Introduction to Financial Accounting and Mechanics of Accounting

This module does two things. It explains what financial accounting is for and who reads it, and it then walks the whole mechanical chain from a single transaction to a finished set of financial statements. Everything later in the course sits on top of this chain, so the mechanics matter more than they look.

1.1 Scope and Purpose of Financial Accounting

Financial accounting involves recording and summarising the effects of business transactions into three financial reports: the Balance Sheet, the Profit and Loss Account (also called the Income Statement or Statement of Profit and Loss) and the Cash Flow Statement.

Accounting generates one-stop information on revenues, expenses, receivables, payables and the cash balance. It enables systematic recording and summarising of business transactions for informed decision making.

Smaller businesses can record these financial transactions in small notebooks, but the same will not be feasible for a company on a larger scale. Hence, they use software and services such as Tally, Zoho and Oracle Financials to keep track of their financial transactions.

The three purposes

1. Recording financial transactions as and when they occur.
2. Summarising the financial transactions at the end of the period, that is yearly, half-yearly or quarterly.
3. Preparation of financial statements, namely the Balance Sheet, the Income Statement and the Cash Flow Statement.

The six questions accounting answers

• What are the sources of capital and how much capital was raised?
• How was the capital used?
• How much does the business owe, and to whom?
• How much is owed to the business, and from whom?
• What is the amount of revenue earned and expenses incurred?
• Did the business earn a profit or incur a loss during the period?

Memory hook: the first two questions are answered by the balance sheet, the next two by the balance sheet's payables and receivables lines, and the last two by the income statement.

1.2 Different Forms of Business Organisations

Sole Proprietorship

• It is the simplest form of business organisation, suitable for small ventures.
• It is owned by an individual, who enjoys the profit and bears the losses.
• The owner and the business are assessed as the same entity. In the eyes of the law the business and the owner are the same.
• The liability of the proprietor is unlimited.

Partnership

• Partners enter into a partnership agreement through a partnership deed.
• The deed mentions the percentage of profit or loss attributed to each partner. In the absence of any percentage, profit or loss is distributed equally.
• Partners are jointly and severally liable for business obligations and losses, which means each is individually responsible for the full amount of any debt or loss, not just a portion.
• A partner's transactions with the business, such as investments or profits, are recorded in the partner's capital account, which serves as a running record of their financial involvement.
• Any withdrawal from the business for personal use is accounted for by debiting the partner's capital account.

Limited Liability Partnership

There is a variation of the partnership form called the Limited Liability Partnership (LLP). The liability of partners is limited, so personal wealth is not affected by business failure.

Company

Companies need to be registered under the Companies Act. Shareholders have limited liability, that is only up to the face value of the share.

• Public Limited Company: can raise capital from the public by issuing shares. Offers limited liability to shareholders (liability limited to the amount invested). Shares are traded on stock exchanges, giving high liquidity. Examples: Tata Steel, Asian Paints, Infosys.
• Private Limited Company: similar to public limited companies but with fewer shareholders. Shares are not publicly traded, giving lower liquidity. Offers limited liability.

Co-operative Society

• Owned and controlled by its members, who are typically connected to the business's objective (for example, milk producers in a milk co-operative).
• Democratic control: each member has one vote, regardless of their investment. This contrasts with companies, where voting rights depend on the number of shares held.
• Examples: AMUL, IFFCO.

Comparing the four forms

Common trap: limited liability is limited to the face value of the share, not to the market price paid. A partly paid share still carries a call obligation for the unpaid portion.

