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Financial Statement Analysis

ACCOUNTING & ACCOUNTING PRINCIPLES Next >>>
 
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Financial Statement Analysis-FIN621
VU
Lesson-1
ACCOUNTING & ACCOUNTING PRINCIPLES
Accounting
Almost every organization and individual maintains accounts and deals with
accounting. In simple terms, it can be described as a record of Income and expenditure of a business
organization, or budget vs. utilization, in the case of a government non-commercial organization. In the
case of the business entity, accounting would deal with measuring, recording and communicating the
results of business activities. That is why; Accounting is often called "Language of Business".
Purpose of Accounting
Accounting provides decision-makers with sufficient, relevant information to make
prudent and intelligent business decisions. This information is provided through accounting reports
called financial statements. The whole process is called "financial reporting"
·
The purpose of accounting is to organize the financial details of business.
·
To identify the financial transactions.
·
To organize the financial data into useful information
·
To measure the value of these information in terms of money
·
To analyze, interpret, and communicate the information to persons or groups, both
inside or outside the business.
Financial Statements Generated by a Business
A business generates four financial statements at the end of its accounting period:-
i)
Income statement: shows operational results of business during/over the accounting
period.
ii)
Statement of owners' equity: showing changes in owner's equity through
profit/additional investment or through losses/drawl by owner.
iii)
Balance sheet showing financial position at the end of the accounting period i.e. a
picture of what the business owns and what it owes.
iv)
Statement of cash flows giving a picture of cash inflows (receipts) and cash outflows
(payments) over/during the accounting period. It is prepared from the two major
financial statements viz Income Statement and Balance Sheet.
Notes to Financial Statements:
In addition to above, notes containing additional information (financial & non-
financial) about the business are also attached to financial statements.
Accounting Period
Accounting period is the period of time covered by an Income Statement. It is usually one
year. It can either be calendar year (Jan to Dec) or financial year (July to June). Financial Statements are
prepared at the end of accounting period and are the end product of accounting process/cycle.
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Financial Statement Analysis-FIN621
VU
Different Types of Business Organizations
1. Sole Proprietorship
According to D.W.T. Stafford, "It is the simplest form of business organization, which is owned and
controlled by one man"
Sole proprietorship is the oldest form of business organization which is owned and controlled by one
person. In this business, one man invests his capital himself. He is all in all in doing his business. He
enjoys the whole of the profit. The features of sole proprietorship are:
·
Easy Formation
·
Unlimited Liability
·
Ownership
·
Profit
·
Management
·
Easy Dissolution
2. Partnership
According to Partnership Act, 1932, "Partnership is the relation between persons who have agreed to
share the profits of a business carried on by all or any of them acting for all."
Partnership means a lawful business owned by two or more persons. The profit of the business shared
by the partners in agreed ratio. The liability of each partner is unlimited. Small and medium size
business activities are performed under this organization. It has the following features:
·
Legal Entity
·
Profit and Loss Distribution
·
Unlimited Liability
·
Transfer of Rights
·
Management
·
Number of Partners
3. Joint Stock Company
According to S. E. Thomas, "A company is an incorporated association of persons formed usually for
the pursuit of some commercial purposes"
A joint stock company is a voluntary association of persons created by law. It has a separate legal entity
apart from its members. It can sue and be sued in its name. In the joint stock company, the work of
organization begins before its incorporation by promoters and it continues after incorporation. The joint
stock company has the following feature:
·
Creation of Law
·
Separate Legal Entity
·
Limited Liability
·
Transferability of shares
·
Number of Members
·
Common Seal
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Financial Statement Analysis-FIN621
VU
Generally Accepted Accounting Principles (GAAP)
These are `Ground rules' i.e. Principles for preparing financial statements. These are
constantly evolving. These embody accounting concepts, measurement techniques and standards of
presentation of financial statements. These Accounting Principles enable comparability between various
enterprises and of the operational performance of the same enterprise over many years. These give
reliability to Financial Statements.
Following are some of the Generally Accepted Accounting Principles:
i)
Entity principle:
specific business entity separate from personal affairs of the
owner(s).
ii)
Cost principle: valuation and recording of assets at cost.
iii)
Going-concern assumption: connected with cost principle, assets acquired for use and
not for resale.
iv)
Objectivity principle: definite, factual basis for assets valuation; measuring
transactions objectively.
v)
Stable currency principle. The currency remains more or
less stable and rate of
inflation is almost zero.
vi)
Adequate disclosure concept: facts necessary for proper interpretation of statements;
"subsequent  events",  lawsuits  against  the  business,  assets  pledged  as
securities/collaterals, contingent liabilities etc; reflected in Notes.
