ACCOUNTING

WHAT IS ACCOUNTING• Language of Business ( Information system which provide information

to users about economic activity• Reflect a window through which we see how economic event effect

business• Accounting is the backbone of business. and allows managers to make

informed decisions, keeps investors abreast of developments in the business, and keeps the business profitable.

• Series of Steps which record information & convert into Financial Statement

• The Identifying ( Business transactions, their relevance can be denominated in money terms ) systematic recording ( Business transactions in books- Documenting revenues by invoice or cash receipts and purchases by cash payment or credit purchases ), Summarizing transactions ( in the form of BS, P&L Equity statements ) , reporting ( Written form to satisfy managerial ,governmental, investing or banking needs – A power full tool to help owners), and analysis of financial transactions of a business

• Thus accounting Is the skill, or job of keeping the financial records of a business

PURPOSE / NEED / BASIC FUNCTIONS

NEED• In an economy, Companies and other need to communicate to the

outside company, statutory bodies, stake holders, lenders, creditors, debtors about the transactions they performed having financial implications and these are done through the language known as “ Accounting “

• Accounting helps you keep track of your business expense & income as well as forecast how much money would be available in future

• Every business need to have two prime objectives, such as, to earn profit and to remain solvent and the information in relation to these objectives is provided by Accounting

• In other words three reasons for the need of accounting– To make prediction about the future– To help you make more effective commitments of time, energy, and

money to attract customers and deliver goods & services at a large &more effective scale.

– To measure & reassure your progress, so you can reward and encourage profitable behaviors, report progress to third party and change directions when necessary

PURPOSE / NEED / BASIC FUNCTIONS-Cont

PURPOSE A tool that enhance understanding of economic event

• To prepare financial statements for meeting regulatory requirements• Help in understanding financial health of the Company for variety of

reasons. • Help decision making - where and when Company should spend -

make commitments• Provide information for evaluation of financial performance• In order to understand what is happening – like are u making profit or

loss, surviving or going well.• Accounting allows companies to record, analyze and retrieve critical

financial information to be used to determine a company's financial status and provide reports and insights needed to make sound financial decisions.

• The primary purpose is to identify and records all activities that impact the organization financially. All activities include purchases, sales, acquisition of assets, incurring liabilities

PURPOSE / NEED / BASIC FUNCTIONS• BASIC FUNCTIONS / ROLE OF ACCOUNTING IN BUSINESS

• Accounting refers to the process of bookkeeping is a very important process in an organization.

• The information derived from the accounting processes gives complete financial information about the company and conveys its financial standing to the owners and employees of the company.

• It also shows which products or assets of the company are most profitable and those which are weak.

• Day to day bookkeeping helps in preventing any frauds. • Interpret and record business transactions – payment, assets &

liabilities• Classify transactions into useful heads / reports• Summarize & communicate to decision makers on

– Economic / financial decision making – Help in making investment / credit decisions– Assignment of timing and amount of cash flow

• Book keeping is the function of accounting that help maintain above types of transactions through the process of debit and credit to create accurate and timely financial statements / reports

Financial statements being maintained by a company

The four primary financial statements are

– Balance Sheet- Measuring Financial Position

– Income Statement- Measuring Financial Performance

– Statement of Owners Equity ( Retained Earning )

– Statement of Cash Flows

ACCOUNTING FROM USERS PERSPECTIVE

• User of Financial statements – External / Internal users

• External users - Shareholders ( present Investors ), Potential Investors, Lenders, Consumer groups, Creditors, Employees, Government agencies and Public at large

• Limited Information - General-purpose financial statements of the company’s economic position which is the type of accounting aimed at supplying information to users not directly affiliated with the target company.

User of Financial statements – External / Internal users

External users - Some of their different needs includes following

(A) Investors. ( Present and Potential Investors ) They require comprehensive analyses that offer the highest level of scrutiny

- Whether they should buy, hold or sell.- To assess the ability of the enterprise to pay dividends - long-term earnings and growth,- stock price appreciation. - Profit – Current Financial Statements- Past Performance- Security of investment

(B) Lenders. Interested in information that enables them to determine - Paying capability - Mark Up & return of principal at maturity.

- Future Business


External users -Some of their different needs includes following

(C) Consumer Group / Debtors. - Continuous of an enterprise / Going concern / dependent on one product- Quality product- Warranty obligations- Business with Company

(D) Suppliers and other trade creditors. - Interested whether amounts owing to them will be paid when due. -Interested over a shorter period than lenders unless dependent upon continuation of the enterprise as a major customer.

(E) Employees. Interested about the stability and profitability of their employers. Also interested to assess the ability of

- Pay raise, retirement benefits and employment opportunity - Employment security


External users -Some of their different needs includes following

(F) Governments and their agencies. Interested in - Economy – Where stands- No of business & their performance- Allocation of resources- Investment incentive- Taxation- SECP / Corporate Governance

(G) Public Bodies – Employment Organizations- Employment- Corporate / social responsibilities


Internal users • Managers,• Internal auditors,• Sales staff,• Budget officers, • Controllers,• Officers, and ultimately directors.

Why do we bother keeping accounting records?

Financial Accounting• Several groups ( stakeholders', Proposed Investor,

lender, creditor, Debtor, Govt Agencies .) - have an interest in the finances of the business. The law says that they have a legal right to certain information.

Management Accounting• Managers need financial information

- To know how things are going. - To plan for the future; - To check whether actual performance is on target and controlling

Why do we bother keeping accounting records?

• The objectives of financial reporting are to provide information that is:

(1) Useful to those making investment and credit decisions who have a reasonable understanding of business and economic activities;

(2) Helpful to present and potential investors and creditors and other users in assessing the amount, timing and uncertainty of future cash flows; and

(3) About economic resources, the claims to those resources and the changes in them.

(4)While these objectives are aimed at satisfying the equity and credit investors they are likely to be useful to all other user groups.

TYPES OF ACCOUNTING / BASIC TERMINOLOGIES

Accounting can be broadly divided into two categories: financial accounting and management accounting.

• Financial Accounting Serves external decision makers, like stake holders, Suppliers, Banks & Government Agencies

• Management Accounting - Internal decision makers

• - Cost accounting -

TYPES OF ACCOUNTING / BASIC TERMINOLOGIES

• WE MAY ALSO STATE FOLLOWING AS TYPES OF ACCOUNTING

• Cash basis - Receipt & Payment and Balance Sheet• Accrual basis - Profit & Loss or Income & Expenditure Account & Balance Sheet

INTRODUCTION TO DOUBLE ENTRY SYSTEM AND ITS MECHANICS

Double-entry accounting ( Business transaction include two parts, giving & Receiving – (Debit what comes in & credit what goes out )

• Each transaction that is entered consists of one or more debits and credits, and the total debits must equal the total credits.

• Every account has a left side and a right side to enter a transaction. In accounting terms, a debit simply means an entry on the left side of an account, and a credit simply means an entry on the right side of an account.

• If you purchase a car with a down payment of $1,000 and a loan from bank for another $14,000, entries to record this transaction would be the following:

– A debit of $15,000 to your fixed asset account named, for example, "Vehicles.“

– A credit of $1,000 to your bank account for the down payment. – A credit to an Auto Loans account for $14,000.


Double Entry Account Types: • Asset accounts

- Something you own, such as your car & house• Liability accounts

- Something that you owe, like , car loan or credit card balances.

• Income accounts- Money you receive.

• Expense accounts - Money you spend


• Nature of Accounts – with reference to Debit & Credit

– Real Account- Relating to Tangible assets, Debit what comes in-Credit what goes out

– Personal Account-Represents persons & Organisations, Debit the receiver and credit the giver

– Nominal Account- Represents expense & income, losses and gains – Debit all expense and losses and credit all receipt and gains


The Accounting Equation and Double Entry BookkeepingAssets = Liabilities + Owner’s EquityAssets + Expense = Liabilities + Owner’s Equity + Expense

• An entry to increase an asset account must also increase liabilities, owners equity, or reduce another asset by the same amount to keep the accounting.


RULES OF DEBIT & CREDIT• Debits and Credits and Double Entry Accounting• Debits Indicate Credits Indicate

Increases Asset Decrease Assets Decreases Liability Increases Liability Equity Decreases Equity IncreaseIncrease Expenses Increase Revenue

TRANSACTION ANALYSIS / RECORDING THE TRANSACTION

• What is transaction • Event that have a financial impact on business i.e selling product &

paying exp. • Transaction has two sides – receiving & giving ( Debit & Credit ) –

Both sides must be equal

• Analysis of transactions is the heart of accounting• For each transaction the accountant determines

– Which specific account the transaction effect– Whether it decreases or increases the balance– The amount of change in account balance

Transaction Analysis is the process of reconciling the differences made to each side of the equation with each financial transaction occurs. Let’s look at some sample transactions to get a better understanding of how the analysis and equation work.


• The accounting equation for a brand new company will look like this:

Assets = Liabilities + Owner's Equity$0 $0 $0

Transaction 1: The owner deposits $5000 in the checking account to begin operations

Assets = Liabilities + Owner's Equity+$5000 $0 +$5000

Transaction 2: The business purchases a computer, on credit, for $2500.

Assets = Liabilities + Owner's Equity+$2500 +$ 2500 $


• The Recording ProcessThe sequence of five steps in recording and reporting transactions is as follows

Transaction Doc – Journal – Ledger – Trial Balance – F. Statements

Journal ( General Journal ) – chronological recording of transaction. Has three types

1) specify each a/c effected by transaction2) Determine each account increased / decreased3) Follow debit credit rules

• Source documents - Original records of any transaction


Journalizing Transactions

• Journalizing is the process of entering transactions into the general journal

• A journal entry is an analysis of all the effects of a single transaction on the various accounts, usually accompanied by an explanation

• A compound entry means that a single transaction affects more than two accounts

• The following conventions are used for recording in the general journal

– The title of the account or accounts to be debited are placed at the left margin

– The title of the account or accounts to be credited are indented in a consistent way


Posting Transactions to the Ledger

• Posting is the transferring of amounts from the journal to the appropriate accounts in the ledger

Ledger AccountsEach transaction affects at least two accounts• The process of creating a new T-account in preparation for recording a

transaction is called opening the account• An account balance is the difference between the total left-side and right-

side amounts at any particular time• Asset accounts have left-side balances

– Entries on the left side increase asset account balances – Entries on the right side decrease them

• Liabilities and owners’ equity accounts have right-side balances– Entries on the right side increase their balances – Entries on the left side decrease them


• Title of Account

Date Voucher no Particulars Debit Credit Balance

• Chart of Accounts

A chart of accounts is a numbered or coded list of all account titles


Revenue and Expense Transactions• Revenue and expense information is accumulated separately to

prepare a more meaningful income statement• Expense and revenue accounts are part of Retained Earnings

– Revenue account increases retained earnings– An expense account decreases retained earnings

• Revenue expenditures is incurred for the following purposes: - For purchasing floating assets i.e., assets meant for resale at a profit

or for being converted into saleable goods, such as the cost of goods, raw materials and stores.

