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Financial Accounting

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Financial Accounting (Mgt-101)
VU
Lesson-3
Learning Objective
After attending this lecture, the students should be able to:
 Distinguish between Cash Accounting and Accrual Accounting;
 Understand what is
o  Income
o  Expenses
o  Profit or Net Profit
 Distinguish between Cash in Hand and Profit.
 Distinguish between Capital Expenses and Revenue Expenses; and
 Understand what is Liability
Cash Accounting and Accrual Accounting
Cash Accounting
All dealing relating to cash (there is no concept of credit)
 It is the accounting system in which events are recorded when actual cash / cheque is received or paid.
 Let's take the example of utility bills like electricity, telephone etc. The bill of January is received on
15th February and paid on 25th February. If the organization is following cash accounting practice it
will record the expense of electricity / telephone on 25th February.
 The same principle applies for income and other transactions as well i.e. income is recorded when cash
is actually received instead recording when it is earned.
Accrual Accounting
It is the accounting system in which events are recorded as and when they occur.
This means that income is recorded when it is earned and expense is recorded when incurred i.e. the
organization has obtained the benefit from it.
Consider the same example. The electricity is utilized in the month of January so the expense should
be recorded in the month of January. Similarly the company that is providing the electricity should
record the income in the month of January.
Income
Income is the value of goods or services that a business charges from its customers.
Businesses can be distributed in two major categories. One that provides / sells goods and the other
that provides services. If the organization is commercial then these goods or services will always be
provided at some price. This price at which these goods / services are provided is the income of the
organization, providing the goods / services.
Expenses
Expenses are the costs incurred to earn revenue.
In order to earn revenue, one has to spend some money such as the cost of goods that are sold or
the money paid to the individuals who are providing services plus other costs. These costs that are
incurred / spent by the business to earn the revenue are the expenses of the business.
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Financial Accounting (Mgt-101)
VU
Profit or Net Profit
Net income or Net Profit is the amount by which the income exceeds expenses in a specific time
period. OR
Profit is what is left of the income after all expenses, paid and incurred, have been deducted from it.
Net Profit = Income ­ Expenses
Cash in Hand and Profit
We have said that profit is what is left of income after deducting the expenses.
Is it the income received in cash less the expenses paid in cash? Or do we have to consider other
things as well?
It can be explained with the help of following example.
A trader purchases some goods from a supplier for Rs. 1,500 and promises to pay in two weeks
time. (Remember credit transactions from lecture 02).
The same day he sells these to a customer for Rs. 2,000 who pays Rs. 1,000 and promises to pay the
balance amount after one week.
Now at the end of the day, the trader has Rs. 1,000 in his hand. After one week, he will have another
Rs. 1,000 and he will pay Rs. 1,500 after two weeks.
What is profit? Is Rs. 1,000 that he has in his hand on day one is his profit.
The answer is No. He still has to receive Rs. 1,000 and pay Rs. 1,500 to the supplier plus any other
expenses that he may have incurred in the process of this trade.
His actual profit is Rs. 500 less any other expenses that he incurs, which is the difference of the total
amount that he receives from customer and the amount that he pays to the supplier less other
expenses.
What we understand form this example is that cash in hand is not always the profit. To work out the
profit we have to consider the total income and total expenses irrespective of the fact that actual
payment has been made or not.
Capital and Revenue Expenses
We have established, to calculate the profit, all expenses are deducted from income.
Are all payments that we make are expenses and have to be deducted from the income?
Consider the different types of payments that could be made by a business organization. The
payments could be for utility bills, salaries, fuel bills or purchase of vehicle, furniture etc.
Out of the types discussed above utility bills, salaries and fuel bill are the payments for which the
organisation has already enjoyed the benefit. Whereas vehicle and furniture are the types from which
the company will derive the benefit for a long time.
If the payment made for vehicles and furniture is subtracted from the income of the period in which
payment was made, the profit for that period will be too low. Whereas in the future period when the
item will still be providing benefit to the company there will be no expense to match the benefit.
This means that we have to distinguish between the payments / expenses that provide benefit to the
company immediately and those that last for a longer period.
In accounting the expenses that provide benefit immediately are called "Revenue Expenses"
and those expenses whose benefit last for a longer period are called "Capital Expenses".
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Financial Accounting (Mgt-101)
VU
Liabilities
Liabilities are the debts and obligations of the business.
Liability is the obligation of the business to provide a benefit or asset on a future date.
We have discussed credit transactions. Whenever a person purchases something on credit he
promises to pay for the goods on a future date. This is his obligation to pay cash at a future date and
thus it becomes his liability.
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Table of Contents:
  1. Introduction to Financial Accounting
  2. Basic Concepts of Business: capital, profit, budget
  3. Cash Accounting and Accrual Accounting
  4. Business entity, Single and double entry book-keeping, Debit and Credit
  5. Rules of Debit and Credit for Assets, Liabilities, Income and Expenses
  6. flow of transactions, books of accounts, General Ledger balance
  7. Cash book and bank book, Accounting Period, Trial Balance and its limitations
  8. Profit & Loss account from trial balance, Receipt & Payment, Income & Expenditure and Profit & Loss account
  9. Assets and Liabilities, Balance Sheet from trial balance
  10. Sample Transactions of a Company
  11. Sample Accounts of a Company
  12. THE ACCOUNTING EQUATION
  13. types of vouchers, Carrying forward the balance of an account
  14. ILLUSTRATIONS: Ccarrying Forward of Balances
  15. Opening Stock, Closing Stock
  16. COST OF GOODS SOLD STATEMENT
  17. DEPRECIATION
  18. GROUPINGS OF FIXED ASSETS
  19. CAPITAL WORK IN PROGRESS 1
  20. CAPITAL WORK IN PROGRESS 2
  21. REVALUATION OF FIXED ASSETS
  22. Banking transactions, Bank reconciliation statements
  23. RECAP
  24. Accounting Examples with Solutions
  25. RECORDING OF PROVISION FOR BAD DEBTS
  26. SUBSIDIARY BOOKS
  27. A PERSON IS BOTH DEBTOR AND CREDITOR
  28. RECTIFICATION OF ERROR
  29. STANDARD FORMAT OF PROFIT & LOSS ACCOUNT
  30. STANDARD FORMAT OF BALANCE SHEET
  31. DIFFERENT BUSINESS ENTITIES: Commercial, Non-commercial organizations
  32. SOLE PROPRIETORSHIP
  33. Financial Statements Of Manufacturing Concern
  34. Financial Statements of Partnership firms
  35. INTEREST ON CAPITAL AND DRAWINGS
  36. DISADVANTAGES OF A PARTNERSHIP FIRM
  37. SHARE CAPITAL
  38. STATEMENT OF CHANGES IN EQUITY
  39. Financial Statements of Limited Companies
  40. Financial Statements of Limited Companies
  41. CASH FLOW STATEMENT 1
  42. CASH FLOW STATEMENT 2
  43. FINANCIAL STATEMENTS OF LISTED, QUOTED COMPANIES
  44. FINANCIAL STATEMENTS OF LISTED COMPANIES
  45. FINANCIAL STATEMENTS OF LISTED COMPANIES