Financial Accounting and Analysis summary keywords

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Book summary of Financial Accounting and Analysis

Understand the role of accounting information in making economic decisions. There are a number of stakeholders in a business who make some or the other kind of decision. For making these decisions, the stakeholders need relevant economic information. It is accounting that provides the relevant economic information required by the stakeholders.
Identify the users and uses of accounting information. Accounting information includes both internal and external users. Managers are internal users. Investors, lenders, customers, suppliers, labor unions and the government are external users.
Understand the sub-fields of accounting and their relevance. There are two sub-fields of accounting: managerial accounting and financial accounting. Managerial accounting generates detailed information for owners and managers. On the contrary, financial accounting relates to the preparation of financial statements for use by both managers and external stakeholders.
Understand the purpose of generally accepted accounting principles. Generally accepted accounting principles (GAAP) are a set of conventions, rules and procedures that define the accepted accounting practice at a particular time. These result from a broad agreement on the theory and practice of accounting at a particular time.
Understand the accounting process that leads to the preparation of financial statements. Transactions are analyzed in terms of their effect on assets, liabilities and owners’ capital. Following the rules of debit and credit, these are entered into the journal or the ledger.
Analyze the effect of business transactions on the basic accounting equation. The effect of transactions on assets, liabilities and owners’ capital can be analyzed using the basic accounting equation.
Understand the use of an account in the process of building accounting records. A ‘T’ shaped account is a convenient way of determining the balance of an item at any time. The left-hand side of the account is called the debit side and the right-hand side is called the credit side. Increases in the account are entered on one side and decreases on the other. The difference in the amounts on the two sides represents the balance in the account.
Understand the rules of debit and credit in recording business transactions in relevant accounts. Entering the transactions in an account is based on certain rules that differ with the account type. Increases in assets are debits; decreases in assets are credits. Increases in liabilities are credits; decreases in liabilities are debits. Increases in the owners’ capital are credits; decreases in the owners’ capital are debits. Expenses and losses are debits; incomes and gains are credits.
Understand how a journal is maintained and the concept of subsidiary books. The journal has a specific format that consists of five columns. Sometimes, a journal is subdivided according to the nature of transactions. The parts of the journal are called subsidiary books.
Understand the posting of entries in the ledger. The debit and credit amounts in the journal and the subsidiary books are transferred to the relevant side of accounts maintained in the ledger. To find the balance in an account at the end of the accounting period or at any other time, the two sides of the account are totaled and the difference between the two is calculated. This difference represents the balance in the account.
Understand how trial balance is extracted and its purpose. The closing balances of all ledger accounts are transferred to a statement called the trial balance. It serves as a summary of the contents of the ledger. Agreement of the totals of debit and credit balances in the trial balance is an indication of absence of arithmetical errors in the accounting process.
Understand the nature and purpose of balance sheet. The balance sheet reveals the financial position of an entity. It is prepared on a particular date, and is true only on that date. It is prepared only after the preparation of the profit and loss account. The two sides of the balance sheet must have the same total.
Understand the format and contents of a balance sheet. It sets out the assets, liabilities and owners’ capital of an entity as on a certain date. The balance sheet can be prepared in a horizontal or vertical form.
Understand the relationship between profit and loss account and balance sheet. Both the profit and loss account and balance sheet are inter-related. A cost relating to the operations of an accounting period or to the revenue earned during the period whose benefits do not extend beyond that period is shown in the profit and loss account.
Prepare profit and loss account and balance sheet from the given trial balance, without accounting for any adjustment entries. First, the gross profit is determined by deducting the cost of goods sold from the sales revenue. Operating profit is calculated as gross profit minus operating expenses. Net profit is calculated by adjusting the operating profit for non-operating revenues, expenses, gains and losses. Income-tax and drawings are treated as personal expenses of the owner and are, therefore not shown in the profit and loss account.
Understand how to make adjustments for accruals, deferrals and other items. Some business activities affect revenues and expenses of more than one accounting period. Some adjustments are required at the end of the accounting period to ensure proper measurement of income for an accounting period and to give a true picture of the state of affairs of the business at the end of the accounting period. Adjustments are usually made relating to outstanding expenses, prepaid expenses, outstanding or accrued income, income received in advance or unearned income, depreciation and amortization, and provision for bad debts.
