FINANCIAL ACCOUNTING

BALANCE SHEET
 The Mechanics of Financial Accounting
Balance
Accounting is like a balance beam,
 The Mechanics of Financial Accounting
Balance
When we add to one side,
 The Mechanics of Financial Accounting
Balance
We must add the same amount to the
other side.
 The Mechanics of Financial Accounting
• Fundamental Accounting Equation

A = L + E
 Accounting Equation
It is evident from the accounting equation that:

(i) If the total amount of liabilities increases without any

change in the total amount of assets, equity reduces and, if
the total amount of liabilities decreases without any change
in the total amount of assets, equity increases:

(ii) If the total amount of assets increases without any

change in the total amount of liabilities, equity increases
and, if the total amount of assets decreases without any
change in the total amount of liabilities, equity decreases
 Balance Sheet

The balance sheet (also called statement of

financial position or statement of financial
condition) is a snapshot of the financial
status of an organization at a point in time.
    Balance Sheet as at 31-03-17  
             
Owner's Equity     Assets    
Share capital 30   Fixed Assets    
        Furniture   5
Reserves & Surplus 6.8        
Long Term
Liabilities   Current Assets
        Inventory 15  
Loan from Bank 20   Debtors 23  
        Rent Advance 5  

Current Liabilities Cash 50 93

Creditors   36        
Expenses payable 5.2        
    98       98
 Balance Sheet: Assets
Assets
• Probable future economic benefits obtained or controlled
by a particular entity as a result of past transactions or
events.

• The specific types of assets a firm owns depends on the

nature of its business --manufacturing (e.g., Tata Motors)
vs. merchandising (e.g., D mart) vs. financial (e.g.,
Banks) vs. service (e.g., Audit firms) business.
 Current assets
• Cash and other assets that are reasonably expected to be realized
in cash or consumed within one year

– Cash and cash equivalents (liquid assets, not subject to accountant’s

discretion though company can lie!)

– Short-term investments --at market value --We will discuss this

in detail later.

– Accounts receivable (‘Bad Debt Reserve’ to ‘smooth’ profit!)

– Inventory (method of valuing inventory)

– Prepaid expenses (Expense vs. Expenditure) (Art of Finance)

 Fixed Assets
Long-Term Investments
• Investments intended to be held for a period of time usually
extending beyond one year.

• Debt and equity securities such as stocks and bonds

• Tangible assets not currently used in operations, e.g., land held for
investment purposes.
 Fixed Assets
Property, Plant, and Equipment
• Assets of a durable nature that are to be used in the production or
sale of goods, or rendering of services, rather than being held for
sale.
- Machinery, Factory Building, etc.

• Carried at Cost (-) Accumulated Depreciation

• Land on which the company conducts its operations is carried on

the balance sheet at the original cost –no depreciation.
– Distinguish from land held for investment purposes.
 Fixed Assets
Intangible Assets
• Non-current, non-physical assets of a business, the possession of
which provides uncertain future benefits to the owner
E.g., goodwill, trademarks, patents, copyrights, etc.

• Goodwill – Purchase consideration over the fair value of Net Assets

– includes relationship with employees, proprietary knowledge,
customer list, brand names, reputation, strategic strengths etc. (Art
of Finance)

• Is accounts receivable an intangible asset?

• Not for accounting purposes

• Intangible assets are carried on the balance sheet at cost (-)

accumulated amortization. (Exception – Goodwill) (Art of Finance)

• Cost = Whatever was paid to acquire them.

 Balance Sheet: Liabilities

 What a company owes

 How the assets are obtained
 How the company is funded – critical to any future decisions
about debt & equity
 Debt – More risky
 Equity – Giving up partial ownership
 Current Liabilities

• Obligations that are expected to be paid within one year

from current assets or current resources.

• Examples of current liabilities

– accounts payable,
– wages payable,
– interest payable,
– income taxes payable,
– Deferred Revenue
– Current Portion of Long Term Debt
– Short-Term Loans
 Long-Term Liabilities

• Obligations usually expected to require payment over a

period of time beyond one year.

• Usually financing obligations, e.g., arising from issuance

of bonds, long-term notes, and mortgages.

• The maturity date, the rate of interest, and any security

pledged to support the borrowing agreement should be
clearly shown.
 Balance Sheet: Owners’ Equity
• Stockholders' Equity
- The residual interest in the assets that remain after
deducting the liabilities.

