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BASIC CONCEPTS OF ACCOUNTING

Learning Objective

The objective of this lecture is to introduce the subject of “Financial Accounting” to the students and give them an idea as to how did accounting develop?

What is Financial Accounting?

It is the maintenance of daily record of All financial transactions in such a manner that it would help in the preparation of suitable information regarding the financial affairs of a business or an individual.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 01

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RECORD KEEPING AND SOME BASIC CONCEPTS

Learning Objective

The evolution of accounting stated in the previous lecture continues with a slight emphasis on how actual record keeping started? In addition, some basic concepts like capital, profit, and budget are also introduced.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 02

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SYSTEMS OF ACCOUNTING AND SOME BASIC TERMINOLOGIES

Learning Objective

After studying this lecture, the students should be able to:

• Distinguish between Cash Accounting and Accrual Accounting;
• Understand what is
• Income
• Expenses
• Profit or Net Profit
• Distinguish between Cash in Hand and Profit.
• Distinguish between Capital Expenses and Revenue Expenses; and
• Understand what is Liability?

Read more: MGT101 - Financial Accounting - I - Lecture Handout 03

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SINGLE AND DOUBLE ENTRY RECORD KEEPING

Learning Objective

• The objective of this lecture is to develop an understanding in the students about the basic concepts like:
• The separate business entity
• Single and double entry book-keeping
• Debit and Credit
• The dual aspect of a transaction
• Accounting equation

Read more: MGT101 - Financial Accounting - I - Lecture Handout 04

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CLASSIFICATION OF ACCOUNTS

Learning Objective

This lecture will cover

• Classification of accounts into Assets, Liabilities, Income and Expenses, and
• Rules of Debit and Credit for these classes.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 05

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FLOW OF TRANSACTIONS

Learning Objective

• An overview of the flow of transactions.
• An introduction to the basic books of accounts.
• The General Ledger, and
• The ledger balance

Read more: MGT101 - Financial Accounting - I - Lecture Handout 06

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BASIC BOOKS OF ACCOUNTS

Areas Covered in this lecture:

• Cash book and bank book.
• Accounting Period.
• Trial Balance and its limitations

Read more: MGT101 - Financial Accounting - I - Lecture Handout 07

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INTRODUCTION TO FINANCIAL STATEMENTS

Learning Objective

After studying this chapter, you will be able to:

• Draw up Profit & Loss account from the information given in trial balance.
• Differentiate the term, Receipt & Payment, Income & Expenditure and Profit & Loss account.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 08

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INTRODUCTION TO FINANCIAL STATEMENTS (CONTINUED)

Learning Objective

• After studying this chapter, you should be able to:Explain what are Assets and Liabilities and
• Draw up simple Balance Sheet from given information in trial balance

Read more: MGT101 - Financial Accounting - I - Lecture Handout 09

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EXERCISES- RECORDING OF TRANSACTIONS

Transactions of Ali Traders for the month of January:

Read more: MGT101 - Financial Accounting - I - Lecture Handout 10

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EXERCISES- RECORDING OF TRANSACTIONS (Continued)

Cash Account

Read more: MGT101 - Financial Accounting - I - Lecture Handout 11

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THE ACCOUNTING EQUATION

Resources in the business = Resources supplied by the owner

In accounting, terms are used to describe things. The amount of resources supplied by the owner is called capital. The actual resources which are in the business are called assets. This means that the accounting equation above, when the owner has supplied all the resources, can be shown as:

Assets = Capital

Read more: MGT101 - Financial Accounting - I - Lecture Handout 12

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VOUCHERS AND POSTING TO LEDGERS ACCOUNTS

Learning Objectives:

After studying this lecture, you should be able to:

• Understand different types of vouchers.
• How to book entry in voucher?
• Carrying forward the balance of an account.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 13

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POSTING TO LEDGERS AND RECORDING OF STOCK

We have demonstrated the carrying forward of balances in lecture-13. Another solved example is given below:

