Accounting is the language of Business. It’s about recording all the business transactions. Transaction is the business activity where exchange is involved. Large Businesses like Reliance will have thousands of business activities. There is need to record, classify and summarize the activities.
Therefore, accounting is about recording, classifying and summarizing the activities.
The goal of accounting is to prepare the Financial Statements which will help in understanding how the business is performing. The three important Financial Statements are Profit & Loss Statement, Balance Sheet and Cash Flow Statement.
To begin with we need to classify every account into 4 categories:
- Income
- Expense
- Assets
- Liabilities
Some Examples: Sales – Income, Bank Loan – Liability, Plant & Machinery – Asset, Interest Paid – Expense, Patent – Asset, Raw Material Purchased – Expense, Dividend Received – Income, Salaries paid – expense.
In this note, we are going to prepare a basic Profit and Loss Statement as well as a Balance Sheet from scratch. But before we go ahead, lets look at some basic concepts.
Business Entity Concept:
Promoter/Owner & Business for accounting purpose are considered separate from Business entities.
As the business owns nothing of its own.
Matching Principle & Accrual Accounting
Matching Principle: Tells us when should one recognize an expense in Profit and loss statement.
Expenses can be divided into 2 categories:
- Directly related to Revenues earned.
- Not directly related to Revenue.
- A company will report an expense on its Income Statement (Profit and Loss Statement) in the year in which the related revenues are earned.
- For eg: If a company buys 10,000 units in its first year but sells only 7500,then in their Profit & Loss Statement they will account for the cost of only for 7500 units. The cost of the remaining 2500 units will be accounted for when they are sold in subsequent years.
- If the expense is not directly tied up to Revenue, then it should be reported on the Income Statement in the accounting period in which it expires or is used up.
- Eg: If a company takes a factory on rent. Irrespective of what Sales they do they need to pay rent periodically. Thus, it will be charged periodically in the Profit & Loss Statement.
Accrual System of Accounting: Linked to the matching principle. Accrual accounting is an accounting method where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made.
Eg: If the Salary for the year was Rs. 100,000 per year, irrespective of how much payment was done, Salary expense would be Rs. 100,000 in the Profit and Loss Statement.
Eg: Income earned during the year will be recorded in that year irrespective of how much cash was received or not.
Lets start building a Financial Statements for a business from scratch.
Transactions for a new business:
- Started Business with a Capital of Rs. 1,00,000
- Taken a Bank Loan of Rs. 3,00,000
- Purchase of Building of Rs. 200,000
- Total Sales of around Rs. 100,000
- Total Expenses of Rs. 30,000
- Started Business with a Capital of Rs. 1,00,000. We make the balance sheet in the beginning. We will have a Equity Capital of Rs. 100,000 as liability and in Asset side cash of Rs. 100,000. We start the business as on 31st March 2019.
2. Taken a Bank Loan of Rs. 3,00,000. With loan we will see increase in liability of Rs. 300,000 and increase in cash balance on asset side by Rs. 300,000.
3. Purchase of Building of Rs. 200,000. Cash was reduced by Rs. 200,000 while Building worth Rs. 200,000 was recorded on the Balance Sheet.
Income Statement is for a particular period. Its a Flow Concept. Lets prepare the Income statement.
4. Total Sales of around Rs. 100,000. We will record sales of around Rs. 100,000 on income side of P&L. This will lead to increase in cash on the asset side by Rs. 100,000 (assuming cash for the sales was collected)
5. Expenses of Rs. 70,000. Expenses was recorded on the P&L account and cash balance on the balance sheet is reduced by that amount. Moreover, the difference between Sales and expenses is the profit of the firm. Which is Rs. 30,000. This is a liability for the firm. (Read: the business entity)
If the owners don’t withdraw the profit from the business in form of Dividends then it will remain on the balance sheet as Retained Earnings.
This is how the Income Statement and Balance Sheet look at the year end on 31st March 2020.
Lets look at some more advanced entries: That is depreciation, Sales on credit and purchases on credit.
- Started Business with a Capital of Rs. 1,00,000
- Taken a Bank Loan of Rs. 3,00,000
- Purchase of Building of Rs. 200,000 (Charge Depreciation @ 10%)
- Total Sales of around Rs. 100,000 (50% of Sales on Credit)
- Total Expenses of Rs. 30,000 (50% of expenses are on Credit)
But before we go ahead, let’s look at the concept of Revenue Expenditure vs Capital Expenditure & the Concept of Depreciation
Revenue Expenditure – if the benefit is not beyond 1st year. Eg: Salaries paid.
Capital Expenditure – if the benefit is received beyond 1st year. Eg: Machinery purchased.
The Concept of Depreciation:
Lets say a business procures a machinery for Rs. 200,000. Benefits will accrue over 5 years. But life of asset is not indefinite. Because the benefit will accrue for 5 years then the cost of machinery should be spread out over its useful life.
We do it by charging annual depreciation. Depreciation is a Non-Cash Expense. Cash outgo happens when the machinery was purchased but expense is recorded over its useful life.
In our above example if the machinery is useful for 5 years then the entire machinery cost should be spread over that period.
Annual Depreciation – Rs. 40,000 (which is 200,000/5).
After accounting for Depreciation: Cash expense will decrease as Depreciation is a non-Cash expense. Because it is a non-cash expense which reduces the value of building on Balance sheet it will deducted from the balance of Building. (Note: Land is not depreciated. In our case we assume that the firm only owns and not the land). At the end of 5 years, the balance of Building on the Balance Sheet will be zero.
If 50% of the Sales are on credit.
In that case Rs. 50,000 is receivable from customers which will be shown on the Balance sheet on Asset side. Cash would go down by that amount as Cash couldn’t be collected for that amount.
If 50% expenses are on credit.
In that case Rs. 25000 is payable to the suppliers. Its a liability for the firm and thus will be shown on the Liability side of the Balance Sheet as Accounts Payables or Creditors. Getting our supplies on credit increases our Cash Balance by that amount which is Rs. 25000 in this case.