Prepare profit and loss account and balance sheet after accounting for adjustment entries. The amounts in the trial balance get adjusted with the amount of adjustments made. Following the same principles that apply in the absence of adjustments, the profit and loss account and the balance sheet are prepared on the basis of the adjusted trial balance.
Prepare closing entries and post-closing trial balance. At the end of the accounting period, revenue and expense accounts are closed by transfer to profit and loss account. The balance in the profit and loss account is transferred to owners’ capital account or retained earnings account. Thereafter, post-closing trial balance is prepared that consists of only balance sheet accounts.
Understand the meaning and importance of accounting standards. Accounting standards are pronouncements made by accounting bodies specifying the accounting requirements for different transactions and events. Accounting standards also bring about uniformity in financial reporting and make financial statements of different entities comparable.
Understand the role of Accounting Standards Board in bringing out new accounting standards. Accounting Standards Board (ASB) is instrumental in formulating the accounting standards that standardize different accounting policies and practices so that financial statements prepared by different entities are reliable and comparable.
Understand how new accounting standards are issued and how is compliance with accounting standards ensured. The Central Government may prescribe the Standards of Accounting or any addendum thereto, as recommended by the ICAI, in consultation with and after examination of the recommendations made by the National Financial Reporting Authority (NFRA).
Understand the current structure of Accounting Standards in India. Except for some categories of companies, Indian companies are required to follow the new ‘Ind AS’. These are accounting standards that are converged to IFRS. Convergence means that there are certain departures from IFRS in Ind AS. Other companies are required to follow the existing accounting standards commonly known as the Indian GAAP (generally accepted accounting principles).
Understand the concept of GAAP. Generally accepted accounting principles (GAAP) are a set of conventions, rules and procedures that define the accepted accounting practice at a particular time.
Understand the structure of International Financial Reporting Standards (IFRS) and advantages of adopting them. IFRS comprise two series of standards and two series of interpretations. By adopting IFRS, investors can compare financial statements of companies located in different countries and decide where to invest money.
Understand the key differences between Indian GAAP, IFRS and Ind AS with respect to important accounting transactions and events. Ind AS are more or less converged with IFRS. There are major differences in the Indian GAAP and the Ind AS with respect to the presentation of financial statements, inventory accounting, presentation of cash flows, revenue recognition, etc.
Explain requirements relating to corporate books of account and financial statements. Companies Act, 2013 requires every company to prepare and keep books and papers and financial statements for every financial year, which give a true and fair view of the state of affairs of the company.
Explain the form and contents of corporate financial statements. Financial statements of a company include the balance sheet; profit and loss account; cash flow statement; statement of changes in equity, if applicable and explanatory notes annexed to these statements. Financial statements are required to give a true and fair view of the state of affairs of the company or companies, comply with the notified accounting standards and shall be in the form or forms as may be provided for different class or classes of companies in Schedule III.
Prepare corporate financial statements. Income and expense accounts from the trial balance accounts are carried to the Profit and Loss account. The net result of the Profit and Loss account represents the net profit or loss made by the business during the accounting period. Asset and Liability accounts are transferred to the Balance Sheet along with the net result of the Profit and Loss account.
Understand the purpose of preparing the cash flow statement. The purpose of the cash flow statement is to provide information about the company’s ability to generate positive cash flows in future periods, to meet its obligations and to pay dividends.
Understand the classification of cash flows from different activities. Cash flow statement should report cash flows during the period from operating, investing and financing activities.
Understand the difference between direct and indirect methods of computing cash flows from operating activities. In case of direct method, gross cash receipts and gross cash payments are shown under major classes such as cash sales, receipts from debtors, commission and fee received and interest received, payments for purchases, payments to and for employees, operating expenses, interest payments and direct tax payments.
Under the indirect method, the net profit or loss disclosed by the income statement is adjusted for non-cash items such as depreciation, provisions and unrealized foreign exchange gains or losses; change in current assets and current liabilities; and all other items for which the cash effects are on investing or financing cash flows.