Illustration

Following is the Trial Balance of Rahil & Co. for the month ended January 31, 2002.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 14

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RECORDING OF STOCK (Continued)

Stock is termed as “the value of goods available to the business that are ready for sale”. For accounting purposes, stock is of two types:
• Opening stock
• Closing stock
Opening stock is the value of goods available for sale in the beginning of an accounting period.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 15

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COST OF GOODS SOLD STATEMENT AND VALUATION OF STOCK

In manufacturing concern, separate books are maintained to keep the record of every single work done in manufacturing process to ascertain cost incurred on production of goods. This record gives information about total cost incurred on manufacturing process and per unit cost of goods manufactured. When goods are produced, these are sold to the customers of the business and goods unsold are taken into stock. At the end of the financial year, manufacturing concern prepares a statement which gives the brief summary of the whole process.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 16

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FIXED ASSETS & DEPRECIATION

Depreciation is a systematic allocation of the cost of a depreciable asset to expense over its useful life. It is a process of charging the cost of fixed asset to profit & loss account.

Fixed Assets are those assets which are:

• Of long life
• To be used in the business to generate revenue
• Not bought with the main purpose of resale.

Fixed assets are also called “Depreciable Assets”

Read more: MGT101 - Financial Accounting - I - Lecture Handout 17

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METHODS OF CHARGING DEPRECIATION (Continued)

It is a systematic allocation of the cost of a depreciable asset to expense over its useful life”.

Grouping of Fixed Assets

Major groups of Fixed Assets:

• Land
• Building
• Plant and Machinery
• Furniture and Fixtures
• Office Equipment
• Vehicles

Read more: MGT101 - Financial Accounting - I - Lecture Handout 18

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METHODS OF CHARGING DEPRECIATION (Continued)

If an asset is not completed at that time when balance sheet is prepared, all costs incurred on that asset up to the balance sheet date are transferred to an account called Capital Work in Progress Account. This account is shown separately in the balance sheet below the fixed asset. Capital work in progress account contains all expenses incurred on the asset until it is converted into working condition. All these expenses will become part of the cost of that asset. When an asset is completed and it is ready to work, all costs in the capital work in progress account will transfer to the relevant asset account through the following entry:

Read more: MGT101 - Financial Accounting - I - Lecture Handout 19

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DEPRECIATION ON PURCHASE AND DISPOSAL OF FIXED ASSETS

If an asset is not completed at that time when balance sheet is prepared, all costs incurred on that asset up to the balance sheet date are transferred to an account called Capital Work in Progress Account. This account is shown separately in the balance sheet below the fixed asset. Capital work in progress account contains all expenses incurred on the asset until it is converted into working condition. All these expenses will become part of the cost of that asset. When any expense is incurred or paid, it is included in the Capital Work in Progress Account through the following entry:

Read more: MGT101 - Financial Accounting - I - Lecture Handout 20

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REVALUATION OF FIXED ASSETS

Fixed assets are purchased to be used for longer period. In the subsequent years, the value of asset could be higher or lower than its present book value due to inflationary condition of the economy. Assets are valued at Historical Cost in the books of accounts.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 21

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BANK RECONCILIATION STATEMENTS

After reading this lecture, you will be able to understand that:
• What are Banking transactions, and
• How a Bank reconciliation statement is made?

Read more: MGT101 - Financial Accounting - I - Lecture Handout 22

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BANK RECONCILIATION STATEMENTS (Contd.)