• Contributed Capital
– A measure of the capital contributed to the company by its
owners.
– Contribution can be through cash, or non cash assets.
– Different classes of capital: Common stock (par value, voting
rights, no fixed dividend) and Preferred stock (No voting rights,
fixed dividends, senior to common shares)
• Retained earnings
 Retained earnings

• A measure of undistributed profits of a business

• Do not include capital contributed by owners

• Retained earnings = Cumulative sum of profits earned from the

inception of business – Cumulative sum of all “dividends” distributed
to the owners from the inception of business

• How does retained earnings change over a period of time(e.g., a

year)
– Beginning balance in retained earnings
– Add Net income earned during the period
– Subtract Dividends distributed during the period
– Ending balance in retained earnings
 Balance Sheet Structure

Particulars HUL Infosys Suzlon

ASSETS
Total Assets 14,751 79,885 14,226
EQUITY AND
LIABILITIES
Equity (Owners’ claim) 6,490 68,017 1,022
Liabilities (Outsiders’ 8,261 11,868 13,204
claim)
Total 14,751 79,885 14,226
The Analytical Power of the
Balance Sheet Equation
The accounting equation can highlight the link
between the income statement and balance sheet.

Assets (A) = Liabilities (L) + Stockholders’ equity (SE)

A = L + Paid-in capital + Retained income

A = L + Paid-in capital + Revenue – Expenses

Revenues and Expenses

Revenues are increase in ownership

claims arising from the delivery
of goods or services.

Expenses are decrease in ownership

claims arising from delivering goods
or services or using up assets.
 Decisions: Good or Bad for
profitability?
• Your plant manager hears of a good deal on an
important raw material and decides to buy a lot of it –
Good?

• But
– Accounts Payable increases
– Cash decreases
– To pay to warehouse the inventory
– To borrow money to cover the decrease in cash
 Decisions: Good or Bad for
profitability?
• Your sales manager is targeting smaller business as
customers to boost revenue and profit – Good?

• But
– Credit risk is higher than larger customers
– Accounts receivable may rise
– Bad-debt allowance may increase which reduces
profit
Can he increase gross margin to compensate for the
increased risk on sales to smaller customers?
 Decisions: Good or Bad for
profitability?
• Your IT guy wants to buy a new computer system to
boost productivity and hence profitability – Good?

• But
– How to fund it?
– Is it an overleveraged company with high debt load?

To balance impact on financial statement as well as

potential improvement in productivity.
 Assessing Your Company’s Health
• Is the company profitable? (From Income statement)

Beyond that, (From Balance Sheet)

• Is the company solvent? (Asset > liability?)

• Can the company pay its bills? (current asset status?)

• Has owners‘ equity been growing over time? (Source:

RE or CC?)
Key Components in the Process to
Capture Accounting Information
Accounting Transaction—any economic event
that affects a company’s assets, liabilities or
equity at the time of the event.   

Account—an accounting record that

accumulates the activity of a specific item and
yields the item’s balance.   

Chart of Accounts—the various accounts that a

company uses to capture its business.
 [

Chart of Accounts Example

Chart of Accounts 
ASSETS
Cash
Accounts Receivable
Supplies/ Inventory
Equipment
LIABILITIES
Accounts Payable
Unearned Revenues
Notes Payable
EQUITY
Common Stock
Retained Earnings
REVENUES
Service Revenue
EXPENSES
Wage Expense
Interest Expense
DIVIDENDS
 What type of account?
• Identify assets, liabilities, or equity

• Equipment
• Retained Earnings
• Patent
• Dividend Payable
• Prepaid Expense
 What type of account?
• Inventory
• Accounts Receivable
• Land
 Accounting Transactions
• What business transactions are recorded in the financial
accounting system?

– Exchange of assets and liabilities with other entities

– As opposed to “executory” transactions

• Supplier: I will supply 5,000 units six months from now.
• Customer: I will pay when I receive the goods
• Exchange of promises

• How do transactions affect the accounting equation?

– The accounting identity is always maintained
Accrual Basis and Cash Basis

The accrual basis of accounting

recognizes revenues and expenses
when they occur regardless of when
cash is received or disbursed.

The cash basis of accounting recognizes

revenue and expense when cash is
received and disbursed.
Accrual Basis and Cash Basis

The major deficiency of the cash basis

of accounting is that it is incomplete.