-For maintaining assets in proper working order e.g., repairs to plant and machinery, building furniture and fittings etc.

-For meeting day to day expenses of carrying on a business e.g., salaries, rent, rates, taxes, stationery, postage etc

All revenue expenditures have to be deducted from the income earned by the firm. That is to say, all revenue items will be taken to the profit and loss account.


Preparing the Trial Balance

• A trial balance is a list of all the accounts with their balances• The purpose of the trial balance is twofold:

– Proving whether the total debits equal the total credits in the ledger– Summarizing the balances in the ledger accounts in preparation to

construct the financial statements• The trial balance is prepared with the accounts in the following order:

– Asset accounts– Liability accounts– Stockholders’ equity accounts– Revenue accounts– Expense accounts

• The trial balance is the spring board for preparing the balance

TYPES OF ERRORS IN TRIAL BALANCE• Classification of Errors• Keeping in view the nature of errors, all the errors can be classified

into the following four categories:• Errors of Commission• Errors of Omission• Errors of Principle• Compensating Errors• Errors of Commission• These are the errors which are committed due to wrong posting of

transactions, wrong totalling or wrong balancing of the accounts, wrong casting of the subsidiary books, or wrong recording of amount in the books of original entry, etc. For example: Raj Hans Traders paid Rs. 25,000 to Preetpal Traders (a supplier of goods). This transaction was correctly recorded in the cashbook. But while posting to the ledger, Preetpal’s account was debited with Rs. 2,500 only. affect in the trial balance

TYPES OF ERRORS IN TRIAL BALANCE• Errors of Omission• The errors of omission may be committed at the time of recording the

transaction in the books of original entry or while posting to the ledger. These can be of two types:

• (i) error of complete omission• (ii) error of partial omission• When a transaction is completely omitted from recording in the books

of original record, it is an error of complete omission. For example, credit sales to Mohan Rs. 10,000, not entered in the sales book. When the recording of transaction is partly omitted from the books, it is an error of partial ommission. If in the above example, credit sales had been duly recorded in the sales book but the posting from sales book to Mohan’s account has not been made, it would be an error of partial omission

TYPES OF ERRORS IN TRIAL BALANCE• Errors of Principle• Accounting entries are recorded as per the generally accepted

accounting principles. If any of these principles are violated or ignored, errors resulting from such violation are known as errors of principle. An error of principle may occur due to incorrect classification of expenditure or receipt between capital and revenue. This is very important because it will have an impact on financial statements. It may lead to under/over stating of income or assets or liabilities, etc. For example, amount spent on additions to the buildings should be treated as capital expenditure and must be debited to the asset account. Instead, if this amount is debited to maintenance and repairs account, it has been treated as a revenue expense. This is an error of principle. Similarly, if a credit purchase of machinery is recorded in purchases book instead of journal proper or rent paid to the landlord is recorded in the cash book as payment to landlord, these errors of principle. These errors do not affect the trial balance

TYPES OF ERRORS IN TRIAL BALANCE• Compensating Errors• When two or more errors are committed in such a way that the net

effect of these errors on the debits and credits of accounts is nil, such errors are called compensating errors. Such errors do not affect the tallying of the trial balance.

• For example, if purchases book has been overcast by Rs. 10,000 resulting in excess debit of Rs. 10,000 in purchases account and sales returns book is under cast by Rs. 10,000 resulting in short debit to sales returns account is a case of two errors compensating each other’s effect. One plus is set off by the other minus, the net effect of these two errors is nil and so they do not affect the agreement of trial balance.

SEARCHING OF ERRORS IN TRIAL BALANCERE

If the trial balance does not tally, it is a clear indication that at least one error has occured. The error (or errors) needs to be located and corrected before preparing the financial statements. If the trial balance does not tally, the accountant should take the following steps to detect and locate the errors :

• Recast the totals of debit and credit columns of the trial balance.• Compare the account head/title and amount appearing in the trial balance, with that of the ledger to detect any difference in amount

or omission of an account.• Compare the trial balance of current year with that of the previous year to check additions and deletions of any accounts and also

verify whether there is a large difference in amount, which is neither expected nor explained.• Re-do and check the correctness of balances of individual accounts in the ledger.• • Re-check the correctness of the posting in accounts from the books of original entry.• • If the difference between the debit and credit columns is divisible by 2,• there is a possibility that an amount equal to one-half of the difference• may have been posted to the wrong side of another ledger account. For• example, if the total of the debit column of the trial balance exceeds by Rs.• 1,500, it is quite possible that a credit item of Rs.750 may have been• wrongly posted in the ledger as a debit item. To locate such errors, the• accountant should scan all the debit entries of an amount of Rs. 750.• • The difference may also indicate a complete omission of a posting. For• example, the difference of Rs. 1,500 given above may be due to omissions• of a posting of that amount on the credit side. Thus, the accountant should• verify all the credit items with an amount of Rs. 1,500.• • If the difference is a multiple of 9 or divisible by 9, the mistake could be due• to transposition of figures. For example, if a debit amount of Rs. 459 is posted• as Rs. 954, the debit total in the trial balance will exceed the credit side by• Rs. 495 (i.e. 954 – 459 = 495). This difference is divisible by 9. A mistake• due to wrong placement of the decimal point may also be checked by this• method. Thus, a difference in trial balance divisible by 9 helps in checking• the errors for a transposed mistake.


• If the difference between the debit and credit columns is divisible by 2,there is a possibility that an amount equal to one-half of the difference may have been posted to the wrong side of another ledger account.

• For example, if the total of the debit column of the trial balance exceeds by Rs.1,500, it is quite possible that a credit item of Rs.750 may have been wrongly posted in the ledger as a debit item. To locate such errors, the accountant should scan all the debit entries of an amount of Rs. 750.

• • The difference may also indicate a complete omission of a posting. For example, the difference of Rs. 1,500 given above may be due to omissions of a posting of that amount on the credit side. Thus, the accountant should verify all the credit items with an amount of Rs. 1,500.


If the difference is a multiple of 9 or divisible by 9, the mistake could be due to transposition of figures. For example, if a debit amount of Rs. 459 is posted as Rs. 954, the debit total in the trial balance will exceed the credit side by Rs. 495 (i.e. 954 – 459 = 495). This difference is divisible by 9. A mistake due to wrong placement of the decimal point may also be checked by this method. Thus, a difference in trial balance divisible by 9 helps in checking the errors for a transposed mistake.

A mistake due to wrong placement of the decimal point may also be checked by this method. Thus, a difference in trial balance divisible by 9 helps in checking the errors for a transposed mistake.

RECTIFICATION OF ERRORS IN TRIAL BALANCERE

From the point of view of rectification, the errors may be classified into the

• following two categories :• (a) errors which do not affect the trial balance.• (b) errors which affect the trial balance.• This distinction is relevant because the errors which do

not affect the trial balance usually take place in two accounts in such a manner that it can be easily rectified through a journal entry whereas the errors which affect the trial balance usually affect one account and a journal entry is not possible for rectification unless a suspense account has been opened. Such errors are rectified by passing a nullifying entry in the respective account

Recording Transactions• Accounting Equation

• The other form of equation is• Assets + expense = Liability + Equity + Income

• Assets are Economic reserves, produce future benefits, & are cash, cash equivalent, inventory, other receivables & plant & machinery

Equity – Inside claim, ownership of stock holders, amount invested & retained earning

Liability – Outside claim – Debt payable, notes payable etc


• Closing the AccountsClose the accounts by transfers the balances of the “temporary” stockholders’ equity accounts (revenues and expenses) to the P&L account and thereafter to “permanent” stockholders’ equity account (retained earnings) This makes the revenues and expense accounts have a zero balance.

• There are three closing entries:C1: Close all revenue accounts to Income StatementC2: Close all expense accounts to Income StatementC3: Transfer the Profit/Loss to Retained Earnings


• C1. Transaction: Clerical procedure of transferring the ending balances of revenue accounts to the Income Statement

Journal Entry: Sales …………160,000 Income Statement…… 160,000

• C2. Transaction: Clerical procedure of transferring the ending balances of expense accounts to the Income Statement

Journal Entry: Income Statement……………102,100 Cost of goods sold………. 100,000

Rent expense……………. 2,000 Depreciation expense…… 100

• C3. Transaction: Clerical procedure of transferring the FINAL RESULT of Income Statement (PROFIT/LOSS) to the Retained Earnings accountIN CASE OF PROFIT

Journal Entry: Income Statement…………57,000 Retained earnings…… 57,000

IN CASE OF LOSS Journal Entry: Retained Earnings…………57,00

Income Statement…… 57,000

THE CONCEPT OF ACCOUNTING PERIOD CAPITAL / REVENUE EXP.

Revenue expenditures• Expenditure is revenue if incurred for the following purposes:

– Purchasing floating assets i.e., assets meant for resale at a profit or for being converted into saleable goods, such as the cost of goods, raw materials and stores.

– Expenditures incurred for maintaining assets in proper working order e.g. repairs to plant and machinery, building furniture and fittings etc.

– Expenditures incurred for meeting day to day expenses of carrying on a business e.g. salaries, rent, rates, taxes, stationery, postage etc.

• All revenue expenditures have to be deducted from the income earned by the firm. That is to say, all revenue items will be taken to the profit and loss account.

THE CONCEPT OF ACCOUNTING PERIOD DIFFERENCE - CAPITAL / REVENUE EXP.

Revenue Expense• Its effect is temporary, i.e., it is exhausted within the current

accounting year.• Neither an asset is acquired nor the value of an asset is

increased.• This occurs repeatedly – It is recurring and regular. It has no

physical existence, i.e., Generally in some cases it cannot be seen with eyes.

• This expenditure helps to maintain the concern. The whole amount of this expenditure is shown in trading and profit and loss account or income and expense account. But deferred revenue expenditure and prepaid expenses are not shown. It does note appear in balance sheet. Deferred revenue expenditure, Outstanding expenditure, outstanding expenses and prepaid expenses, however, temporarily shown in the balance sheet. It reduces revenue. Payment of salaries to employees decreases revenue

THE CONCEPT OF ACCOUNTING PERIOD DIFFERENCE - CAPITAL / REVENUE EXP.

CAPITAL EXPENDITURE

• Its effect is long term i.e., it is not exhausted within the current account year. In a word, its effect is reduces gradually.

• An asset is acquired or the value of an asset is increased as a result of this expenditure.

• It does not occur against and again – it is non – recurring and irregular.

• Generally, it has physical existence i.e. it can be seen with eyes.

• This expenditure improves the position of the concern.• A portion of this expenditure is shown in the trading and

profit and loss account or income and expenditure account as depreciation.

