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Financial Statement Analysis

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Financial Statement Analysis-FIN621
VU
Lesson-2
ACCOUNT AND ACCOUNTING CYCLE/PROCESS
Account
An accounting system keeps separate record of each item like assets, liabilities, etc. For example, a
separate record is kept for cash that shows increase and decrease in it.
This record that summarizes movement in an individual item is called an Account.
Each element/sub-element of the balance sheet is named as "Account", having three parts
viz title, left side (Debit or Dr) and a right side (Credit or Cr). Technically, these are also called `Ledger
Accounts'. The same is true of Income Statement, which would be discussed later.
The Ledger Accounts are also called T-account, because these are in the shape of the alphabet `T' as
shown below:-
Dr
Title
Cr
!
!
!
!
!
Account Payable:An amount owed to a supplier for good or services purchased on credit; payment is
due within a short time period, usually 30 days or less.
Notes Payable: A liability expressed by a written promise to make a future payment at a specific time,
OR are obligations (short term debt) evidenced by a promissory note? The proceeds of the note are used
to purchase current assets (inventory & receivables).
Dual Aspect of Transactions
For every debit there is an equal credit. This is also called the dual aspect of the transaction i.e. every
transaction has two aspects, debit and credit and they are always equal. This means that every
transaction should have two-sided effect. For example Mr. A starts his business and he initially invests
Rupees 100,000/- in cash for his business. Out of this cash following items are purchased in cash;
A building for Rupees 50,000/-;
o
Furniture for Rupees 10,000/-; and
o
A vehicle for Rupees 15,000/-
o
This means that he has spent a total of Rupees 75,000/- and has left with Rupees 25,000 cash. We will
apply the Dual Aspect Concept on these events from the viewpoint of business.
When Mr. A invested Rupees 100,000/-, the cash account benefited from him. The event will be
recorded in the books of business as,
Debit
Cash
Rs.100, 000
Credit
Mr. A
Rs.100, 000
Analyse the transaction. The account that received the benefit, in this case is the cash account,
and the account that provided the benefit is that of Mr. A.
Building purchased ­ The building account benefited from cash account
·
Debit
Building
Rs.50, 000
Credit
Cash
Rs.50, 000
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Financial Statement Analysis-FIN621
VU
·
Furniture purchased ­ The furniture account benefited from cash account
Debit
Furniture
Rs.10, 000
Credit
Cash
Rs.10, 000
·
Vehicle purchased ­ The vehicle account benefited from cash account
Debit
Vehicle
Rs.15, 000
Credit
Cash
Rs.15, 000
Basic Principle of Double Entry
We can devise the basic principle of double entry book-keeping from our discussion to this point "Every
Debit has a Credit" which means that "All Debits are always equal to All Credits".
Assets
Assets are the properties and possessions of the business.
Properties and possessions can be of two types:
o  Tangible Assets that have physical existence ( are further divided into Fixed Assets and
Current Assets)
o  Intangible Assets that have no physical existence
Examples of both are as follows:
o  Tangible Assets ­ Furniture, Vehicle etc.
o  Intangible Assets ­ Right to receive money, Good will etc.
Accounting Equation
From the above example, if the debits and credits are added up, the situation will be as follows:
Debits
Cash
Rs.100, 000/-
Building
50,000/-
Furniture
10,000/-
Vehicle
15,000/-
Credits
Mr. A
Rs.100, 000/-
Cash
75,000/-
The total Equation becomes:
·
DEBITS
=
CREDITS
Cash  + Building + Furniture + Vehicle
=
Cash + Mr. A
100000 + 50000  + 10000
+ 15000
=
75000 + 75000
Cash on Left Hand Side is Rupees 100,000/- and on Right Hand Side it is Rs.75, 000/-. If it is gathered
on the Left Hand Side it will give a positive figure of Rupees 25,000/- (which you will notice is our
balance of cash in hand). Now the equation becomes:
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Financial Statement Analysis-FIN621
VU
DEBITS
=
CREDITS
Cash + Building
+ Furniture+ Vehicle
=
Mr. A
25,000+ 50,000 + 10,000  + 15,000
=
100,000
Keeping the entity concept in mind we can see that the business owns the building, furniture, vehicle
and cash and will obtain benefit from these things in future. Any thing that provides benefit to the
business in future is called `Asset'. Similarly the business had obtained the money from Mr. A and this
money will have to be returned in form of either cash or benefits. Any thing for which the business has
to repay in any form is called `Liability'. So cash, building, furniture and vehicle are the assets of the
business and the amount received from Mr. A for which the business will have to provide a return or
benefit is the liability of the business. Therefore, our equation becomes:
Assets
=
Liabilities
The liabilities of the business can be classified into two major classes i.e. the amounts payable to
`outsiders' and those payable to the `owners'. The liability of the business towards its owners is called
`Capital' and amount payable to outsiders is called liability. Therefore, our accounting equation finally
becomes:
Assets
=
Capital
+
Liabilities
Business or Commercial Accounts are based upon Double entry accounting involving Debit and
credit entries. Rule for Dr. & Cr entries to record changes in balance sheet Accounts or Accounting
Equation is: increase in assets are debited (since Assets are on left side of Accounting Equation) and
increase in liabilities and Owner's Equity are credited because these are on the right side of Accounting
Equation. Correspondingly, decrease in Assets is credited and decrease in liabilities and Owners Equity
are debited.
Dr+ Assets = Liabilities + Owner's equity
Cr_
Cr + _ Dr +Cr _ Dr.
Rule for Income Statement items is that Revenues are credited and expenses are
debited. The basis of this rule is that income statement shows the effect of Revenues & Expenses on
owner's equity. Difference of Revenues and Expenses causes difference in owner's equity. Since
Revenues increase owner's equity, these are credited. Correspondingly, since expenses ultimately
reduce owner's equity, these are debited.
It would thus be seen that normal balances in Assets Accounts would be debit and those in
Liability and Owner's Equity Accounts would be credit. Orderly arrangement of Accounts is to be
maintained. Numbering of Accounts is also done to facilitate proper record-keeping and cross-
references. When the business is large, a Chart of Accounts is maintained which lists the various
Accounts giving details of their titles and numbers.
Compound Entry. A journal entry that has more than one debit or credit entry.
General Journal
Date
Account Title and explanation
LP
Dr.
Cr.
Cash
1
180,000
Khizr, Capital
50
180,000
July, 2006 (1)
(Owner invested cash in business)
July, 2006 (5)
Building
36,000
Cash
15,000
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Financial Statement Analysis-FIN621
VU
Accounts payable
21,000
(Purchase building partly for cash and
Partly on credit)
"LP" is reference account No: of the particular ledger accounts. For example cash account has been
assigned number 1 in ledger and capital account is given number 50.
C) Posting in ledger which mean transferring debits and credits from journal to ledger account. This is
also called ledgerising or classification
Date
Explanation
Ref
Dr.
Cr.
Jul 1
1
180,000
Khizr
1
Capital
Account No:50
Jul 1
180,000
"Ref" is reference to the page of journal i.e. page 1. This shows that there is cross-reference between
journal and ledger through "LP" and "ref" columns in journal and ledger respectively.
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