Basics of Accounting

 What is accounting?

Identifying a business transaction

  • Preparation of Business Documents(Voucher)
  • Recording of the transaction in the book of first entry (Journal)
    • Sales or Purchase Module
    • Relevance with the banking operations
  • Posting in the ledger
  • Preparation of Trial Balance
  • Preparation of Profit and Loss Account and Balance Sheet

WHY? – ADVANTAGES

  1. A Clear picture of the functioning of the business.
  2. Monitoring of the state of the financial health of the organisation.
  3. Establishment of internal controls and procedures to detect errors and fraud
  4. Banks and financial institutions require the Financial data
  5. Calculation of tax liabilities

WHO? USERS OF FINACIAL STATEMENT

  1. Shareholders, security analysts, and investors, Management, Employees, Lenders, Customers, Government, and Regulatory Agencies, Others- academicians, researchers, and analysts.

Important Accounting Terminology:

  • Capital:
  • It refers to the amount invested by the proprietor in the business enterprise.
  • Capital = All Assets-External Liabilities
  • Capital is also known as Owner’s Equity or Net Worth or Net Assets 

Liability: It refers to the amount which the firm owes to the outsiders

Long-term liabilities or Fixed Liabilities: To be paid off after one year.

  • Long-term loan
  • Debentures

Current Liabilities: To be paid off within one year i.e. Creditors, Cash Credit, bills payable, Outstanding Expenses, Income received in advance

Assets:

  • Current Assets: Will be realised within the year i.e. Cash, Bank Balance, Stock, Debtors, Bills receivables, Prepaid Expenses, Accrued Income.
  • Fixed Assets: Will not be realised within the year. These can be tangible or intangible.
    • Tangible Fixed Assets: Land, Building, Plant & Machinery, Furniture & Fixture. These are shown in the books after providing for depreciation
    • Intangible Fixed Assets: Goodwill, Patents, Copyrights, Brand Names. These are shown in the books after deducting amortisation.
    • Fictitious Assets: Accumulated Losses, Discount on issue of shares & debentures, Preliminary Expenses, Deferred Revenue Expenditure
    • Non-Current Assets: Investment in businesses other than your own (in sister concerns), Security Deposits 

Basic Categories of Accounts:

  1. Personal Accounts: Natural Persons, Artificial Persons, Representative Personal A/c, Accounts of customer s, suppliers, and owners.
  2. Real Accounts: Accounts of fixed and current assets e.g. cash, Building, Plant & Machinery, Vehicles
  3. Nominal accounts: accounts relating to expenses, and revenues e.g. Discount allowed, Repairs, salaries, discount received, interest received

Golden Rules in Accounting

  • To identify the effect of a transaction on an account there are rules:
    • For Personal Account:
      • Debit: the receiver
      • Credit: the giver
    • For Real Account: The account of all those things which really exist & whose value can be measured in terms of money & which are the properties of business Cash A/c, Furniture A/c, Machinery A/c, Building A/c, Goodwill A/c
      • Debit: what comes in
      • Credit: what goes out 

For Nominal Account: These accounts include the accounts of all incomes & expenses

  • Debit: all expenses and losses
  • Credit: all incomes and gains

 

LIABILITIES ASSETS
NET WORTH/EQUITY/OWNED FUNDS

Share Capital/Partner’s Capital/Paid up Capital/ Owners Funds Reserves (General, Capital, Revaluation & Other Reserves)

Credit Balance in P&L A/c

FIXED ASSETS : LAND & BUILDING, PLANT & MACHINERIES

Original Value Less Depreciation

Net Value or Book Value or Written down value

LONG-TERM LIABILITIES/BORROWED FUNDS:  Term Loans (Banks & Institutions)

Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities

NON CURRENT ASSETS

Investments in quoted shares & securities

Old stocks or old/disputed book debts

Long Term Security Deposits

Other Misc. assets which are not current or fixed in nature

CURRENT LIABILITIES

Bank Working Capital Limits such as CC/OD/Bills/Export Credit

Sundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or deposits

Expenses payable & provisions against various items

CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & Inventory (RM,SIP,FG) Stores & Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months
INTANGIBLE ASSETS

Patent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses

 