1.3 Users of Accounting Information

• Investors: existing and potential investors use accounting information (primarily financial statements) to evaluate a company's performance and make informed investment decisions. This includes mutual fund analysis.
• Lenders (creditors): banks and other financial institutions use accounting information to assess creditworthiness before lending money and to monitor borrowers' financial health. This includes banks, leasing companies (who want to know whether the potential lessee can pay the lease rental) and companies offering hire-purchase agreements.
• Credit rating agencies: use financial data to assess credit risk and assign credit ratings, which influence investment and lending decisions. An AAA rating implies stable financials and high creditworthiness.
• Suppliers: suppliers often extend credit to their customers. They rely on accounting information to evaluate the customer's ability to repay debts.
• Government agencies:
  • Tax authorities: to determine the correct amount of taxes owed by businesses.
  • Planning authorities (for example NITI Aayog in India): to monitor economic growth and industry performance and to inform policy decisions.
• Employees and unions: employees, prospective employees and labour unions are interested in a company's financial health to assess job security, potential salary increases and benefits.
• Customers: for large purchases or long-term contracts, customers rely on accounting information to assess their suppliers' stability and long-term viability. The example given is the Indian Air Force evaluating the financial health of aircraft manufacturers before making a purchase.

1.4 Double-entry System of Bookkeeping

Bookkeeping is the systematic recording of transactions in the books of accounts. These transactions are usually supported by source documents like invoices (bills), receipts, contracts and vouchers.

The core principle of the double entry system is that every transaction has two sides, debit and credit. For example:

• Buying raw materials on credit: increases the raw materials asset account (debit) and accounts payable (credit).
• Paying for raw materials with cash: increases the raw materials asset account (debit) and decreases the cash asset account (credit).

This system ensures proper recording of transactions by avoiding mistakes through cross-checking.

Process:

1. Source document: a transaction occurs and a source document is generated (invoice, receipt).
2. Recording: the bookkeeper records the transaction in the books of accounts using the double-entry method, often in accounting software.
3. Posting: at the end of a period, the transactions recorded in the books are posted to the respective accounts (raw materials, cash, accounts payable).
4. Financial statement preparation: the balances in these accounts are then used to create the financial statements.

The accounting cycle

The manual accounting process runs through five steps in a fixed order. This is the spine of the whole module.

Memory hook: journal, ledger, trial balance, adjustments, statements. Each step narrows the data: a thousand transactions become a hundred accounts, then one page of statements.

Types of Accounts

An account is a systematic record of all transactions relating to a particular head, that is an asset, liability, equity, revenue or expense. The double-entry system classifies accounts into three types.

Personal Accounts

These accounts represent individuals, businesses or other organisations with whom the company has financial transactions.

• Natural personal accounts: accounts of individuals (a customer named John Doe, a supplier named ABC Company, an employee salary account).
• Artificial personal accounts: accounts of legal entities or organisations (XYZ Corporation, Asian Paints Limited, an SBI bank account).
• Representative personal accounts: accounts that represent a group of individuals or organisations. Examples include:
  • Creditors / Accounts Payable: amounts the business owes its suppliers.
  • Debtors / Accounts Receivable: amounts owed to the business by its customers.

Real Accounts

These accounts represent the assets of a business.

• Tangible real accounts: physical assets that can be touched and seen (buildings, machinery, cash, inventory).
• Intangible real accounts: non-physical assets (patents, copyrights, trademarks, goodwill, software licences, spectrum licence fees).

Nominal Accounts

These accounts represent income, expenses, gains and losses. They are temporary accounts closed at the end of each accounting period.

• Income accounts: sales revenue, interest income, rent income.
• Expense accounts: rent expense, salaries expense, utilities expense, depreciation expense.
• Gain / loss accounts: profit or loss on the sale of assets.

Understanding Debit and Credit

Debit and credit have Latin origins. Debit comes from debitum, meaning "what is due". Credit comes from creditum, meaning "something given to someone, or a loan". In accounting they are purely technical terms and carry none of their everyday meaning.

Debit and credit are useful in the manual system of bookkeeping. Modern software records the same information without asking the user to think in these terms, but the vocabulary survives in every statement and audit report, so it has to be learned.

The golden rules of accounting

Common trap: the nominal-account rule runs in the reverse of the order you naturally think in. We normally say "income and expenses", but the rule is debit the expense, credit the income. Most first-year errors come from this one line.

An equivalent modern statement of the same rules, expressed by element rather than by account type:

Memory hook: DEALER. The first three (Dividends, Expenses, Assets) increase on the debit side. The last three (Liabilities, Equity, Revenue) increase on the credit side.

The formal journal entry format

The ruled journal has five columns. L.F. stands for Ledger Folio, the page number in the ledger to which the entry was posted, and it is what makes the audit trail from journal to ledger traceable. The debit line is always written first, and the credit line is indented and prefixed with "To".