• It appears in balance sheet until its benefit is fully exhausted.• It does not reduce the revenue of the concern. Purchase of

fixed assets does not affect revenue

THE CONCEPT OF ACCOUNTING PERIODINCOME MEASUREMENT AND MATCHING,

• What is INCOME?Some kind of INFLOW of economic benefit - Cash or accounts receivable

• TYPES OF INCOME– Sale of goods– Rendering of services– Others

• Interest• Royalties• Dividends etc

• Generation of INCOMEIncome is generated primarily through the OPERATING CYCLE

• Operating CycleStart with cash--Purchase goods--Build inventory--Sell goods-- A/c Receivables

• Effect of Income on Owners’ EquityINCOME ALWAYS INCREASES OWNERS’ EQUITY

TYPES / SOURCE OF INCOME4 basic types of income. 1.) Earned Income: (also referred to as linear income) This is where

there is a direct correlation between your time and income - They are directly connected. In other words, you're trading your time for dollars -- You work 8 hours, you get paid for 8 hours...

• 2.) Residual Income: This is income that you gain by doing something correctly once, and then reaping the financial profits over and over again without any further effort on your part. Examples: royalties, a percentage of a previously sold product that has a re-occurring income i.e., insurance, song roylaity

• 3.) Leveraged Income: Income that you gain in conjunction with the combined efforts of others. Examples: A team, sub-affiliates in your affiliate programs, or your employees if you own a business and employ others to generate income towards your bottom line

• 4.) Passive Income: Any type of income that doesn't require your time (or verrry little of it) in order to sustain. Examples: Investments, High interest bearing accounts,

TYPES / SOURCE OF INCOME- Cont--

• Four Basic Ways to Earn Money• Employment - When an employee works for an

employer and gets wages/salary in return. • Self-Employment - This means working for

yourself that can earn you money. • Business - This implies having a set

establishment or system that can churn out money for an individual.

• Investment - This involves making money out of money or in other words making money out of the accumulate capital

TYPES OF ACCOUNTING/TERMINOLOGIES

Accounting – financial accounting and management accounting. Double Entry Account Types: • Asset accounts

Liability accounts Income accountsExpense accounts

Nature of Accounts – with reference to Debit & CreditReal Account - Personal Account - Nominal Account

• WE MAY ALSO STATE FOLLOWING AS TYPES OF ACCOUNTING

• Cash basis - Receipt & Payment and Balance Sheet• Accrual basis - Profit & Loss or Income & Expenditure Account & Balance Sheet

THE CONCEPT OF ACCOUNTING PERIODREVENUE RECOGNITION

REVENUE RECOGNITION • The concept indicate that companies should record

revenue in the earliest of period in which they are both earned & realized.

• Earning requires delivery of goods & services and realization require high probability that Company will receive the promised resource – Receive cash or claim to cash in exchange for goods and services

• What holds true for expenses, the same holds true for revenues. Revenues are recognized at the time of sales and not at the time of receipts from debtors.


• INCOME MEASUREMENT

Measuring income is important for every one from individual to businessmen. How well we are doing economically.

• Ways to measure income.Most popular are accrual and cash basis.

The Accrual basis recognize the impact of transaction at the time / period when revenue and expense occur. Record revenue as we earn and record expense as incurred and not when cash change hands.

Accrual basis maintained that the cash basis ignores activities that increase / decrease assets other than cash. Cash basis pointed out that a company, no matter how well it seems to be doing good, can go bankrupt if it does not manage its cash properly..


MATCHING CONCEPTS• We recognize and record expenses in the same period in which we

recognize their related revenues. This process is known as matching• We have seen how to recognize revenue on the accrual basis. What about

expense ??. There are two types of expenses in every accounting period- Those linked with the time period itself.- Those linked with the revenue earned that periodSome expense called product cost are naturally linked with revenues. Cost of sales and sales are very good examples. If there is no revenue there in no cost of goods sold

Example, If company Y makes 20 shirts at a cost of $100 and sells them for $200, she makes a profit of $100. However, if company Y had only sold 18 shirts, it would have been incorrect to charge its profit and loss account with the cost of twenty shirts, as it still has 2 shirts in stock. If it intends to sell them in June it is likely to make a profit on the sale. Therefore, only the purchase cost of 18 shirts $90 should be matched with its sales revenue, leaving it with a profit of $90


MATCHING CONCEPTS - Continued

The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are

(1) incurred (usually when goods are transferred or services rendered, e.g. sold), and

(2) (2) offset against recognized revenues, which were generated from those expenses (related on the cause-and-effect basis), no matter when cash is paid out.

In cash accounting—in contrast—expenses are recognized when cash is paid out, no matter when obligations are incurred through transfer of goods or rendition of services: e.g., sale.

THE CONCEPT OF ACCOUNTING PERIOD

• What Does Accounting Period Mean?• 1. In general, the time period reflected by a set

of financial statements. • 2. In terms of taxation, it is the 12-month period

a taxpayer uses to determine his or her income tax.

• 3. When accountants prepare financial statements, they assume that the life of the business can be divided into time periods. This is called the accounting period concept.

THE CONCEPT OF ACCOUNTING PERIOD ACCRUED / PREPAYMENTS - DEFERRED EXP

• Accrued expense: Expense is recognized before cash is paid out.• Deferred expense: Expense is recognized after cash is paid out.

• Accrued expenses / Deferred IncomeA liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision.

An accurual is an obligation to pay for goods or services received from a counterpart, while cash for them is to be paid out in a later accounting period when its amount is deducted from accrued expenses.

It shares characteristics with deferred income (or deferred revenue) with the difference that a liability to be covered latter is cash received from a counterpart, while goods or services are to be delivered in a latter period, when such income item is earned, the related revenue item is recognized, and the same amount is deducted from deferred revenues.

• In the absence of Accrual accounting, the Income Statement may indicate more profit in one year at the cost of the profits of some other year, which is entirely inappropriate and illogical.


Deferred expenses (or prepaid expenses or prepayment)

Is an asset, such as cash paid out to a counterpart for goods or services to be received in a latter accounting period when fulfilling the promise to pay is actually acknowledged, the related expense item is recognized, and the same amount is deducted from prepayments.

It shares characteristics with accrued revenue (or accrued assets) with the difference that an asset to be covered latter are proceeds from a delivery of goods or services, at which such income item is earned and the related revenue item is recognized, while cash for them is to be received in a later period, when its amount is deducted from accrued revenues.


• ACCOUNTING ADJUSTMENTS • Adjusting entries are journal entries usually

made at the end of an accounting period ( Monthly, bi annually, annually ) to allocate income and expenditure to the period in which they actually occurred.

• The revenue recognition principle is the basis of making adjusting entries that pertain to unearned and accrued revenues under accrual-basis accounting. They are sometimes called Balance Day adjustments because they are made on balance day.

THE CONCEPT OF ACCOUNTING PERIOD ACCRUED / PREPAYMENTS - Adjusting entries

Most adjusting entries could be classified as under

Prepayments (cash paid or Received before

consumption)

Accrued Exp- cash paid or received after consumption

Expenses

Prepaid expenses: for expenses paid in cash and recorded as assets before they are

used

Accrued expenses: for expenses incurred but not yet paid in cash

or recorded

Revenues

Unearned revenue: for revenues received in cash and recorded as liabilities

before they are earned

Accrued revenues: for revenues earned but not yet recorded or

received in cash

THE CONCEPT OF ACCOUNTING PERIOD ESTIMATES

• A third classification of adjusting entry occurs where the exact amount of an expense cannot easily be determined. The depreciation of fixed assets, for example, is an expense which has to be estimated.

• The entry for bad debt expense can also be classified as an estimate.

THE CONCEPT OF ACCOUNTING PERIODIMPLICIT & EXPLICITE TRANSACTIONS

• IMPLICIT & EXPLICITE TRANSACTIONS

• Explicit transactions – Observable events that trigger nearly all day-to-day routine entries– SUPPORTED BY SOURCE DOCUMENTS

Not all the explicit transactions require actual exchange of goods and services between the entity and third party.. For instance loss of assets ( fixed asset or stocks & stores ) from fire or theft. This type of event also require to note adjusting entry.

• Implicit transactions – Do not generate source documents or any visible evidence that the

event actually occurred– NOT SUPPORTED BY SOURCE DOCUMENTS– Are RECORDED IN END-OF-PERIOD ENTRIES and called

ADJUSTMENTS/ADJUSTING ENTRIES

THE CONCEPT OF ACCOUNTING PERIODIMPLICIT & EXPLICITE TRANSACTIONS

ADJUSTMENTS/ADJUSTING ENTRIES– Adjustments arise from FOUR basic types of IMPLICIT

TRANSACTIONS:– Converting an Asset into Expense (Expiration of

unexpired costs)– Converting a Liability into Revenue (Earning of

revenues received in advance)– Depreciation , amortization etc– Creation of a liability like gratuity etc– Accruing Unpaid Exp / income earned but not received– Accruing Uncollected Revenue– Failure to record the adjusting entry Overstate /

understate liabilities and assets. Similarly overstate / understate revenues & expense

ACCOUNTING FOR SALES ( Book keeping )

• To record a journal entry for a sale on account, Debit = Receivable Credit = Revenue account.

• When the customer pays off their accounts,Debit = Cash Credits = Receivable

• The ending balance on Trial Balance / Balance sheet for accounts receivable is always a debit.

ACCOUNTING FOR SALES Merchandise Returns and Allowances

• GROSS SALES are the initial revenues or asset inflows based on the initial sales price

• Gross sales are DECREASED BY the amount of the returns and allowances to calculate the net sales

• A SALES RETURN occurs when a customer returns previously purchased merchandise

• A SALES ALLOWANCE is a reduction of the original selling price

• A CONTRA ACCOUNT (SALES RETURNS AND ALLOWANCES) combines both returns and allowances in a single account-------resulting in NET SALES

ACCOUNTING FOR SALES Cash and Trade Discounts

• Trade discounts offer one or more reductions to the gross selling price for a particular class of customers

• The gross sales revenue recognized from a trade discount sale is the price received after deducting the discount

• Cash discounts are rewards for prompt payment

ACCOUNTING FOR SALES Credit Terms and Meanings

• n/30 The full billed price (net price) is dueon the thirtieth day after the invoice date

• 1/5, n/30 A 1% discount can be taken for payment within 5 days of the invoice date: otherwise the full billed price is due in 30 days

• 15 E.O.M. The full price is due within 15 days after the end-of the-month of sale (an invoice dated December 20 is due January 15)

ACCOUNTING FOR SALES Recognition of Sales Revenue

• REVENUE RECOGNITION requires a two-fold test:

– Goods or services must be delivered to the customers ( the revenue must be earned)

– Cash or an asset virtually assured of being converted into cash must be received (the revenue must be realized)

• Most companies recognize revenue at the point of sale

ACCOUNTING FOR SALES ANALYSIS OF DEBTS

• AGE DEBT ANALYSIS • TRANSACTION ANALYSIS• BY ACCOUNT GROUP

• Analysis may be under following categories

– Individuals– Companies– Government agencies etc

ACCOUNTING FOR SALES ANALYSIS OF DEBTS

Directorate 0-30 days £ 31-59 days £ 60-89 days £ 90-119 days £ Over 120 days £ Total£