Understand how to deal with certain special items such as income taxes, foreign currency cash flows, cash flows from interest and dividend, etc. in preparing the cash flow statement. An entity should record cash flows arising from transactions in a foreign currency in the entity’s functional currency by applying to the foreign currency amount the exchange rate between the functional currency and the foreign currency on the date of the cash flow.
Cash flows arising from interest paid and interest and dividends received in the case of a financial enterprise should be classified as cash flows arising from operating activities. In the case of other enterprises, cash flows arising from interest paid should be classified as cash flows from financing activities, while interest and dividends received should be classified as cash flows from investing activities. Dividends paid should be classified as cash flows from financing activities.
Cash flows arising from taxes on income are to be separately disclosed and need to be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities.
Understand how to deal with financing and investing activities that do not involve any cash flow. Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from the cash flow statement and should be disclosed elsewhere in the financial statements.
Understand and compute ratios used in analyzing profitability, efficiency in asset utilization, financial position and market standing of a company. The profitability ratios are used to check if the company is generating an acceptable return for its owners. Widely used measures of profitability include profit margins, earnings per share (EPS), return on capital employed (ROCE), return on assets (ROA) and return on equity (ROE).
Ratios used to measure efficiency in asset utilization measure the effectiveness with which a concern uses the resources or assets at its disposal. Main ratios in this category include debtors’ turnover ratio, inventory turnover ratio, creditors’ turnover ratio, and cash-to-cash operating cycle.
Tests of financial position include tests of both short-term and long-term solvency of the business. Tests of short-term solvency focus on the liquidity position of the company. Two important ratios used to measure short-term liquidity are: current ratio and quick ratio. Tests of long-term solvency focus on the ability of the company to pay interest and repay principal of its long-term borrowings. The main ratios in this category are: debt-equity ratio and interest coverage ratio.
The market standing of the company is reflected in the market price of the share. Ratios such as dividend payout, dividend yield and price earnings ratio capture the relationship among dividend, earnings and market price of share.
Understand limitations of ratio analysis. Ratio analysis fails to take into account the size and contingent liabilities of the company. Different accounting policies followed by companies in respect of depreciation, inventory valuation and other matters can distort comparison among companies.
Understand the objectives of financial analysis. The purpose of financial statement analysis is to determine the meaning and significance of the data contained in the statements so that a forecast may be made of future earnings and financial position.
Describe and perform horizontal, vertical and trend analysis. Horizontal analysis compares financial data over a number of years to analyze the trend. Comparative Balance Sheets and Comparative Profit and Loss Statements are used to perform horizontal analysis. Vertical analysis is based on the financial data of a particular year. It is carried out by preparing common-size Balance Sheet and common-size Income Statement.
Understand the concept of quality of earnings. Quality of earnings indicates the degree to which full and transparent information is provided to the users of financial statements. Quality of earnings suffers when earnings are managed. Earnings management is the planned timing of revenues, expenses, gains and losses to smooth the net income.
Understand the concept of sustainable income. Net income adjusted for irregular items is called sustainable income. It is the most likely level of income to be achieved in the future.

Important Keywords of Financial Accounting and Analysis

Account is a two-column format, resembling the English alphabet ‘T, used to record accounting transactions.
Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the users of accounts.
Accounting period is a small interval of time, usually a year out of the life of business, determined to track the business performance and to measure its financial position.
Accounting Standards are pronouncements made by accounting bodies specifying the accounting requirements for different transactions and events.
Accounting system keeps a separate record for each item of assets, liabilities, income and expense. This record is called an account. An account has two sides, the left-hand side and the right-hand side.
Accounting transaction occurs when an economic event causes a change in the assets, liabilities or owners’ capital.
Accrual basis of accounting implies that revenues are recognized when these are earned and expenses are recognized when these are incurred. The timing of receipt of revenues and payment of expenses is immaterial.
Adjusted trial balance After posting of adjustment entries in the ledger, an adjusted trial balance is prepared that carries a summary of updated account balances.
AS (Accounting Standards) is a common set of principles, standards, and procedures that define the basis of financial accounting and policies and practices.
Assets are economic resources controlled by an entity whose cost (or fair value) at the time of acquisition could be objectively measured.