Transaction 1: credit purchase of raw materials

Raw materials worth Rs. 100 lakhs were bought from Sun Limited, with payment agreed at the end of 90 days.

• Raw Materials (real account): the materials came in, so debit.
• Sun Limited (personal account): Sun Limited is the giver, so credit.

Transaction 2: rent paid in cash

Rent of Rs. 3 lakhs was paid to the building owner, Mr. Vivek. Because the rent was paid immediately, Mr. Vivek's account is never opened in the books.

• Rent Expense (nominal account): an expense, so debit.
• Cash and Bank (real account): cash went out, so credit.

Credit purchase: goods or services are received now, but payment is made later. Cash purchase: payment is made immediately at the time of purchase. Because most payments now happen by bank transfer rather than currency, "cash account" in this course always means the combined Cash and Bank account.

1.5 Recording Business Transactions: the Ram garment business

Scenario: Mr. Ram starts a garment business. Ten transactions follow. All figures are in Rs. lakhs.

1. Initial investment. Mr. Ram invests Rs. 100 lakhs as capital. Cash and Bank (real) is debited because cash comes in; Ram's Capital (personal) is credited because Ram is the giver. This is the entity concept in action: the business is treated as an entity separate from Mr. Ram, so the money he put in is a liability of the business towards him.
2. Loan from State Bank of India. The business borrows Rs. 50 lakhs. Cash and Bank is debited; the SBI Loan account (personal) is credited because SBI is the giver.
3. Shop purchase. The business buys a shop in a mall for Rs. 20 lakhs. Building (real) is debited; Cash and Bank is credited.
4. Furnishing and interior decoration. Rs. 5 lakhs is paid to Miss Swati. Furniture (real) is debited; Cash and Bank is credited.
5. Cash purchase of garments. Garments worth Rs. 20 lakhs are bought from Mr. Sen for cash. Goods (real, also called Purchases) is debited; Cash and Bank is credited.
6. Credit purchase of garments. Garments worth Rs. 30 lakhs are purchased on one week's credit from Grasim Limited. Goods is debited; Grasim Limited (personal) is credited.
7. Cash sales. Garments are sold for Rs. 15 lakhs in cash. Cash and Bank is debited; Sales (nominal) is credited.
8. Cost of goods sold. The cost of the garments sold in transaction 7 is Rs. 10 lakhs. Cost of Sales (nominal) is debited; Goods (real) is credited because the goods went out.
9. Payment to Grasim Limited. Rs. 30 lakhs is paid. Grasim Limited is debited as the receiver; Cash and Bank is credited.
10. Salary payment. Rs. 2 lakhs is paid in salaries. Salary Expense (nominal) is debited; Cash and Bank is credited.
11. Maintenance and electricity charges. Rs. 3 lakhs is paid. Maintenance Expense (nominal) is debited; Cash and Bank is credited.

Memory hook: a sale is always two entries, not one. One records the revenue and the cash or receivable that came in. The other records the goods that went out and the expense they became. Forgetting the second entry is the most common way a student's profit figure comes out wrong.

The same eleven entries in ruled journal form

Discussion forum: a food truck business

If I were to start a food truck business, the initial transactions and how I would account for them would be as follows.

Initial investment: contribution of Rs. 100,000 towards the business from my own savings.

Purchase of a van: a used van bought for Rs. 70,000 in cash to use as the food truck.

Purchase of food supplies: all the food supplies needed to start the business, on credit.

Securing a business loan: to run the business smoothly until it is financially stable, a bank loan is taken.

These are some of the expenses I could think of for this example and how I would account for them. The expenses will increase in the future as the business grows, through activities such as hiring employees and maintenance.

1.6 Books of Accounts: Subsidiary Books

Subsidiary books simplify recording frequent, similar transactions. They keep the main ledger cleaner. They are also called day books.