Community & Social Services

2,521,213 378,061 71,187 79,282 1,188,538 4,238,281

Environmental Services

100,264 58,161 11,353 8,196 129,310 307,284

Chief Executives 92,868 0 0 0 17,796 110,664

Development Services

1,445,753 159,477 44,578 41,020 346,740 2,037,568

Commercial Rents 664,231 40,568 36,111 162,682 660,404 1,563,996

Corporate Services

1,014,334 69,805 24,363 19,021 16,429 1,143,952

Housing Services 274,307 6,497 73 2,723 90,107 373,707

Personnel Services 0 1,528 0 0 4,941 6,469

Education & Leisure

1,772,838 520,848 42,692 377,799 368,902 3,083,079

Sub total – SAP raised

7,885,808 1,234,945 230,357 690,723 2,823,167 12,865,000

Ex Radius debt 2,663,837 2,663,837

Total 7,885,808 1,234,945 230,357 690,723 5,487,004 15,528,837

ACCOUNTING FOR SALESBAD DEBTS AND WRITING OFF BAD DEBTS

• Most sales are on credit, which create Accounts Receivable• Credit sales create a new set of problems for measuring revenue

and managing the company’s assets• Credit sales generate POTENTIAL UNCOLLECTIBLE ACCOUNTS

• Uncollectible Accounts Granting credit entails both costs and benefits:

– The main benefit is the boost in sales and profit that a company generates when it extends credit

– The most significant cost is uncollectible accounts or bad debts—receivables that some credit customers are either unable or unwilling to pay

– The cost of granting credit that arises from uncollectible accounts is called BAD DEBTS EXPENSE

ACCOUNTING FOR SALES Measurement of Uncollectible Accounts

• Two methods available to measure the net value of account receivables,

• 1- Allowance method • 2- Direct write-off method.

X - Measurement of Uncollectible Accounts Allowance method

• The allowance method has two basic elements:

– An ESTIMATE of the amounts that will ultimately be uncollectible and

– A CONTRA ACCOUNT, which contains the estimated uncollectible amount that is deducted from the total Accounts Receivable

Measurement of Uncollectible Accounts Allowance method- Cont--

• Bad debt provision can be computed in Three ways, • (1) by reviewing each individual debt and deciding

whether it is doubtful (a specific provision); • (2) – Income Statement Method approach • - By providing for a fixed percentage (e.g. 2%) of total

debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement.

• (3) Balance Sheet Approach - The percentage of ACCOUNTS RECEIVABLE method estimates uncollectible accounts based on the historical relationship between uncollectible to year-end gross accounts receivable

Measurement of Uncollectible AccountsDirect write-off method

• It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value.The entry would consist of

• Debit Bad Debt written Off• Credit Accounts receivable

• The specific( Direct ) write-off method assumes that all sales are fully collectible until proved otherwise

• When a company identifies a specific customer account as uncollectible, it reduces the Accounts Receivable

• The specific write-off method fails to apply the matching principle of accrual accounting

• Matching requires recognition of the bad debts expense at the same time as the related revenue

• The two methods are not mutually exclusive =====

Measurement of Uncollectible AccountsConsidered factors for write off

• Debt has been inactive since last six month or more and all avenues have been exhausted by management to collect the outstanding amount

• Debtor has passed away• Left the business premises and disappeared• Any other reason company deem fit for write off• Probability of no recovery• Insolvent

Measurement of Uncollectible Accounts PROCEDURES FOR BAD DEBT WRITE OFFS

• Issue Notice to the party for payment giving full details• The reminder notice gives the owing customer 7 days to pay the outstanding

amountA second reminder to the party for payment• The Corporation’s Legal Advisor will issue a final letter of demand • Decide as to for how much amount due legal case be initiated.• The General Manager must ensure that all avenues for collection of the debt have

been fully exhausted before a debt is recommended for write-off• Prepares the Write-off of Uncollectible Debts form on which the following is

indicated– Debtor/Account name– Amount of debt– Age of debt– Method (s) taken to collect the debt– Reason (s) why it is uncollectible– Submits the above form accompanied by a covering letter signed by the

Chief Finance Officer, Marketing and Administration Manager for the Board’s consideration and approval.• Upon approval, retains written evidence of the approval at the Debts Recovery

Unit in a proper form that meets accounts/audit requirements for good record keeping.

• - Makes necessary adjustments to the relevant accounts.

Measurement of Uncollectible Accounts

• Bad Debt Recoveries

When bad debt recoveries occur, THE WRITE-OFF IS REVERSED and the collection is handled as a NORMAL RECEIPT on account

TRADING PART OF P&L & COMPREHENSIE PROVISIONS = IAS - 2

• The following terms are used in this Standard :• Inventories are assets:• (a) held for sale in the ordinary course of business;• (b) in the process of production for such sale; or• (c) in the form of materials or supplies to be consumed in the

production process or in the rendering of services.• Net realisable value is the estimated selling price in the

ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

• Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in a arm’s length transaction


• Cost of inventories• The cost of inventories shall comprise all costs of purchase, costs of

conversion and other costs incurred in bringing the inventories to their present location and condition

• The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods

• Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition

• Cost of inventories of a service provider• To the extent that service providers have inventories, they measure

them at the costs of their production.These costs consist of the labour and other costs of personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads

TRADING PART OF P&L & COMPREHENSIE PROVISIONS = IAS - 2• Recognition as an expense• When inventories are sold, the carrying amount of those

inventories shall be recognised as an expense in the period in which the related revenue is recognised. The amount of any write-down of inventories to net realisable value and all losses of inventories shall be recognised as an expense in the period the write-down or loss occurs. The amount of any reversal of any write-down of inventories, arising from an increase in net realisable value, shall be recognised as a reduction in the amount of inventories recognised as an expense in the period in which the reversal occurs.


The financial statements shall disclose:• (a) the accounting policies adopted in measuring inventories,

including the cost formula used;• (b) the total carrying amount of inventories and the carrying

amount in classifications appropriate to the entity;• (c) the carrying amount of inventories carried at fair value less

costs to sell;• (d) the amount of inventories recognised as an expense during

the period;• (e) the amount of any write-down of inventories recognised as

an expense in the period in accordance with paragraph 34;• (f) the amount of any reversal of any write-down that is

recognised as a reduction in the amount of inventories recognised as expense

INVENTORY

• Inventories represent one of the most important elements of a business.

• Much of company's resources is invested in this asset, which is usually its chief source of revenue.

• Financial statements normally indicate the basis of inventory valuation, generally the lower figure of either cost price or current market price,

• Given the importance differences that exist between the various inventory accounting methodologies, imperative that the inventory footnote be read carefully in financial statements,

INVENTORY Classes of Inventory

Merchandise or supplies on hand – Raw materials - includes the purchase price, freight,

receiving, storage and/or other charges necessary to make the finished goods ready for use

– Work-in-progress - partly completed goods. Generally, the cost of raw material, direct labor and manufacturing overhead applied to date

– Finished goods - completed products awaiting saleIn transit at a particular point in time

– Goods in transit for which title has been received – Goods out on consignment

INVENTORY VALUATION SYSTEM

INVENTORY • A current asset on the balance sheet.• Valuation directly affects the inventory,

total current asset, and total asset balances.

• Companies intend to sell their inventory increases the cost of goods sold, which is often a significant expense on the income statement

INVENTORY VALUATION SYSTEMHow an Organization Values Its Inventory

- Rretailer/ Wholeseller - What it cost to acquire that inventory - Under the Specific Identification Method.- Each inventory item is unique Company knows the cost of every individual item This method works well where inventory is limited (car ships, jewelers, art galleries).- Personal finance: Owned by an individual and the value of each, based on cost, market value, or both. -Securities: Securities bought and held by a dealer for later resale. Market or cost which ever is less - Broadcast and print media industry, inventory is the time or space available for sale to advertisers. In magazine publishing, inventory is the number of copies of each issue available for distribution.- Where a company owns a great deal of inventory and each specific inventory item is relatively indistinguishable from each other. As a result, other inventory valuation methods have been developed. The best known of these are the FIFO , LIFO, Average ( weighted average ) method.

Each method produces different income results, depending on current price levels. In times of inflation, LIFO produces a larger cost of goods sold and a lower closing inventory. With FIFO, the cost of goods sold will be lower, and the closing inventory will be higher. In deflationary times, the opposite is true.


Specific Identification Method

• The specific identification method concentrates on the physical linking of the particular items sold with the cost of goods sold that is reported

• Easy to use for EXPENSIVE LOW-VOLUME MERCHANDISE• The use of bar cods and scanning equipment makes specific

identification economically feasible for many companies• EXAMPLES:

– Custom artwork-----paintings etc– Diamond jewelry– Antiques– Automobiles

INVENTORY VALUATION SYSTEM• FIFO – FIRST IN FIRST OUT

• Oldest stock items in inventory are sold first .• Inventory that remains is from the most recent purchases.• In a period of rising prices, this accounting method yields a higher

ending inventory, a lower cost of goods sold, a higher gross profit, and a higher taxable income. And in a period of declining prices vice versa

• Since the oldest inventory is always sold first, therefore the valuation of inventory still on hand is at the most recent price.

• A major advantage of FIFO is that it has the effect of maximizing net income within an inflationary environment. Thus higher income taxes

• FIFO provides inventory valuations that closely approximate the actual market value of the inventory at the balance sheet date


LIFO – LAST IN FIRST OUT • Most recently acquired items are the first ones sold.• The inventory that remains is always the oldest

inventory.• When prices are rising, inventory yields a lower ending

inventory, a higher cost of goods sold, a lower gross profit, and a lower taxable income And in case of declining prices vice versa

• Method preferred by companies because it has the effect of reducing a company's taxes, thus increasing cash flow. However, these attributes of LIFO are only present in an inflationary environment.


Average Cost: • Requires to calculate the average unit cost

of the goods in the beginning inventory plus the purchases made in the period. Based on this average unit cost the cost of sales (production) and the ending inventory of the period are determined.

INVENTORY VALUATION SYSTEM• Holding Gains and Inventory Profits

LIFO • Matches the most recent acquisition cost with sales

revenues• Cost of goods sold typically offers a close approximation to

the replacement cost• Reported net income rarely contains significant holding

gains FIFO

Reports a profit which includes an economic profit plus the holding gain because the value of the inventory rises over time


Lower-of-Cost-or-Market Method• The lower of cost or market value

( Replacement cost ) method requires a comparison of the current market price of inventory with historical cost derived under one of the four primary methods used

• The lower of the two amounts is reported as the inventory value

INVENTORY ERRORS• Incorrect unit count. • Incorrect unit of measure. • Incorrect inventory layering. If you use an inventory cost layering

system, such as FIFO or LIFO, the system has to assign a cost to an item based on the inventory layer.