It fails to match efforts and accomplishments

in a manner that properly measures economic
performance and financial position.
 Should we recognize the
asset?
Assets arise from transactions and events
• A firm issues a Rs.12m cheque to an insurance company
for liability insurance over the next year.

• A firm issues a cheque for Rs.500K as a deposit on a

custom-built machine.

• A firm buys shares in another firm for Rs.325K

• A firm acquires chemicals to be used as raw materials

for Rs.800K.
 Should we recognize the
asset?
Assets arise from transactions and events
• A well-known scientist is hired to manage the R&D function for 480K
a year. Employment starts next month.

• The firm receives an order for $15K in products.

• The firm writes a cheque for $1M to obtain an option to purchase a

tract of land.

• A firm receives notice from a supplier that it has shipped raw

materials of $200K. The firm has title to the goods while in transit.

• The firm purchases a patent from its creator for $1.2M

 Should we recognize the
liability?
Liabilities arise from transactions and events

• The firm owes its attorneys Rs.50K in legal expenses.

• The firm provides warranties on its products.

• The firm borrows Rs.60K from the bank for a 90-day

period.
 Example

• (1) Mr. A contributes Rs.10,000 in cash

• Assets = Liabilities + Owners’ Equity

• Cash Contributed Capital

• +10,000 +10,000
 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
(2) The company borrows Rs. 3,000 from a bank

• Assets = Liabilities + Owners’ Equity

• Cash Loans Payable

• +3,000 +3,000
 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
+3,000 +3,000
(3) Company purchases equipment for Rs.
5,000 cash

• Assets = L + OE

• Cash Equipment

• -5,000 +5,000
 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
+3,000 +3,000
- 5,000 +5,000
• (4) Company performs service for Rs.12,000.
The customer pays Rs. 8,000 in cash and
promises to pay the balance at a later date.

• Assets =L + Owners’ Equity

• Cash Receivables Retained Earnings

• +8,000 +4,000 +12,000

 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
+3,000 +3,000
- 5,000 +5,000
+ 8,000 +4,000 +12,000
• (5) Company pays Rs. 9,000 for expenses
(wages, interest, and maintenance)

• Assets = Liabilities + Owners’ Equity

• Cash Retained Earnings

• -9,000 -9,000
 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
+3,000 +3,000
- 5,000 +5,000
+ 8,000 +4,000 +12,000
- 9,000 - 9,000
(6) Company pays dividend of Rs. 1,000

• Assets = Liabilities + Owners’ Equity

• Cash Retained Earnings

• -1,000 -1,000
 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
+3,000 +3,000
- 5,000 +5,000
+ 8,000 +4,000 +12,000
- 9,000 - 9,000
- 1,000 - 1,000
6,000 4,000 5,000 = 3,000 10,000 2,000
 Balance Sheet as at March 31, 2017
Owners’ Equity Amount (Rs.) Assets Amount (Rs.)
& Liabilities

Contributed Capital 10,000 Equipment 5,000

Retained Earnings 2,000 Receivables 4,000

Loans Payable 3,000 Cash 6,000

Total Owners’ Equity 15,000 Total Assets 15,000

& Liabilities
 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
+3,000 +3,000
- 5,000 +5,000
+ 8,000 +4,000 +12,000
- 9,000 - 9,000
- 1,000 - 1,000
6,000 4,000 5,000 = 3,000 10,000 2,000
 Income Statement
For the year ended March 31, 2017

Revenues: Fees earned for service Rs.12,000

Expenses: Wages, interest, maintenance Rs. 9,000

Net income Rs. 3,000

 Transactions and the Accounting Equation

Cash + A/R + Equip. = L/P + C. Cap. + R/E

+10,000 +10,000
+3,000 +3,000
- 5,000 +5,000
+ 8,000 +4,000 +12,000
- 9,000 - 9,000
- 1,000 - 1,000
6,000 4,000 5,000 = 3,000 10,000 2,000
 Statement of Retained Earnings
For the year ended March 31, 2017

Beginning retained earnings balance 0

Plus: Net income 3,000

Less: Dividend to stockholder 1,000

Ending retained earnings balance Rs. 2,000

 Summary
Balance sheet
• Listing of
– Resources owned by a firm (assets or investments)
– Financing of the assets through obligations to external parties
(liabilities)
– Financing of the investments through residual claimants
(shareholders’ equity)

• Preparing a balance sheet using transaction history