In the last lecture, we studied what is Bank Statement and how does it differ from our Bank Book. We told you that money lying in our bank account is our asset. Therefore, it usually has a DEBIT BALANCE. Also, when we deposit cash in our Bank, we DEBIT the Bank Book / Bank Account. Whereas, for Bank, the money lying in our Bank Account is a liability that bank has to return to us. Therefore, in Bank Statement which is a ledger account for bank normally has a CREDIT BALANCE. When we deposit cash in our bank account the liability of the bank to pay us increases. Therefore, our account in the Books of Bank is CREDITED. Bank Statement is, therefore, a MIRROR IMAGE of our bank book.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 23

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DEBTORS, CREDITORS, ACCRUALS AND PROVISION FOR BAD DEBTS

Creditors

Creditors are the third persons/parties, who owe money from the business. These are payables of the business against purchase of goods for resale purposes. It is liability of the business and is shown in balance sheet under the heading of ‘current liabilities’.

While studying ‘Accounting for Stocks’, we studied about the accounting for Creditors and studied following ransactions:

Read more: MGT101 - Financial Accounting - I - Lecture Handout 24

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PROVISION FOR BAD DEBTS AND CONTROL ACCOUNTS

Debit: Provision for Bad Debts (P&L)
Credit: Provision for Bad Debts

The debit account is charged against current years profit and the credit head is shown as a deduction from debtors in the balance sheet.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 25

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CONTROL ACCOUNTS (Continued)

A number of books are opened in connection with control accounts to reduce the volume of general ledger. These books are called ‘Subsidiary Books’.

It is important to note that only credit sales/purchases become part of control accounts. Cash sales/purchases are not included in the control accounts.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 26

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CONTROL ACCOUNT (Continued)

A person is both debtor and creditor:

This happens so many times in business that a person is both your debtor and creditor. This means that you are purchasing one thing from him. So, you have to pay him against that purchase and at the same time you are selling him another thing for which he has to pay you. For example, you purchase item X from Mr. A for Rs. 50,000 and sell him item Y for Rs. 25,000. Now, one way of settling the payable and receivable is that you can pay Mr. X 50,000 and ask him to pay you Rs. 25,000. The other and may be the wiser method is that you pay him Rs. 25,000 and both transactions are settled. This is how such transactions are handled in real life.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 27

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RECTIFICATION OF ERROR

In financial accounting, every single event occurring in monetary terms is recorded. Sometimes, it just so happens that some events are either not recorded or it is recorded in the wrong head of account or wrong figure is recorded in the correct head of account.

Whatever the reason may be, there is always a chance of error in the books of accounts. These errors in accounting require rectification. The procedure adopted to rectify errors in financial accounting is called “Rectification of error”.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 28

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PRESENTATION OF FINANCIAL STATEMENTS

Profit & Loss Account

Standard format of profit & loss account is shown as follows:

Read more: MGT101 - Financial Accounting - I - Lecture Handout 29

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PRESENTATION OF FINANCIAL STATEMENTS (Continued)

Standard Format of Balance Sheet (Liability Side)

Read more: MGT101 - Financial Accounting - I - Lecture Handout 30

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TYPE OF BUSINESS ENTITIES

There are two types of entities:

• Commercial organizations
• Non-commercial organizations

Commercial Organization

Commercial organization is the entity that is working to earn profit. At the end of the financial year, the profit is distributed among the owners of the business. Normally, commercial organizations include:

• Sole proprietorship
• Partnership, and
• Limited Company

Read more: MGT101 - Financial Accounting - I - Lecture Handout 31

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FINANCIAL STATEMENTS OF SOLE PROPRIETORSHIP

Illustration # 1

Prepare profit & loss account and balance sheet for the year ending June 30, 2002 from the following trial balance of Naseem Trading Company.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 32

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FINANCIAL STATEMENTS OF MANUFACTURING CONCERN

In this lecture, we will discuss financial statements of manufacturing concern. In manufacturing concern, cost of goods sold statement is also prepared.

Illustration #1

Following trial balance has been extracted from the books of Hassan Manufacturing Concern on June 30, 2002.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 33

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FINANCIAL STATEMENTS OF PARTNERSHIP

Example # 1

The following trial balance was extracted from A, B & Co. books on June 30, 2002.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 34

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MARK UP ON CAPITAL AND DRAWINGS

The partnership agreement may include one or both of the following clauses:

• Partners are charged interest on drawings (this may be on the total amount of the current account balance or on the amount exceeding a specific limit, depending upon the terms of agreement).
• Partners are given interest on their capital (again this can be on the total amount of the capital or the amount exceeding a specific figure).