• Incorrect part number. • Cycle counting adjustment error• Customer owned inventory. Customers may have some of their

inventory at your location, so you may mistakenly count it as yours• Consignment inventory. Forget to count it.• Improper cutoff. Receiving dock during a physical count and

include it in the count. so you have just recorded inventory for which there is no cost.

• Transfer imbalance. The inventory transfer from one dept to another and counted at both places.

• Incorrect scrap relief


Effects of Inventory Errors

• An undiscovered inventory error usually affects two reporting periods

• The error will cause misstated amounts in the period in which the error occurred, but the effects will then be counterbalanced by identical offsetting amounts in the following period

• If ending inventory is understated, retained earnings in understated

• If ending inventory is overstated, retained earnings is overstated

INVENTORY VALUATION METHODSPERPATUAL / PERIODICAL SYSTEM

The Periodic System: • - Does not require a day to day record of inventory change. • - Determined by physical count, subtracted from the sum of opening

inventory and purchases ( or cost of goods manufactured in case of manufacturer )

• - An adjusting entry is used to determine the cost of goods sold.• - This system requires a physical count of goods on hand at the end of• the period. A cost basis (i.e., FIFO, LIFO, etc.) is then applied to

derive• an inventory value.• - Widely used, simple, requires computations primarily only at the end• of the period. • - Sales are recorded as they occur but the inventory is not updated. A physical inventory taken at the period end to determine cost of goods sold• - The most commonly used inventory costing methods under periodic system are: FIFO, LIFO & weighted average


Shrinkage in Periodic Inventory Systems

• A periodic inventory system has no running balance in the inventory account

• Cost of goods sold automatically includes inventory shrinkage by virtue of the system

• Shrinkage is much more difficult to isolate in the periodic system


• The Perpetual System:

• Continuous record of receipt and disbursement for every item of inventory

• Maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out.

• Physical counts of the quantities on hand are usually made at least once a year and reconciled to the perpetual records.

• Most large manufacturing and merchandising companies use the perpetual system to provide continuous control over the quantities and the investment in inventory.

• Adequate supplies are assured for production or sale and costly machine shut-downs and customer complaints are minimized.


The Perpetual System: Cont---

The most commonly used inventory costing methods under a perpetual system arefirst-in first-out (FIFO), last-in first-out (LIFO), and average cost or weighted average cost.

In the FIFO and LIFO method, each purchase record is kept with its purchase prices. Every piece sold is subtracted from each purchase record until no qty is left and the next purchase record is considered. When the average cost method is used, an average unit cost of each good is calculated each time a purchase is made.

Whenever a shortage (i.e. a missing or stolen good) is discovered, the Inventory Shortages account should be debited.


Shrinkage in Perpetual Inventory Systems• Shrinkage is the difference between the cost of inventory

from a physical count and the inventory balance in the general ledger

• The journal entries to record shrinkage under a perpetual inventory system would be:

Inventory shrinkage Inventory

• To adjust inventory to its balance per physical countCost of goods sold Inventory shrinkage

To transfer inventory shrinkage to cost of goods sold

INVENTORY VALUATION METHODSPERPATUAL VERSUS PERIODICAL

Perpetual Periodic

At the time of every sale At the time of every Salewe record sale we record sale

And inventory reduction on each sale No inventory reduction

• Inventory Open stockPayables + Purchases

• Cost of Goods sold - Closing stockInventory Cost of goods sold

• Accounts receivable Accounts receivable• Sales Sales

TANGIBLE V/S INTANGIBLE• INTANGIBLE ASSETS• Externally acquired Internally acquired• Purchase the rights to assets from R.D. cost – They may lead to • External party like patient & are capitalized patents are expensed

• Externally acquired Internally acquired• Purchase the rights to assets from R.D. cost – They may lead to • External party like patient & are capitalized patents are expensed. R

& D

• FINIT VALUE V/S INFINITE VALUEAssets are amortised over the useful life. Assets which are not amortised Here useful life is shorter of economic life or have infinite value. They are legal life subject to period of impairment

DETERMINATION OF COST OF NON CURRENT ASSETS UNDER IAS 16

• The objective of IAS 16 is to prescribe the accounting treatment for property, plant, and equipment. The principal issues are the recognition of assets, the determination of their carrying amounts, and the depreciation charges and impairment losses to be recognised in relation to them

• Scope• IAS 16 applies to the accounting for property, plant and equipment,

except where another standards requires or permits differing accounting treatments, for example:

• assets classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations

• biological assets related to agricultural activity• exploration and evaluation assets recognised in accordance with

IFRS 6 Exploration for and Evaluation of Mineral Resources• mineral rights and mineral reserves such as oil, natural gas and similar

non-regenerative resources.


• Recognition Items of property, plant, and equipment should be recognised as assets when it is probable that: [IAS 16.7]

– it is probable that the future economic benefits associated with the asset will flow to the entity, and

– the cost of the asset can be measured reliably.• This recognition principle is applied to all property, plant, and equipment

costs at the time they are incurred. These costs include costs incurred initially to acquire or construct an item of property, plant and equipment and costs incurred subsequently to add to, replace part of, or service it.

• In a cost model each part of an item of property, plant, and equipment with a cost that is significant in relation to the total cost of the item must be depreciated separately [IAS 16.43]

• IAS 16 recognises that parts of some items of property, plant, and equipment may require replacement at regular intervals. The carrying amount of an item of property, plant, and equipment will include the cost of replacing the part of such an item when that cost is incurred if the recognition criteria (future benefits and measurement reliability) are met


• Initial measurement• An item of property, plant and equipment should initially be recorded at

cost. [IAS 16.15] Cost includes all costs necessary to bring the asset to working condition for its intended use. This would include not only its original purchase price but also costs of site preparation, delivery and handling, installation, related professional fees for architects and engineers, and the estimated cost of dismantling and removing the asset and restoring the site

• If payment for an item of property, plant, and equipment is deferred, interest at a market rate must be recognised [IAS 16.23]

• If an asset is acquired in exchange for another asset (whether similar or dissimilar in nature), the cost will be measured at the fair value unless (a) the exchange transaction lacks commercial substance or (b) the fair value of neither the asset received nor the asset given up is reliably measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up. [IAS 16.24]


• Measurement subsequent to initial recognition• IAS 16 permits two accounting models:• Cost model.• The asset is carried at cost less accumulated depreciation and

impairment. [IAS 16.30]• Revaluation model.• The asset is carried at a revalued amount, being its fair value at the

date of revaluation less subsequent depreciation and impairment, provided that fair value can be measured reliably. [IAS 16.31]

• Revaluations should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS 16.31]

• If an item is revalued, the entire class of assets to which that asset belongs should be revalued. [IAS 16.36]


• Revalued assets are depreciated in the same way as under the cost model (see below).

• If a revaluation results in an increase in value, it should be credited to other comprehensive income and accumulated in equity under the heading "revaluation surplus" unless it represents the reversal of a revaluation decrease of the same asset previously recognised as an expense, in which case it should be recognised in profit or loss. [IAS 16.39]

• A decrease arising as a result of a revaluation should be recognised as an expense to the extent that it exceeds any amount previously credited to the revaluation surplus relating to the same asset. [IAS 16.40]

• When a revalued asset is disposed of, any revaluation surplus may be transferred directly to retained earnings, or it may be left in equity under the heading revaluation surplus. The transfer to retained earnings should not be made through profit or loss. [IAS 16.41]

DEPRECIATIONWhat is the depreciation

• Depreciation in accounting is the process of spreading the cost of an asset over its useful life to the entity.

• It is an allowance for the wear and tear, deterioration, or obsolescence of the property.

• A non- cash expense that reduces the value of an asset as a result of wear and tear, age, or obsolescence.

• Depreciation is the term used to describe the process of allocating a share of the costs of non-current assets to each accounting period

• Is a system for cost allocation and not valuation • 1- Accurual a/c capitalize the cost and then allocate cost in the

form of Depreciation over the period • 2- More efficiently matches exp with revenue generated

DEPRECIATIONThe purpose of depreciation / Why we charge depreciation

– To spreading the cost of an asset over its useful life to the entity.

– To provide allowance for the wear and tear, deterioration, or obsolescence of the property.

• To reduces the value of an asset as a result of wear and tear, age, or obsolescence. To allocate a share of the costs of non-current assets to each accounting period.

• If we were to charge the full cost of assets which will be used for five years against the profit of the year in which they are purchased, profit would be distorted. It would be reduced

- perhaps even wiped out- when capital expenditure is incurred and charged off then

this would undermine the reliability of accounting information.

DEPRECIATIONUsefull life

Shorter of physical life ( before it wear out ) or economic life ( before it becomes obsolete

• Depreciation ScheduleList of depreciation amounts for each year of usefull life of assets

• Form of DepreciationDepreciation is chatged on- Tangible property (except land) such as building, machinery

equipments etc( called Depreciation ) ,- Intangible property, such as patents, copyrights, and computer

software (called amortaisation ) • - Natural resources ( called depletions - Considered on unit of production

method - is a direct reduction of the asset

• Calculation of depreciationAccounting standards (IFRSs and FRSs) do not define a single method of calculating depreciation. Rather, the principle to be applied is that the charge against profit over the useful economic life of the asset should reflect the cost of the use of the asset.

DEPRECIATION• Depreciation Schedule

List of depreciation amounts for each year of usefull life of assets• Residual Value

The value Company expect to receive from disposal of a fixed asset after usefull life. GeneralNo depreciation charge for an asset held for less than the full year. This is usually communicated by accounting policy stating that a full year’s depreciation is charged in the year an asset is purchased, and no depreciation is charged in the year of its disposal.

The alternative treatment is that depreciation is only charged for the part of the year for which an asset is held. This is sometimes expressed as ‘pro rata’. In such circumstances, the approach is to first calculate the depreciation charge that would have applied if the charge for a full year was required. The annual depreciation is then converted to the required period by dividing by 12 and multiplying by the number of months for which the asset was held.

DEPRECIATIONMIND IT

• Depreciation do not generate cash• Allocate the original cost to the period of use• Is deductable non cash expense• Higher Depreciation result in lower income • Lower Depreciation result in higher income• Normal repairs are an expense• Improvements are capitalized since increase the future benefits• Impairment of tangible assets is considered to be impaired when it

ceases to have economic value as large as book value• Impaired loss = Book value – Fair market value• Debit = loss on impairment• Credit = Accumulated depreciation

DEPRECIATION Methods of Calculation

1 - Diminishing value Method ( Declining, reducing, written down value )

The amount of depreciation is worked out on the adjusted value of the asset. This value is the original cost less any depreciation already claimed in previous years.To calculate depreciation with the declining balance method, you need to know both the asset's price of purchase, its reduced value and its depreciation rate.


2 - Straight Line Method Simplest and most common used depreciation method. Under this method the basis of the asset is written off evenly over its useful life. An equal amount of depreciation expense is recorded each period. The annual depreciation is calculated by subtracting the salvage value of the asset from the purchase price, and then dividing this number by the estimated useful life of the asset. The straight line method is usually expressed as a percentage (eg 20% per annum) but it might also be expressed in terms of the useful economic life of the asset.


