (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 fi nalising the accounts:1.Determination of income and expenses not relating to cur rent year 2.Calculation of Depreciation on Fixed Assets and amount of Deferred R evenue Expenses to beamortised3.Calculation of Provisions to be made for doubtfu l debts4.Calculation of Provision for Taxation5.Valuation of Closing Stock 6.Cal culation of Dividend and tax thereon7.Adjustments relating to prior years8.Journ al Entry for transfer of all current income to the credit of the Profit and Loss Account, andall 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 fromthe finalisation journal entry. The current years profit is dete rmined by balancing the account andcarried 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 theBalance Sheet. Generally, the assets and liabiliti es are stated in decreasing order of permanence.6 Finance for Non-Finance ProfessionalsBalance Sheet Preparation Fictitious Limited Profit and Loss Account for the year ended 31 st March Dr.Cr.Particulars1998(Rs.)1997(Rs.)Particulars1998(Rs.)1997(Rs.) To Opening Stock of FinishedGoodsBy SalesTo Raw Materials ConsumedBy Interest Ea rnedTo Wages and SalariesBy Other IncomeTo Administrative ExpensesBy Closing Sto ck of FinishedGoodsTo Interest and Bank ChargesBy Net Loss c/dTo Sales and Distr ibutionExpensesTo Provision for Doubtful DebtsTo DepreciationTo Provision for Ta xationTo Net Profit c/dTotalTotalTo Balance b/fBy Balance b/f To Net Loss for th e year b/dBy Net Profit for the year b/dTo Prior Years AdjustmentsBy Prior Years A djustmentsTo Transfer to ReservesBy Balance c/f To Proposed DividendTo Tax on Pr oposed DividendTo Balance c/f TotalTotal Profit and Loss Account - T Format 7 Finance for Non-Finance ProfessionalsBalance Sheet Preparation Fictitious Limited Balance Sheet as at 31 st March LIABILITIES1998(Rs.)1997(Rs.)ASSETS1998(Rs.)1997(Rs.) Share CapitalFixed Assets- Equity Share Capital Gross Block- Preference Share Ca pital Less: DepreciationNet BlockCapital Work-in-ProgressReserves and Surplus- G eneral ReserveInvestments- Profit and Loss Account Government SecuritiesSharesDe benturesSecured LoansCurrent Assets, Loans andUnsecured LoansAdvances- Inventory - Sundry Debtors- Cash and Bank Balance- Other Current Assets- Loans and Advance sCurrent Liabilities andProvisions- Sundry CreditorsMiscellaneous Expenses (to t he- Outstanding Expensesextent not written off or adjusted)- Provision for TaxPr ofit and Loss AccountContingent Liabilities: Balance Sheet - T Format -

8 Finance for Non-Finance ProfessionalsBalance Sheet Preparation Fictitious Limited Profit and Loss Account for the year ended 31 st March PARTICULARS1998(Rs.)1997(Rs.)INCOME SalesInterest EarnedOther Income TOTAL INCOMEEXPENDITURE Raw Materials ConsumedCost of Finished Goods soldWages and SalariesAdministrativ e ExpensesInterest and Bank ChargesSales and Distribution ExpensesProvision for Doubtful DebtsDepreciationProvision for Taxation TOTAL EXPENSES Net Profit/Loss for the year Add: Balance brought forward from previous yearsAdd /(Less): Prior Years adjustmentAmount available for appropriationAppropriations:D ividend for the year Transfer to ReservesBalance carried forwardTotal Appropriat ions Profit and Loss Account - Vertical Format (Income Statement) 9 Finance for Non-Finance ProfessionalsBalance Sheet Preparation Fictitious Limited Balance Sheet as at 31 st March PARTICULARSSchedule1998(Rs.)1997(Rs.)SOURCES OF FUNDS Shareholders FundsShare Capital- Equity Share Capital- Preference Share CapitalRe serves and Surplus- General Reserve- Profit and Loss AccountLoan FundsSecured Lo ansUnsecured Loans TOTAL SOURCESAPPLICATION OF FUNDS Fixed AssetsGross BlockLess: DepreciationNet BlockCapital Work-in-ProgressInvest mentsGovernment SecuritiesSharesDebenturesCurrent Assets, Loans and Advances- In ventory- Sundry Debtors- Cash and Bank Balances- Other Current Assets- Loans and AdvancesLess: Current Liabilities and Provisions- Sundry Creditors- Outstanding Expenses- Provision for TaxNet Current AssetsMiscellaneous Expenses (to the ext ent not writtenoff or adjusted)Profit and Loss Account TOTAL APPLICATION Balance Sheet - Vertical Format 10 Finance for Non-Finance ProfessionalsBalance Sheet Preparation Requirements of the Companies Act, 1956 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 company1.sales and purchase s of goods by the company1.assets and liabilities of the company1.cost records i n case of companies manufacturing notified products1.Accounts must be maintained such that they give a true and fair view of the state of affairs of thecompany. 1.Accounts must be maintained on accrual basis and according to the double entry system of accounting.1.Books of accounts and vouchers must be preserved for eig ht years.1.The Balance Sheet must be drawn up at the end of the financial year a ccording to the format prescribed in Schedule VI Part IA (horizontal format) or Part IB (vertical format) of the Act, andmust also disclose:1.details of utilisa tion of Share Premium1.gross value of assets and accumulated depreciation1.free reserves net of debit balance in Profit and Loss Account1.Loans and Advances due from companies under the same management1.details of investments in each compan y (statement to be attached to the Balance Sheet)1.balances due from directors1.