  1. Current Ratio: Current Assets/Current Liabilities:

If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be:  Rs.4,00,000/Rs.2,00,000= 2 : 1

         The ideal Current Ratio preferred by Banks is   1.33: 1

  1. Net Working Capital(NWC): This is worked out as a surplus of Long Term Sources over Long Tern Uses. Alternatively, it is the difference between Current Assets and Current Liabilities. NWC = Current Assets – Current Liabilities 
  1. ACID TEST or QUICK RATIO: It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1. Quick Current Assets: Cash/Bank Balances + Receivables up to 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits       

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

  1. DEBT EQUITY RATIO: It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity).

Debt Equity Ratio = Long Term outside Liabilities / Tangible Net Worth                       

                 Debt = Liabilities of Long Term Nature               

Tangible Net Worth = Total of Capital and Reserves & Surplus Less Intangible Assets     

  1. Proprietary Ratio: This ratio indicates the extent to which Tangible Assets are financed by Owner’s Fund.

        Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100 

  1. Gross Profit Ratio: = (Gross Profit / Net Sales) x 100 Alternatively,

Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net Sales] x 100. A higher Gross Profit Ratio indicates efficiency in the production of the unit.

  1. Operating Profit Ratio: (Operating Profit / Net Sales) x100
  1. Net Profit Ratio: (Net Profit / Net Sales) x 100       
  1. Stock Turnover Ratio: (Average Inventory/Sales) x 365 for days( 52 for weeks & 12 for months)          

Average Inventory or Stocks = (Opening Stock + Closing Stock)/2     

  1. Debtors Turnover Ratio: (Average Debtors/Sales) x 365 for days(52 for weeks & 12 for months)
  1.   Asset turnover ratio:net sales/tangible assets
  2. Fixed asset turnover ratio: net sales /fixed assets
  3. Current asset turnover ratio: net sales / current assets
  4. Creditors turnover ratio:(average creditors/purchases) x365 for days/ (52 for weeks & 12 for months)
  5. Return on assets: Net Profit after Taxes/Total Assets 
  1. Return On Capital Employed: (Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share capital and long-term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.      

  1. Return on equity capital (ROE): Net Profit after Taxes / Tangible Net Worth 
  1. Earnings Per Share: EPS indicates the quantum of net profit of the year that would be ranking for dividend for each share of the company being held by the equity share holders.   

           EPS= Net profit after Taxes and Preference Dividend/ No. of Equity Shares      

  1. PRICE EARNING RATIO: PE Ratio indicates the number of times the Earning Per Share is covered by its market price. Market Price Per Equity Share/Earning Per Share
  1. DEBT SERVICE COVERAGE RATIO: This ratio is one of the most important ones which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project. (The Ideal DSCR Ratio is considered to be 2)

       (PAT + Depr. + Annual Interest on Long Term Loans & Liabilities)/ (Annual Interest on Long Term Loans & Liabilities + Annual Installments payable on Long Term Loans & Liabilities)     

(Where PAT is Profit after Tax and Depr. is Depreciation)

For the accounting purpose expenditures are classified into three types:

Capital Expenditure is an amount incurred for acquiring the long-term assets such as land, building, equipment which are continually used for the purpose of earning revenue. These are not meant for sale. These costs are recorded in accounts namely Plant, Property, Equipment. Benefits from such expenditure are spread over several accounting years.

E.g. Interest on capital paid, Expenditure on purchase or installation of an asset, brokerage and commission paid.

Revenue Expenditure is the expenditure incurred in one accounting year and the benefits from which is also enjoyed in the same period only. This expenditure does not increase the earning capacity of the business but maintains the existing earning capacity of the business. It included all the expenses which are incurred during day to day running of business. The benefits of this expenditure are for a short period and are not forwarded to the next year. This expenditure is on recurring nature.

Eg: Purchase of raw material, selling and distribution expenses, Salaries, wages, etc.

Deferred Revenue Expenditure is a revenue expenditure which has been incurred during an accounting year but the benefit of which may be extended to some years. And these are charged to profit and loss account. E.g. Development expenditure, Advertisement, etc


Numericals will be shared later.

Source: JAIIB Accounts Book

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