ACCOUNTING EQUATION
ASSETS = LIABILITIES + OWNER'S EQUITY
Balance Sheet is based on Accounting Equation. It is in fact, a detailed statement of the
Equation. The Equation in a way shows, utilization of Funds and Sources of Funds. In other words, it
shows what a business OWNS and what it OWES. Alternately, the Accounting Equation or Balance
Sheet is a description of Total Assets of a business against the claimants of these Assets. Therefore, this
Equation shows financial position on a specific date. The three titles in the Equation are Elements of
Balance Sheet. Similarly Elements of Income Statement would be Revenues & Expenses and their net
affects Owner's equity.
Within the Elements, there would be sub-elements, for example, the Element or Account
"Assets" would consist of cash, Accounts Receivable, Land, and Building etc. Each financial
transaction affects two or more elements or sub-elements of the Accounting Equation. Therefore, we
can say that each financial transaction affects Balance Sheet i.e. financial position of the business. This
would be clear from the following illustration.
Khizr property dealer:
The proprietor starts business with deposit of Rs.180, 000. On July 1, 2006
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Financial Statement Analysis-FIN621
VU
Financial Position as on July 1, 2006
Assets (Rs)
Owner's equity (Rs)
i)
Deposit in business by proprietor/ Cash 180,000
Khizr, Capital 180,000
owner.
Jul 3, 06
Land Valuing Rs. 141, 000 is purchased for cash on July 3.
Financial Position on that date would be
II) Purchase of land for cash
Cash
39,000
Khizr, Capital
180, 000
(Rs.141,000)
Land
141,000
Total assets
180,000
Total owner's equity
180,000
(Cash is reduced by
Rs.141, 000, but
correspondingly a new
asset land has come up)
Jul 5, 06
III) Purchase of building for
Cash
24,000
Liabilities & Owner's equity
(Rs.36,000) partly on cash
Land
141,000
Accounts/Notespayable21,000
Rs.15,000) and partly on credit
Building
36,000
Owner's equity
180,000
(Rs.21,000)
Total assets
2,01,000
Total
201,000
Rs.15, 000 is paid in cash for the building which further reduces cash from Rs.39, 000 to Rs.24, 000.
For remaining amount of Rs.21, 000, a liability in the form of accounts or notes payable involve
interest, where as accounts payable are without interest.
July 10, 2006: A part of land valuing Rs.11, 000 was sold on credit. A new asset "Accounts
Receivable" has been introduced. The new financial position as a result of this transaction would be:
24,000  Accounts Payable
21,000
iv)
Sale of part of Cash
11,000  Owner's equity
180,000
land on credit for Accounts Receivable
Rs.11,000
Land
130,000
_______
Building
36,000
201,000
Total
201,000
July 14, 2006: Office equipment for Rs.5400/- was purchased on credit. A new liability of Rs.5400 has
accrued, raising Accounts Payable from Rs.21, 000 to Rs.26, 400.
v)
Purchase of Office Cash
24,000
A/C Payable
26,400
Equipment
for A/Cs Receivable
11,000
Owner's equity
180,000
Rs.5400 on credit.
Land
130,000
Building
36,000
Office equipment
5,400
206,400
Total
206,400
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Financial Statement Analysis-FIN621
VU
July 20, 2006. Accounts receivable which were Rs.11, 000 on July 14, have been converted into cash to
the extent of Rs.1, 500. Cash has therefore increased from Rs.24, 000 to Rs.25, 500 and accounts
receivable have correspondingly decreased to Rs.9, 500
(VI)
Partial collection of
Cash
25,500
A/Cs payable
26,400
Accounts (Rs.15,00)
A/C receivable
9,500
owner's equity
180,000
Land
130,000
Building
36,000
Office equipment
5,400
Total
206,400
Total
206400
July 31, 2006
(VII)
Payment of liability
Cash
22,500
A/Cs payable
23,400
(A/C payable) Rs.3,000
A/C receivable
9,500
owner's equity
180,000
Land
130,000
Building
36,000
Office equipment
5,400
Total
203,400
Total
2,03,400
It is thus clear from the above illustration that each financial transaction affects financial
position, (which in effect is the balance sheet). Accounting period in the example was one month. It
must also be noted no business activity (commissions/ fees/ Revenues & Expenses) was involved in
above example. Only setting up of business was involved and therefore owner's equity remains the
same.
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