The Profit and Loss Account must comply with the requirements of Part II of Sche dule VI of theAct and must disclose:1.details of non-recurring or exceptional tr ansactions1.commission paid to sole selling and other selling agents1.in case of a manufacturing company, the value of raw materials consumed and the openingand closing stocks of goods produced, and in case of a trading company, the purchas es madeand opening and closing stocks of goods1.the value of work-in-progress at the beginning and the end of the reporting period1.depreciation on fixed assets 1.interest on debentures and loans, stating separately the interest paid to dire ctors1.provision for income tax1.amounts transferred to and from reserves1.provi sions made for meeting specific liabilities1.expenditure incurred on certain ite ms1.income from investments and other sources1.dividend paid and proposed to be paid1.impact of changes in accounting policies1.amounts paid as salaries, commis sion, reimbursement of expenses, etc. to Directors1.amounts paid to the auditors 1.11 Finance for Non-Finance ProfessionalsFinancial Analysis Techniques 3. OVERVIEW OFFINANCIAL ANALYSIS TECHNIQUES Financial Analysis Techniques Ratio Analysis and Funds Flow Analysis are the two most widely-used techniques f or analysingthe financial position of businesses. Ratio Analysis A ratio is one quantity expressed as a proportion of another. Ratio Analysis is a simple andeffective method of understanding some crucial facts about a firms op erations and financialsituation viz. debt burden, operating efficiency and profi tability. Ratios are computed fromfinancial statements and may be used for inter -firm or inter-period comparison.The ratios used in analysing the financial posi tion of a company are classified into four types:1. Liquidity Ratios measure the firms ability to fulfil short-term commitments out of its liquidasset s. Assets are liquid if they are either cash or relatively easy to convert into ca sh.1.1. Current Ratio 1.1.Current Assets1.Current Liabilities1.1.Current Assets are relatively liquid (i.e. they can be converted into cash in a relativelyshort time period) and Cur rent Liabilities are those liabilities which are due within oneyear.1. 1.Quick Ratio or Acid Test Ratio 1.Current Assets-InventoryCurrent Liabilities1.1.The Quick Ratio measures the fi rms ability to meet short-term obligations from its mostliquid assets. In this ca se, inventory is not included with other current assets because itis generally f ar less liquid than the other current assets.2) Leverage Ratios measure the extent of the firms total debt burden. They reflect the firmsability t o meet its short- and long-term debt obligations1. Debt to Total Assets Ratio Total External LiabilitiesTotal AssetsThe Debt to Total Assets Ratio indicates how much of the investment in the firms business has been funded by outsiders. b) Debt Equity Ratio Long Term DebtShareholders FundsThe Debt Equity Ratio measures the extent of borr owing by the firm as a proportion of the investment of its owners.12 Finance for Non-Finance ProfessionalsFinancial Analysis Techniques c) Interest Coverage Ratio Cash ProfitInterest ExpenseThe Interest Coverage Ratio reflects the firms 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 firms investments in current and long-term assets ar

e toosmall or too large.a) Inventory Turnover Cost of Goods SoldAverage InventoryThe Inventory Turnover Ratio shows the speed with which the firm is able to sell itsoutput. b) Average Collection Period Sundry Debtors x 12Credit SalesThe Average Collection Period indicates the firms efficiency in col lecting receivables. Alonger collection period will lead to an increase in the i nterest burden on the firm.c) Fixed Assets Turnover SalesFixed AssetsThis ratio indicates how intensively the fixed assets of the fi rm are being utilised. A lowfixed assets turnover ratio means that the value of the goods produced by the firm is lowwhen compared to the investment made for pr oducing those goods.d) Total Assets Turnover SalesTotal AssetsTotal Assets Turnover reflects how well all the firms assets are being utilised to generatesales.4) Profitability Ratios measure the success of the firm in earning a net return on sales or oninvestment . Since profit is the ultimate objective of the firm, poor performance hereindic ates a basic failure that, if not corrected, would probably result in the firms g oing out of business.a) Gross Margin Sales - Cost of Goods SoldSalesThe Gross Margin reflects the effectiveness of pr icing policy and of productionefficiency.13 Finance for Non-Finance ProfessionalsFinancial Analysis Techniques b) Net Operating Margin Operating ProfitSalesThe Net Operating Margin indicates the profitability of sal es before taxes and interest. Non-operating revenues and expenses are excluded w hen calculating this ratio.c) Net Margin Net ProfitSalesThe Net Margin is simply the net profit earned by the firm expre ssed as a proportion of sales. It is similar to the Net Operating Margin, but is slightly distorted as non-operating income and expenditure can impact it substa ntially.d) Return on Total Assets Net Profit + Interest ExpenseTotal AssetsThe Return on Total Assets is the retu rn earned by the firm for all investors (i.e.shareholders and lenders). It refle cts the ability of the firm to earn profits withoutconsidering the financing pat tern.e) Return on Equity Net Profit-Preference Dividend Net Worth-Preference Share CapitalThe Managements objective is to maximise returns on shareholders investment in thefirm. Return o n Equity is the best indicator of the Managements effectiveness inachieving this objective. Funds Flow Analysis Funds Flow Analysis involves the determination of the sources of cash flowing in to the firm and theuses of that cash by the firm. While the Balance Sheet only s hows the monetary value of each sourceand application of funds at the end of the year, an analysis of the flow of funds reveals the extent of changes in each so urce and application during the year.Inflow of funds will be indicated by:1.a de crease in assets1.an increase in liabilities1.an increase in shareholders fundsOn the other hand, outflow of funds will be indicated by:1.an increase in assets1. a decrease in liabilities1.a decrease in shareholders funds14 -