Average collection period shows the accounts receivables in terms of number of days of credit sales during a particular period. It is calculated dividing 365 days by debtors’ turnover ratio.
Capital/owners’ equity generally refers to an amount invested in an enterprise by the owners.
Cash includes cash (cash on hand, demand deposits with bank) and cash equivalents.
Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash, and are subject to an insignificant risk of changes in value.
Cash inflows are transactions which increase cash.
Cash outflows are transactions which decrease cash.
Closing entries At the end of the accounting period, expense and revenue accounts are closed by transferring their balances to the profit and loss account. The profit and loss account is also closed by transferring the balance to the owners’ capital or retained earnings (in the case of companies).
Common base In common-size analysis, all figures of a financial statement are expressed as a percentage of a common base, which is taken as 100. This common base is the sales figure in the case of Statement of Profit and Loss and the total of assets or of liabilities in the case of Balance Sheet.
Common-size analysis, also known as vertical analysis, can be used to compare the financial statements of two periods to identify variations which form the basis for further analysis.
Conservatism is the non-anticipation of incomes and making provision for all possible losses.
Consistency means that the same accounting policies and procedures are followed by an enterprise in preparing its accounts from one accounting period to another.
Cost concept is the concept on which the value of an asset is determined on the basis of its acquisition cost, which is the most objective basis.
Cost is a monetary measurement of the amount of resources used for some purpose.
Cost of goods sold is equal to the cost of goods available for sale (beginning inventory + net purchases + direct expenses) minus ending inventory.
Cost of goods sold is the cost of that part of goods available for sale (beginning inventory + purchases), which is sold during the accounting period. It is calculated as the cost of goods available for sale minus the cost of ending inventories.
Credit results from entering an amount on the right-hand side of an account.
Creditors (accounts payable) are persons to whom the business owes money for goods purchased by the business.
Current asset is an asset that is expected to be realized in, or is intended for sale or consumption in, the company’s normal operating cycle; held primarily for the purpose of being traded; expected to be realized within 12 months after the reporting date; or is cash or cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting date.
Current assets are assets, which are either in the form of cash or are meant to be converted into cash or other current assets during the accounting period or its operating cycle, whichever is longer.
Current liabilities are liabilities that must be settled within one year.
Current liability is a liability that is expected to be settled in the company’s normal operating cycle; it is held primarily for the purpose of being traded; it is due to be settled within 12 months after the reporting date; or the company does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date.
Current ratio is the relation of a company’s current assets to its current liabilities. This ratio establishes the ability of the business to meet its short-term obligations.
Debit results from entering an amount on the left-hand side of an account.
Debt-equity ratio relates debts to equity or owners’ funds, and measures the ability of the business to meet its long-term obligations.
Debtors (accounts receivable) are persons who owe money to the business for goods purchased.
Directors’ Responsibility Statement is the report of Board of Directors that states that in the preparation of the annual accounts, the applicable accounting standards had been followed along with proper explanation relating to material departures;
Discontinued operations refer to the disposal of a significant part of the business or an activity.
Double-entry accounting system requires debit and credit entries of equal amount to record every transaction.
Dual aspect concept states that every transaction or event has two aspects. The impact of a transaction is such that the accounting equation: Assets = Liabilities + Owners’ Capital always holds.
Entity concept is a concept in which the affairs of business are distinguished from the personal affairs of the owners.
Expense is the cost relating to the operations of an accounting period or to the revenue earned during the period or to the benefits of which do not extend beyond that period.
External analysis is the analysis carried out by parties external to the organization such as investors, credit rating agencies, government agencies etc.
Extraordinary items are events and transactions that are both unusual in nature and occur infrequently.
Financial statement analysis is the study of relationships between the elements of the same statement or different financial statements and the trend of these elements.
Financial statement in relation to a company includes a balance sheet as on the end of the financial year; a profit and loss account for the financial year; cash flow statement for the financial year; a statement of changes in equity, if applicable and related explanatory notes.
Financing activities are activities that result in changes in the size and composition of the owner’s capital (including preference share capital in case of a company) and borrowings of an enterprise.
Functional currency is the currency of the primary economic environment in which the entity generates and expends cash.