3 – Units of Production depreciation method. ( Activity level method ) • When physical wear tear determine useful life. Depreciation may be

on service or production.• Under straight line method of depreciation one common method is the

Units of Production depreciation method. ( Activity level method ) This depreciation method ties the rate of depreciation with the asset’s lifetime capacity to do work.

• These units can be measured in a number of ways, miles for cars or trucks, kilowats produced by the generator and hours used for machines and other equipment.

• This method has nothing to do with assets age rather the more the asset is used the more it depreciates.Depreciation is calculated on the original cost price of the asset, and the same amount is claimed each year.

• Find the difference between the initial cost of the asset and its salvage value and then divide this by the Usage method / number of years of useful life it has. The result of this calculation is the depreciation that you will incur each year


4 - Accelerated Depreciation Refers to the method by which a company, for financial accounting and or tax purposes, depreciates a fixed asset in such a way that the amount of depreciation taken is higher during the earlier years of an asset’s life. This is method is fairly complicated This depreciation method allows faster write-offs than the straight line method. It provide a greater tax shield effect than straight line depreciation, Accelerated depreciation methods are popular for writing-off equipment that might be replaced before the end of its useful life since the equipment might be obsolete (e.g. computers).


5- Double Declining Balance." The asset is depreciated twice as fast as under straight line. This method of depreciation assumes higher depreciation charges and greater tax benefits in the early years of an asset’s life. The declining-balance method may be appropriate in industries where equipment and technology changes quickly. This method ignore the residual value. Rather multiply the assets net value at the beginning of the year DDB rate. Can be understood through following example


5- Double Declining Balance.“ Cont----

Asset cost Rs 41,000 Then First year Dep Rs 41,000*2/4 = 20500

Life 4 years 2nd year Dep (Rs 41,000-20500)*.0.50 = 10,250

Then 41,000/4 = 10250 3rd Year Dep (Rs 41,000-30,750)*0.50 = 5,125

10,250/41,000= 0.25 4th Year Dep ( Rs 41,000- 35,875)*0.50 = 2563

0.25 * 2 = 0.5 Remaining residue value


Sum-of-the-Years'-Digits Method

• Sum-of-the-years-digits, the asset are depreciated faster than straight line but not as fast as declining balance. It is a depreciation method in which the amounts recognized in the early periods of an asset's useful life are greater than those recognized in the later periods. The SYD is found by estimating an asset's useful life in years, assigning consecutive numbers to each year, and totaling these numbers

• This method also calculates a higher depreciation for the first years. To calculate depreciation with this method, you multiply the difference between the initial cost of the asset and its salvage value by the depreciation fraction. To find the depreciation fraction, you divide the years of life still left by the sum of all the years. If the asset has four years of useful life, the sum of all the years is 1+2+3+4, or 10. This method's advantages are very similar to the previous one: it provides a more accurate decrease in the value of the asset if it is being used more frequently in the first years and decreases your tax burden faster than the straight line method does.


Sum-of-the-Years'-Digits Method- Conti---• Example: If an asset has Original Cost $1000, a

useful lifeof 5 years and a Salvage Value of $100, compute its depreciation schedule. First, determine Years' digits. Since the asset has useful life of 5 years, the Years' digits are: 5, 4, 3, 2, and 1.Next, calculate the sum of the digits. 5+4+3+2+1=15Depreciation rates are as follows:5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the3rd year, 2/15 for the 4th year, and 1/15 for the 5th year.


• CHANGE IN ESTIMATED USEFUL LIFE / RESIDUE VALUE

• Initial value / life is determined at the initial stage. If based on latest information

• ( other than historical system ) Company must adopt new estimate & revise depreciation schedule & recomputed depreciation for the period in which the estimate is revised and in subsequent period


• CHANGE IN ESTIMATED USEFUL LIFE / RESIDUE VALUE – Cont-

• Example• Initial value Rs 41,000 Life 4 years Residual value Rs 1,000

• Depreciation ( Rs ) Balance ( Rs )• 1st year 10,000 31,000• 2nd year 10,000 21,000• 3rd year 10,000 11,000• Now estimates are changed and other three years life is there - now • 4th Year 3,333 7,667• 5th Year 3,333 4,333• 6th Year 3,333 1,000 –

Residual value 1,000

DEPRECIATION DISPOSAL

• To deal with the disposal of a non-current asset, several steps / entries are required. New accounts are opened These entries are discussed as under

• Assets accountCredit- Cost of asset at current cost Debit Asset disposal account

• Accumulated depreciation to the point of disposal:Debit Accumulated depreciation account Credit Asset disposal account

• Proceeds of sales of AssetsDebit cash / receivables Credit Disposal Account

• These entries mean that the net book value has been transferred to the disposal account. If we compare the net book value with the proceeds of disposal, the resulting balance is the profit or loss on sale. A profit arises if the proceeds are greater than the net book value; if the proceeds are less than net book value, a loss has been sustained. The balance on the disposal account is transferred to the income statement.

DEPRECIATION Part Exchange

• When a non-current asset is replaced by another non-current asset, it is quite common to use the sale of the original asset as part of the transaction. This is referred to as ‘part exchange’ (or sometimes ‘trade‑in’).

• By stating the transaction in this way, we have recognised that it is, in fact, two separate transactions. The first transaction is the sale of a non-current asset. This is dealt with in broadly the same way as the straightforward sale discussed above. The difference is that instead of receiving payment for the asset sold, the sale proceeds settle part of the cost of the acquisition. So the debit entry is made in the non-current assets at cost account. This means that the amount to be settled is the balance ofthe cost of the acquisition. This is recorded in the same way as any other acquisition, except that the value of the entries is less than the full cost of the acquisition.

PARTNERSHIP• Meaning• A partnership form of organisation is one where two

or more persons are associated to run a business with a view to earn profit. Persons from similar background or persons of different ability and skills, may join together to carry on a business. Each member of such a group is individually known as ‘partner’ and collectively the members are known as a ‘partnership firm’. These firms are governed by the Indian Partnership Act, 1932.

•

PARTNERSHIP CAPITAL ACCOUNTS OF PARTNERS• The partnership capital account • Is an equity account in the accounting records of a partnership. It

contains the following types of transactions:• Initial and subsequent contributions by partners to the partnership,

in the form of either cash or the market value of other types of assets• Profits and losses earned by the business, and allocated to the

partners based on the provisions of the partnership agreement• Distributions to the partners The ending balance in the account is

the undistributed balance to the partners as of the current date.• For example, if Partner Smith originally contributed $50,000 to a

partnership, was allocated $35,000 of its subsequent profits, and has previously received a distribution of $20,000, the ending balance in his account is $65,000, calculated as:

• $50,000 initial contribution + $35,000 profit allocation - $20,000 distribution

PARTNERSHIP Sharing of Profit and Loss

• Sharing of Profit and Loss : The partners can share profit in any ratio as agreed. In the absence of an agreement, they share it equally.

• SOLVE EXAMPLE ON WHITE BOARD FOR• PROFITS,• INTEREST ON CAPITAL,• DISTRIBUTION OF NET PROFITS,• DRAWINGS • CALCULATION OF NET CAPITAL FOR EACH PARTNER

INTRODUCTION TO PROCESS OF COMPANIES INCORPORATION

CORPORATION / COMPANY- A voluntary association of persons to carry on business.- Distinct and separate existence from the individuals who created it, and those

who control its operations .- It is given a legal status and is subject to certain legal regulations.- It is an association of persons who generally contribute money for some

common purpose. - The money so contributed is the capital of the company. - The persons who contribute capital are its members. - The proportion of capital to which each member is entitled is called his share,

and members of a company are known as shareholders and the capital of the company is known as share capital.

- The total share capital is divided into a number of units known as ‘shares’.- The companies are governed by the Companies Ordinance - The Act / Ordinance defines a company as an artificial person created by law,

having separate legal entity, with perpetual succession and a common seal.- When a business incorporates, it becomes a legal entity that survives of its

own accord. No longer a dependent branch of its owners. - If the principals were to pass away or sell their respective stakes in a

corporation, the entity would continue to exist in the wake of their absence or departure..


CORPORATION / COMPANYFeatures :

- Artificial Person / Created by Law- Separate legal Entity from individual who created & who control - Common Seal- Perpetual Existence- Limited liability of Members- Transferability of Shares- Minimum membership– 2 for Private ltd company, 3 for public ltd and 7 for

public ltd co- Maximum membership – 50 for Private ltd company Unlimited for Public

Co- Profit / non profit making company- Non profit co relies on donation and grants- Ability to enter into a contract- Incur liability, buy and sell assets in corporate name- Shares have identical rights and privileges’- Companies are considered to be more regulated- Earnings are transferable as dividend- Shares are trade able


CORPORATION / COMPANIES

CLASSES OF COMPANIES

• Single man company• Private Limited Company• Public Company ( Listed & unlisted )• Limited liability company• Unlimited Liability Company• Company with guarantee and no capital• Company with guarantee and capital• Profit and non profit Companies - Relies on donations & grants


CORPORATION / COMPANIES Characteristics• Distinct Ownership• Lawful Business• Separate State and Management• Dealing in goods and services• Continuity of business operation• Risk involvement


CORPORATION / COMPANY

• Choice of an appropriate form of business organisation :

- The following factors can be considered while selecting an appropriate form of business organisation

- Nature of business- Volume of business- Area of operation- Finance required- Ownership and control- Liability- Independence


CORPORATION / COMPANY

• The Roles Within A Corporate Entity

ORGANIZATION OF A CORPORATION / ORGANIZATIONAL STRUCTURE OF A CORPORATION

• 1) Shareholders of a corporation elect the board of directors.2) The board of directors are responsible for determining corporate policies and electing officers.3) Officers are responsible for operations and hiring employees. When shareholders are not pleased with the performance of the board of directors, they can elect new directors.

• Three main parties: officers, directors, and shareholders.

• - Officers are responsible for watching over a company's operations.• - Directors are typically involved with implementation of policies / decisions • - Finally, the shareholders own a portion of the incorporated business.

Including other powers can remove and appoint directors, vote for a corporate reorganization, or completely liquidate the business.

AUTHORISED, ISSUED AND PAID UP CAPITAL, CASH DIVIDEND, STOCK SPLITS AND STOCK DIVIDEND

Legal capital of the corporation This is par value per share multiplied by the total number of shares issued.

• Par value This is a value of preferred and Ordinary share that is arbitral (artificial); it is set by management on a per share basis. This artificial value has no relation or impact on the market value of the shares.

• Additional paid-in capital (paid-in capital or Share premium ) This is the difference between the actual value the company sold the shares for and their par value.