Read more: MGT101 - Financial Accounting - I - Lecture Handout 35

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INTRODUCTION TO COMPANIES

Disadvantages of Partnership Firm

The Local Law restricts the number of partners in a partnership firm to twenty. If the firm needs more capital for its business, the partners may not be in a position to invest more money in the business.

Secondly, if the business of the partnership firm is very large and twenty persons can not manage it, they cannot admit new partners in the business. However, there is one exception. The partnership firm of professionals can have more than twenty partners.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 36

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COMPONENTS OF FINANCIAL STATEMENTS

The maximum amount with which a company gets registration/incorporation is called authorized share capital of that company. This capital can be increased with the prior approval of security and exchange commission. This capital is further divided in to smaller denominations called shares. Each share usually has a face value equal to Rs. 10. According to Companies Ordinance, this face value can be increased but can not be decreased. The value of share written on its face is called face value.
Shares are issued for cash as well as for any asset. For example, if any member of the company sell his/her land to the company. In return, company issue him/her fully paid shares instead of paying cash. Those shares are also part of paid up capital because company has received the benefit of that amount.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 37

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FINANCIAL STATEMENTS OF LIMITED COMPANIES

Statement of Changes in Equity

Statement of changes in equity shows the movement in:

• Share Capital (issued share capital)
• Share Premium
• Nature of Reserves created
• Un-appropriated Profit / Loss
• Dividend Distributed

Read more: MGT101 - Financial Accounting - I - Lecture Handout 38

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FINANCIAL STATEMENTS OF LIMITED COMPANIES (Continued)

Question # 1

KKB (Private) Limited is a manufacturing company. Following list of balances has been extracted from its books as on June 30, 2002.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 39

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FINANCIAL STATEMENTS OF LIMITED COMPANIES (Continued)

Question

Following trial balance has been extracted from the books of Alpha Ltd. as on June 30, 2002.

You are required to prepare the profit and loss account for the year and the Balance Sheet as at June 30, 2002.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 40

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CASH FLOW STATEMENT

Cash flow statement shows, how cash was generated and how it was used during the period. These days, it is required by law to include this statement in financial statements, especially in case of financial statements of limited companies.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 41

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CASH FLOW STATEMENT (Continued)

Question # 1

You are given the Balance Sheet of ABC Limited as at June 30, 2001 and June 30, 2002 and its Profit and Loss Account for the year ended June 30 2002.

Required

You are required to prepare Cash Flow Statement for the given period.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 42

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FINANCIAL STATEMENTS OF LISTED/QUOTED COMPANIES

According to Companies Ordinance 1984, the contents of financial statements are as follows:
• Balance Sheet
• Profit and Loss Account
• Cash Flow Statement
• Statement of changes in Equity
• Notes to the Accounts

For the sake of presentation same order should be followed while solving the questions. But we cannot complete the balance sheet without first preparing the Profit and Loss Account. To solve the problem in exam situation we usually prepare the forms of Balance Sheet and Profit and Loss Account first. That is way we can also plan the Serial Numbers of Notes to the Accounts beforehand. Otherwise a sheet of question paper can be left blank for preparation of Balance Sheet.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 43

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FINANCIAL STATEMENTS OF LISTED COMPANIES

Illustration:

Read more: MGT101 - Financial Accounting - I - Lecture Handout 44

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FINANCIAL STATEMENTS OF LISTED COMPANIES AND FINANCIAL RATIOS

Question # 1

Following is the trial balance and balance sheet of Sheraz Ltd. as on June 30, 2002.

Read more: MGT101 - Financial Accounting - I - Lecture Handout 45