GAAP (generally accepted accounting principles) is a collection of commonly-followed accounting rules and standards for financial reporting.
GAAP or generally accepted accounting principles are a set of conventions, rules and procedures that define the accepted accounting practice at a particular time.
Gross profit is the difference between the sales revenue and the cost of goods sold.
Horizontal analysis compares financial data over a number of years to analyze the trend.
IFRS (International Financial Reporting Standards) are accounting standards that are issued by the International Accounting Standards Board (IASB) with the objective of providing a common accounting language to increase transparency in the presentation of financial information.
IFRS are common accounting rules for financial reporting developed by International Accounting Standards Board (IASB).
Indian Accounting Standard (Ind-AS) is the Accounting standard adopted by companies in India and issued under the supervision of Accounting Standards Board (ASB) which was constituted as a body in the year 1977.
Interest coverage ratio relates interest obligations to the profits before interest and tax and indicates the number of times interest obligation is covered by the profits for the period.
International Accounting Standards (IAS) are older accounting standards issued by the International Accounting Standards Board (IASB), an independent international standard-setting body based in London. The IAS were replaced in 2001 by International Financial Reporting Standards (IFRS).
International Accounting Standards Board (IASB) is an independent, private-sector body that develops and approves International Financial Reporting Standards (IFRSS).
Inventory turnover ratio relates the cost of goods sold to the average stock. It measures how many times the average stock is sold during the year.
Investing activities include the acquisition and disposal of longterm assets and other investments not included in cash equivalents.
Journal is an accounting record in which transactions are entered as they occur.
Ledger is an accounting record with separate accounts for each account classification in which transactions are posted from the journal. Nominal accounts relate to expenses, revenues, losses and gains.
Net profit is calculated by adjusting the operating profit for non- operating revenues, expenses, gains and losses.
Non-current asset is an asset other than a current asset.
Non-current liability is a liability other than a current liability.
Operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities.
Operating cycle is the time between the acquisition of assets for processing and their realization in cash or cash equivalent. Where the normal operating cycle cannot be identified, it is assumed to have a duration of 12 months.
Operating expenses are related to normal operations of the business and include administrative, selling and general expenses.
Operating profit is calculated as gross profit minus operating expenses.
Other comprehensive income (OCI) comprises those items that are not reported on the statement of profit and loss but have an effect on the balance sheet amounts.
Periodic inventory system does not keep a detailed record of inventory on hand. The value of the ending inventory is determined by taking a physical inventory count.
Perpetual inventory system keeps a detailed record of each inventory purchase and sale. The inventory that should be on hand is available perpetually from these records.
Personal accounts relate to persons. An account of customers, suppliers, lenders and bankers fall in this category. The capital account of the owners is also a personal account.
Price-earnings (P/E) ratio compares the market price per share to the earnings per share. It is calculated as the market price per share divided by earnings per share.
Quality of earnings indicates the degree to which full and transparent information is provided to the users of financial statements.
Quick ratio is a more precise measure of liquidity than the current ratio. Quick ratio relates quick current assets to current liabilities. Quick current assets are current assets minus inventories. Quick ratio is also known as “Acid Test Ratio” or “Liquid Ratio”.
Real accounts relate to assets of the firm such as land, building, investments, fixed deposits, cash balance, etc.
Return on assets relates profit to investment in all the financial resources, that is, owners’ equity, long-term liabilities and current liabilities.
Return on capital employed measures the returns generated by the business on total of owners’ funds and non-current liabilities.
Subsidiary books are records used to enter special types of transactions such as purchase and sale of goods, receipts and payments of cash, etc. Such transactions may otherwise be recorded in the journal.
Sustainable income is the most likely level of income to be achieved in the future. It differs from the actual net income by the amount of irregular revenues, expenses, gains and losses.
Trade payable is a payable in respect of the amount due on account of goods purchased or services received in the normal course of a business.
Trade receivable is a receivable in respect of the amount due on account of goods sold or services rendered in the normal course of a business.
Trial balance is the statement that shows the closing balances of all ledger accounts separately for debit and credit balances.
Vertical analysis is based on the financial data of a particular year and is carried out by expressing each item in the financial statement as a percentage of a base amount.

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