• Contributed Capital Legal capital ( par value ) + Paid in Capital / Share premium )

• Earned Capital / Retained earningEmerges from the company’s day-to-day operations


• SHARE CAPITAL AND RESERVESShare capital and reserves shall be classified under the following subheads, namely:—(i) Issued, subscribed and paid up capital, distinguishing in respect of each class between,—(a) shares allotted for consideration paid in cash;(b) shares allotted for consideration other than cash, showing separately shares issued against property and others (to be specified); - ALSO CALLED NON CASH EXCHANGE and(c) shares allotted as bonus shares.


• AN OTHER DIVISION OF SHAREHOLDERS EQUITY

Ordinary Shares – Common stock Securities representing equity ownership in a corporation, providing voting rights, and entitling the holder to a share of the company's success through dividends and/or capital appreciation. In the event of liquidation, common stockholders have rights to a company's assets only after bondholders, other debt holders, and preferred stockholders have been satisfied. Typically, common stockholders receive one vote per share to elect the company's board of directors

Right Shares – Pre-emptive Right ( Junior Equity ) In addition to voting rights, common shareholders sometimes enjoy what are called "preemptive rights". Preemptive rights allow common shareholders to maintain their proportional ownership in the company in the event that the company issues another offering of stock.


AN OTHER DIVISION OF SHAREHOLDERS EQUITY – Cont-• Bonus Shares – Stock Dividend – Scrip Dividend

A dividend payment made in the form of additional shares, rather than a cash payout. Companies may decide to distribute stock to shareholders of record if the company's availability of liquid cash is in short supply. These distributions are generally acknowledged in the form of fractions paid per existing share. If dividends paid are in the form of cash, those dividends are taxable. When a company issues a stock dividend, rather than cash, there usually are not tax consequences until the shares are sold

• Preference Shares -Preferred stock Offers owners different rights and preferential treatment-Dividend preference- preference over dividend claims of common stockholders-Liquidation preference—preference to assets in the event of a liquidation-Preferred stock does not normally have voting rights-Preferred stock usually has a liquidation value-The liquidation value (plus any dividends in arrears) must be paid to preferred stockholders before distributions to common stockholders -The liquidation value is often the same as par value-The company must pay off all debts first-There is less risk associated with preferred stock than common stock

• .


• Convertible securitiesWhen bonds or preference stocks have the right to be converted into ordinary shares

• Tracking stock Just similar to Common Stock. It has been issued in Europe / America. This is issued on one part of the business for which separate financials are prepared. They are some issued to the employees. Are trade able on stock exchanges

• Other Stock Holder Equity = Other Stockholder Equity

The portion of the balance sheet that represents the capital received from investors in exchange for stock (paid-in capital), donated capital and retained earnings. Stockholders' equity represents the equity stake currently held on the books by a firm's equity investors


Treasury Stock / Treasury Shares• Exist when a company buys back its own shares of stock without

reissuing them or canceling them When a company issues stock, net assets and stockholders equity increase because the company receives an asset, usually cash, in exchange for the stock. Similarly, when a company repurchases its own stock, net assets and stockholders equity decrease because the company used assets, generally cash, to repurchase the stock.

• Does not represent an asset to the company, but rather a reduction in stockholders equity. Cash or other assets are used to reduce stockholders equity by purchasing treasury stock. Treasury stock is stock taken off the market and not yet retired, thereby reducing the number of shares outstanding.

• The amount of stock issued does not change, since the portion of the stock issued is now treasury stock. Since the stock has been purchased back by the company and is no longer outstanding, treasury stock does not confer voting rights, liquidation rights, or rights to dividends.


Why Companies Purchase Treasury Stock• 1. To meet additional stock needs for various reasons, including newly

implemented stock option plans, stock for convertible bonds or convertible preferred stock, or a stock dividend.

• 2. To eliminate the ownerships interests of a stockholder.• 3. To increase the market price of the stock that returns capital to

shareholders.• 4. To potentially increase earnings per share of the stock by

decreasing the shares outstanding on the same earnings.• 5. To make more shares available for a merger.• 6- A company can effectively increase its return on remaining equity

by purchasing its own stock.

To measure return on equity without the effect of treasury stock, add back the amount of treasury shares listed in the equity section of the balance sheet.


• STOCK SPLIT – SUBDIVISION OF SHARES • A corporate action in which a company's existing shares are divided into multiple shares.

Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because no real value has been added as a result of the split.

• One reason as to why stock splits are performed is that a company's share price has grown so high that to many investors, shares are too expensive to buy in round lots

. • A stock split is usually done by companies that have seen their share price increase to levels that

are either too high or are beyond the price levels of similar companies in their sector. The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company has not changed.

A stock split can also result in a stock price increase following the decrease immediately after the split. Since many small investors think the stock is now more affordable and buy the stock, they end up boosting demand and drive up prices. Another reason for the price increase is that a stock split provides a signal to the market that the company's share price has been increasing and people assume this growth will continue in the future, and again, lift demand and prices.


• CASH DIVIDEND

– Sharing of profit between the members in cash-- Are distributions of some of the company’s assets (cash) to stockholders - Reduce Cash and Retained Earnings- Are not expenses- they are transactions with stockholders

• A cash dividend involves three important dates:– Declaration date—the date on which the board declares the dividend– Record date—stockholders owning the stock on this date receive the

dividend– Payment date—the date on which the corporation pays the dividend

AUTHORISED, ISSUED AND PAID UP CAPITAL, CASH DIVIDEND, STOCK SPLITS AND STOCK

DIVIDEND [POLICY .

• Dividend policies are the regulations and guidelines that companies develop and implement .to make dividend payments

• Stability of earning – Most consistent policy than those having an uneven flow of income• Availability of cash – Availability of cash and sound financial position is an important

factor. Dividend represent cash outflow. The greater the liquidity – better the ability to pay cash dividend. Very much depend on the investment, rate of expansion and the manners of financing available. If cash position is week despite good results then bonus share suggested

• Legal Restrictions – Companies Ordinance has imposed certain restrictions like:• Current or past profits• Payment of dividend out of capital is illegal – lendors may put some restrictions as well• Ability to borrow.- Well established and large companies have better access to capital

market than the new companies and may borrow funds from external resources easily.• Earning Capacity – The earning capacity of the Company is widely affected by change in

fiscal, industrial labor, controls and govt policies. Sometime Govt restrict the dividend beyond a certain level.

• Regularity and stability in Dividend Payment. – Should be paid regularly at the constant rate because each investor is interested in the regular payment.

•

AUTHORISED, ISSUED AND PAID UP CAPITAL, CASH DIVIDEND, STOCK SPLITS AND STOCK

• RIGHTS OF SHARE HOLDER – • Share holders are granted special privileges depending

on the class of shares. These rights in general includes• Right to sell their shars• Right to receive dividend• Right to inspect the records and books of accounts of the

company• Right to bring suits against the Company for wrongfull

acts by the Directors / officers• Right to share in the proceeds at the time of liquidation• Right to inspect the management of Board of Directors

appointed by them• Ist right to get right shares

Bank Reconciliation Statement• Introduction: • When a business concern opens an account with the bank

then bank supplies a bank statement This statement is simply a copy of depositor’s account in the bank’s ledger. Amounts paid into and withdrawn from the bank by the depositor are entered date wise in the statement by the banker.

• The Bank statement and the Cash Book record the same transactions. All deposits by the firm are shown in the ‘bank’ column of the Cash Book and withdrawals on credit side. The bank credits its customer account with all deposits made by him and debits it with withdrawals.

• “What is shown on the debit side of the Cash book appears on the credit side of the statement and what is shown on credit side of the Cash Book appears on the Debit side of the statement. Thus the balances shown in the statement and the balances shown in the Cash Book should be equal.

Bank Reconciliation

CashBook Dr Cr

• Deposits xxxx Withdrawal xxxx

• Bank Statement

Dr Cr• Withdrawals xxxx Deposits xxxx

Bank Reconciliation• When the bank Statement is received from the bank, the depositor checks the

entries therein with those in the bank column of the Cash Book to ascertain the accuracy. Often these balances do not match each other due to various reasons and are as under

• Uncollected Cheques: Cheques that may have been entered in the Cash Book and sent to the bank; but the bank may not have credited in the account. This happens because usually banks credit the client only when the amount has been collected.

• Non-presentation of Cheques: The cheques issued by the firm, which are entered in the bank column on the credit side of the Cash Book, may have not been presented for payment. Thus the balance at bank falls short. Entries in the books of the bank are made only when the payment is received. Because of this reason, the balances in the statement appear more than that shown in the Cash Book.

• Direct Deposits: When a client instructs his/her banker to make payment on his/her behalf to clubs, insurance company, news paper agents, etc. the banker debits the account of the client as soon as the payment is made. But the client records the transaction in the Cash Book only after he/she receives advice from the banker. This causes a higher balance in the Cash Book.

• Direct collection: The bank may have collected money on behalf of the client such as interest on securities and dividend. The bank makes the entries directly and the entries by the client are made only after being informed. Until then, the balance with bank statement will appear to be more than that in the Cash Book.

• Service charges and interest on overdraft: Entries regarding the bank charges, interest on overdraft, payments made according to the standing instructions of the client are made in the bank statement. The entry in the Cash Book is made later. This leads to a reduced balance as per statement compared to balance as per Cash Book.

Bank Reconciliation

• Dishonor of customer’s cheques: When cheque are sent to bank for collection, entries are made both in the Cash Book & bank statement. But when the cheque are dishonored and not collected, the bank will debit the client’s account.. The Corresponding entry will not be made in the Cash Book until the client receives a statement. This leads to a difference.

• Mistakes in the bank statement. The bank may also commit mistakes while recording the transactions in the client’s account. Such mistakes are as under:

• Omitting to record the transactions in customer’s account • Recording a transaction on the wrong side of the clients

account • Recording the transactions in some other clients account

Bank Reconciliation• Steps in preparation of Bank Reconciliation Statement

• Take the balance as per Pass Book or as per Cash Book as the starting point. Important points: Debit balance as per Cash Book indicates favorable balance Credit as per Cash Book indicates overdraft or unfavorable balance. Debit balance as per Pass Book indicates overdraft or unfavorable balance Credit balance as per Pass book indicates favorable balance. Adjust the Staring Point amount as per the information given and analyze its impact on the other balances. After adjusting all the differences or errors, the balance as per the other book is obtained. If the final balance is positive, it denotes favorable balance, and if the final balance is negative, it denotes an unfavorable balance. *One should note that the entries that have been made both in the Cash Book and the Pass Book do not cause any difference.

INTRODUCTION TO CASH FLOWSTATEMENT

• The official name for the cash flow statement is the statement of cash flows..

• Previously known as the flow of Cash statement The cash flow statement reflects a firm's liquidity.

• The statement of cash flows is one of the main financial statements. (The other financial statements are the balance sheet, income statement, and statement of stockholders' equity.)


• The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time

• Income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues.

• The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments.

• An outflow of cash occurs when a company transfers funds to another party for goods, services etc A purchase made on credit - is not recorded as a cash outflow until the money actually leaves the company's hands.

• A cash inflow is of course the exact opposite and are from customers, lenders (such as banks or bondholders) and investors who purchase company equity from the company.


