Flow of Information
A business transaction passes through a set of steps before entering the records. These steps are:
BUSINESS TRANSACTION - > JOURNAL ENTRY of information -> Clubbing Journal Entries to form a LEDGER - >
Consolidating ledger entries into a Trial Balance
The purpose of a trial balance is to ensure that all entries made into an organization's general ledger are properly
balanced.
Two different prospects of keeping records are:
Accounting : Done internally to create useful reports for internal purpose
Financial Reporting: creating financial reports and sharing with the outside world
Financial Statements:
INCOME STATEMENT : Gives a sense of finacial Performance of the business
BALANCE SHEET: Gives a sense of financial Position of the business with respect to assets and liabilities
CASH FLOW STATEMENT: It shows the total cash that has been generated by the business
STATEMENT OF EQUITY: It reflects the transactions that lead to change in equity balance
Five Elements of Financial Statements:
ASSETS : The useful resources owned by the business and are source of future cash flows
LIABILITIES: The obligations of the business which can be short or long term
EQUITY : The amount that the business entity owes to the business man. Equity is the amount of capital invested or
owned by the owner of a company. Equity is ownership of an asset of value.
INCOME: Is the outcome of revenue generating activities of the firm
EXPENSE: The cost incurred to generate income, it could be operating or non-operating
Different business transactions are categorised as :
1. Operating activities: cash generated from the sale of goods (revenue) and cash paid for goods (expense), selling &
admistrative expenses, Income and other taxes paid, are operating activities because revenues and expenses are
included in net income. Interest expense payments on debt.
2. Investing activities: Investing activities involve purchasing and disposing assets necessary for business operations.
Different businesses need to acquire different types of assets such as land, property, plant, equipment, patents,
copyrights, cash, accounts receivable, etc.,the principal amount of loans made to other entities. cash generated from
the sale of land ( interest received from loans is included in operating activities.)
3. Financing activities: financing activities involve obtaining funds to start and operate a business. E.g. issuing bonds
and repaying the debt, paying cash dividends (1) the principal amount of long-term debt, (2) stock sales and
repurchases, and (3) dividend payments.
Stakeholders of Financial Reports / Stakeholder Concerns
[1] Investors: Adequate returns or ROI [2] Employees: Job security, salary increments and benefits.
[3] Creditors/Lenders: Provisions for additional loans for expansion plans and ability for repayment of interest and
principle in time. [4] Suppliers and trade creditor: Ability to settle invoices in time [5] Government: Tax collection,
provision of grants and subsidies. [6] Customers: Sustainability of the company to provide good after sales service
Accounting and Financial reporting assumptions:
Going Concern:
Accounting is done assuming business will run forever. It allows for accounting those transactions, whose effect can be
spread over years uniformly. In other words, the going concern concept assumes that businesses will have a long life
and not close or be sold in the immediate future.
E.g. Concept of depreciating and amortizing assets is based on the idea that business will continue to operate well into
the future.
Companies prepay and accrue expenses because they believe that they will continue operations in future.
Accrual Basis:
Occurrence of a transaction is important than the actual cash flow associated with it, which may happen later.
It helps companies avoid the delays that would occur if they rely on cash exchanges.
The balance sheet is affected at the time of the revenue recognition by either an increase in Cash (if the service or sale
was for cash), or an increase/decrease in Accounts Receivable or Unearned Revenues depending on if the service was
performed on credit, or was performed after the customer had paid in advance for the service.
Six Principles of Accounting:
Money Measurement: Company should only account for transactions that have a monetary value associated with it.
Other transactions e.g. quality of employee, product cannot be accounted for.
Business Entity: Business owner is a separate entity from the business they own. Business owner will have a definite
life while the business will go on forever. Effectively, exchanges of resources between business and its owner should
be accounted.
Conservationism: Company should stay in a conservative state of mind while accounting for transactions. Any losses
foreseen (future) should be acknowledged in the present books. However should wait for any potential gains to
happen before recording in the books.
Materiality: Display only that information in statements, that is expected to be useful for the user groups analyzing it.
Redundant information should not be included in the statements.
Substance over form: Substance of the item prevails over its legal form. Substance of a transaction means its actual
nature.Form is the way the transaction is recorded or presented. i.e. the beneficiary entity should account for it in its
books irregards to the legal owner of an item. e.g Company A is essentially an agent for Company B, and so should
only record a sale on behalf of Company B in the amount of the related commission. However, Company A wants its
sales to appear larger, so it records the entire amount of a sale as revenue.
Consistency: Statement makers should opt. for one method or set of rules for accounting and stick to it untill
conditions are un-avoidable. Fluctuating methods frequenty would be considered as window dressing of the accounts.
IFRS - BENEFITS (International Financial Reporting Standards)
[1] One common set of standards instead of multiple versions. [2] Financial statements are more comparable.
[3] Easier for investors to evaluate the information of various companies across the globe.
[4] Global use will reduce the costs of doing business.
Basis of Accounting
Accrual basis: Records the impact of business transactions on the entity’s assets and liabilities over the period in which
they occur
Cash basis: Records only cash transactions – cash receipts and cash payments