Need / Purpose • A statement of cash flows

– SHOWS the RELATIONSHIP of net income (ACCRUAL BASIS) to changes in cash balances (CASH BASIS)

– HELPS to PREDICT future cash flows– EVALUATES how management generates and uses cash– DETERMINES a company’s ability to pay interest, dividends, and debts

when they are due– IDENTIFIES specific increases and decreases in a firm’s productive assets– Business is all about trade, between two or more parties, and cash is the

asset needed for participation in the economic system – No business can survive in the long run without generating positive

cash flow per share – The statement of a business's cash flows is often used by analysts to

gauge financial performance. Companies with ample cash on hand are able to invest the cash back into the business in order to generate more cash and profit

– Highlight the major activities that directly and indirectly impact cash flows and hence affect the overall cash balance. without sufficient cash balance at the right time, a company may miss golden opportunities or may even fall into bankruptcy

INTRODUCTION TO CASH FLOWSTATEMENT - Importance

• The Importance of Cash Flow• The income statement matches revenues and expenses using

accrual concepts and provides a measure of economic performance• The statement of cash flows explains changes in the cash account

rather than owners’ equity• FREE CASH FLOW

– Is a measure of cash management. – Refers to cash flows from operations less capital expenditures

(and sometimes less dividends– Just because a company is bringing in cash does not mean

it is making a profit (and vice versa). Say a manufacturing company is experiencing low product demand and therefore decides to sell off half its factory equipment at liquidation prices. It will receive cash from the buyer for the used equipment, but the manufacturing company is definitely losing money on the sale

CASH FLOW STATEMENTWHAT CAN CASH FLOW TELL US

• The cash flow statement is intended to• Provide information on a firm's liquidity and solvency and its

ability to change cash flows in future circumstances • Provide additional information for evaluating changes in

assets, liabilities and equity • Improve the comparability of different firms' operating

performance by eliminating the effects of different accounting methods

• Indicate the amount, timing and probability of future cash flows• Income statement is prepared under the accrual basis of

accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information.

CASH FLOW STATEMENTWHAT CASH FLOW DOES NOT TELL US

• Doesn't do a very good job of indicating the overall financial well-being of the company.

• Statement of cash flow indicates what company is doing with its cash and cash is generated, but do not reflect the company's entire financial condition.

• Does not account for liabilities and assets, which are recorded on the balance sheet. Furthermore accounts receivable and accounts payable, each of which can be very large are also not reflected.

Cash flow statement is a compressed version of the company's checkbook that includes a few other items that affect cash,

• Cash flow statement is simply a piece of the puzzle. So, analyzing it together with the other statements can give you a more overall look at a company' financial health.

CASH FLOW STATEMENT

The statement of cash flows can be used to answer crucial questions such as the following:

• Is the company generating sufficient positive cash flows

from its ongoing operations to remain viable? • Will the company be able to repay its debts? • Will the company be able to pay its usual dividends? • Why is there a difference between net income and net

cash flow for the year? • To what extent will the company have to borrow money

in order to make needed investments?

CASH FLOW STATEMENT

People/ groups interested in cash flow statements

• Accounting personnel• Potential lenders or creditors• Potential investors• Potential employees or contractors for

compensation• Shareholders of the business.

CASH FLOW STATEMENT

Some financial models are based upon cash flow.

– When an asset (other than cash) increases, the Cash account decreases.

– When an asset (other than cash) decreases, the Cash account increases.

– When a liability increases, the Cash account increases. – When a liability decreases, the Cash account decreases. – When owner's equity increases, the Cash account increases. – When owner's equity decreases, the Cash account decreases.

FORMAT OF CASH FLOW STATEMENT

The statement of cash flows has four distinct sections:

• Cash involving operating activities • Cash involving investing activities • Cash involving financing activities • Supplemental information.

FORMAT OF CASH FLOW STATEMENT CASH PROVIDED FROM OR USED BY OPERATING ACTIVITIES

• Start with Company's net income and then converts it from the accrual basis to the cash basis by using the changes in the balances of current asset and current liability accounts, such as:

• Accounts Receivable InventorySuppliesPrepaid InsuranceOther Current Assets Notes Payable (generally due within one year)Accounts Payable Wages Payable

• Payroll Taxes PayableInterest Payable Income Taxes PayableUnearned RevenuesOther Current Liabilities

• In addition to using the changes in current assets and current liabilities, the operating activities section has adjustments for depreciation expense and for the gains and losses on the sale of long-term assets. Detail given below

FORMAT OF CASH FLOW STATEMENT CASH PROVIDED FROM OR USED BY OPERATING ACTIVITIES

• Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include:

• Depreciation (loss of tangible asset value over time) • Deferred tax • Amortization (loss of intangible asset value over time) • Any gains or losses associated with the sale of a non-

current asset, because associated cash flows do not belong in the operating section.(unrealized gains/losses are also added back from the income statement)

FORMAT OF CASH FLOW STATEMENT CASH PROVIDED FROM OR USED BY INVESTING ACTIVITIES

• Activities involve the purchase and/or sale of long-term investments and property, plant, and equipment. such as:

Long-term Investments Land Buildings Equipment Furniture & Fixtures Vehicles

FORMAT OF CASH FLOW STATEMENT CASH PROVIDED FROM OR USED BY FINANCING ACTIVITIES

• Reports changes in balances of the long-term liability and stockholders' equity accounts, such as:

• Notes Payable (generally due after one year) Bonds Payable Deferred Income Taxes Preferred Stock Paid-in Capital in Excess of Par-Preferred Stock Common Stock Paid-in Capital in Excess of Par-Common Stock Paid-in Capital from Treasury Stock Retained Earnings Treasury Stock Dividen paidSale or repurchase of the company's stock etc

FORMAT OF CASH FLOW STATEMENT SUPLIMENTAL INFORMATIONAlso called Non cash Activities

Like cash flow activities there are also non cash activities / Significant exchanges not involving cash. For example

• Leasing to purchase an asset • Converting debt to equity • Exchanging noncash assets or liabilities for other noncash assets or liabilities • Issuing shares in exchange for assets

• Besides knowing the cash flow activities, it is essential for investors or businessmen to know and have proper knowledge about non cash activities. Non cash activities items may also include depreciation, amortization and stock-based compensation that are expensed on the profit and loss statement. Items of property, plant and equipment are often acquired through non cash investing and financing activities. In these transactions, equipment-purchase financing is offered at the time of purchase. Such transactions can increase the production capacity of a company. They are not reported as capital expenditures in the statement of cash flows. Accordingly, free cash flow calculated based on capital expenditures reported in the statement of cash flows will often be overstated when assets are acquired through such non-cash transactions. The above details on non cash activities will be useful to you.

FORMAT OF CASH FLOW STATEMENT SUPLIMENTAL INFORMATIONA change in this Is reported in this balance sheet category Section of the cash

flow statement• Current Assets* Operating Activities• Current Liabilities Operating Activities• Long-term Assets Investing Activities• Long-term Liabilities Financing Activities • Stockholders' Equity Financing Activities

* This refers to current assets other than Cash.

CASH FLOW STATEMENTPreparation methods

DIRECT METHOD• The direct method of preparing a cash flow

statement results in a more easily understood report

INDIRECT METHOD• The indirect method is almost universally

used, because FAS 95 requires a supplementary report similar to the indirect method if a company chooses to use the direct method

CASH FLOW STATEMENTPreparation methods( Direct Method )

• Statement reports major classes of gross cash receipts and payments. Dividends received may be reported under operating activities or under investing activities. If taxes paid are directly linked to operating activities, they are reported under operating activities; if the taxes are directly linked to investing activities or financing activities, they are reported under investing or financing activities.

CASH FLOW STATEMENTPreparation methods( Direct Method )

Sample cash flow statement using the direct method

CASH FLOW STATEMENTPreparation methods( Indirect Method )Rules (Operating Activities) The indirect method uses

• 1- Net-income as a starting point, makes adjustments for all transactions for non-cash items,

• 2- Then adjusts from all cash-based transactions. • 3 - An increase in an asset account is subtracted for net

income,• 4 - And an increase in a liability account is added back

to net income.

This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions

CASH FLOW STATEMENTPreparation methods( Indirect Method )The following further rules can be followed to calculate Cash Flows from Operating Activities

* Decrease in non-cash current assets are added to net income • Increase in non-cash current asset are subtracted from net

income • Increase in current liabilities are added to net income • Decrease in current liabilities are subtracted from net income • Expenses with no cash outflows are added back to net income

(depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period)

• Revenues with no cash inflows are subtracted from net income • Non operating losses are added back to net income • Non operating gains are subtracted from net income

CASH FLOW STATEMENTPreparation methods( Indirect Method )

• Operating Activities cont - This procedure might be seen as,

• For example, consider a company that has a net income of $100 this year, and its A/R increased by $25 since the beginning of the year. If the balances of all other current assets, long term assets and current liabilities did not change over the year, the cash flows could be determined by the rules above as $100 – $25 = Cash Flows from Operating Activities = $75. The logic is that, if the company made $100 that year (net income), and they are using the accrual accounting system (not cash based) then any income they generated that year which has not yet been paid for in cash should be subtracted from the net income figure in order to find cash flows from operating activities. And the increase in A/R meant that $25 dollars of sales occurred on credit and have not yet been paid for in cash.

ADJUSTMENTS WITHIN THE OPERATING ACTIVITIES SECTION

• Some cash flow relating to investing or financing activities are classified as operating activities.

– For example, receipts of investment income ( interest and dividend ) and payment of interest to lenders are classified as operating activities.

• Conversely, some cash flows relating to operating activities are classified as investing or financing activities.

– For example, the cash received from the sale of property plant and equipment at a gain, although reported in the income statement, is classified as an investing activity, and effects of the related gain would not be included in net cash flow from operating activities. Likewise a gain or loss on the payment of debt would generally be part of the cash out flow related to the repayment of the amount borrowed, and therefore it is financing activity.

CASH FLOW STATEMENTPreparation methods( Indirect Method )

• Rules Investing Activities -when a change in a fixed asset account, say the Buildings and Equipment account decreases, the change is subtracted from Net Income. The reasoning behind this is that because Net Income is calculated by, Net Income = Rev - Cogs - Depreciation Exp - Other Exp then the Net Income figure will be decreased by the building's depreciation that year. This depreciation is not associated with an exchange of cash, therefore the depreciation is added back into net income to remove the non-cash activity

CASH FLOW STATEMENTPreparation methods( Indirect Method )Rules (Financing Activities) Finding the Cash Flows from Financing Activities needs following explanation.

* Include as outflows, reductions of long term notes payable (as would represent the cash repayment of debt on the balance sheet)

• Or as inflows, the issuance of new notes payable • Include as outflows, all dividends payed by the entity to outside

parties • Or as inflows, dividend payments received from outside parties • Include as outflows, the purchase of notes stocks or bonds • Or as inflows, the receipt of payments on such financing

vehicles