Suppose there are 10 suppliers and the business purchases 100 times from each supplier in a year. That is 1,000 purchase transactions, and in every one of them "debit the Goods account" is the common half. Instead of 1,000 journal entries, the business keeps a Purchase Book recording only the supplier's name and the invoice amount. At the end of the month one single entry is made: Goods A/c debit with the month's total, Sundry Creditors A/c credit with the same amount. The breakup by supplier stays in the Purchase Book.

Likewise, a business can have a Sales Book, a Purchase Returns Book, a Sales Returns Book, or a subsidiary book for any transaction type that occurs frequently. Indian Oil Corporation, for example, keeps a transport book for the invoices received from transport operators, because the number of lorries carrying petrol, diesel and LPG cylinders per day exceeds 1,000.

Purchase Book specimen

The single monthly entry that flows from this book is:

Ledger

A ledger is a register (book of accounts) keeping details of all the accounts of the business over a period. Ledger accounts have a debit (left) side and a credit (right) side, with Date, Particulars, J.F. (Journal Folio) and Amount columns on each side.

Balance: the difference between total debits and total credits in an account.

The T-account in practice

For a credit purchase of goods worth Rs. 30,00,000, the Goods Account carries "To Grasim A/c 30,00,000" on the debit side and the Grasim Account carries "By Goods A/c 30,00,000" on the credit side. The "To" and "By" prefixes are pure convention: "To" marks a debit-side entry, "By" marks a credit-side entry.

Reading a balance

The balances of the ledger accounts are summarised in the trial balance to check arithmetical accuracy, and those balances are then used to prepare the financial statements.

Subsidiary Ledgers

The main ledger is called the General Ledger or GL. The GL contains summary accounts, Sundry Creditors and Sundry Debtors, representing the total amounts owed to suppliers and owed by customers respectively.

Subsidiary ledgers provide the detailed information supporting those summary balances. The Sundry Creditors Ledger shows the amount owed to each supplier, while the Sundry Creditors account in the GL shows the total owed to all suppliers.

Subsidiary ledger worked example

Two suppliers, PQR & Co. and MAX & Co., are dealt with during January.

Subsidiary ledger, PQR & Co.

Subsidiary ledger, MAX & Co.

General ledger, Sundry Creditors A/c

Tie-out: purchases 10,000 + 20,000 = 30,000, payments 5,000 + 5,000 = 10,000, closing balances 5,000 + 15,000 = 20,000. The subsidiary ledger total agrees with the general ledger control account, which is exactly the reconciliation an auditor performs.

Common trap: the GL control account is posted once, in total, at month end. The subsidiary ledger is posted transaction by transaction, as they occur. Posting a transaction to both in full would double count it.

1.7 The Accounting Equation

The entire accounting system can be simplified by recording transactions directly in the accounting equation.

The right-hand side shows the source of capital to the business. The left-hand side shows the use of that capital.

First expansion: bringing in revenue and expenses

The difference between revenue and expense is either profit or loss. The owners enjoy the profit and bear the loss, so revenue and expenses belong inside owner's equity.

Here Owner's Capital is the amount the owners have invested, and $\text{Revenue} - \text{Expenses}$ is the profit retained in the business.

Second expansion: bringing in dividends

If the owners have taken some profit out as dividend, that amount is deducted from profit and only the balance is added to owner's equity.

Memory hook: every one of the six terms above appears in DEALER. Dividends, Expenses and Assets sit on the debit side of the equation; Liabilities, Equity and Revenue sit on the credit side.

The Ram business recorded in the accounting equation

Each transaction is entered with a plus or minus sign in the relevant column. Two entries on the same side of the equation with opposite signs keep it balanced just as well as one entry on each side. All figures are Rs. lakhs.

Check: $150 = 50 + 100 + 15 - 15 = 150$. The equation holds. Revenue equals expenses, so no profit or loss was made.

Deriving the account balances

The cash account is the one touched by almost every transaction, so it is worth tracing in full:

The other balances follow directly. Goods is $20 + 30 - 10 = 40$. Grasim is $30 - 30 = 0$, so nothing is owed to suppliers at the closing date.

Cash and Bank Account

Owner's Equity / Share Capital

Loan Payable (SBI)

Building Account

Furniture Account

Goods / Inventory Account

Accounts Payable (Grasim Limited)

Sales Account

Cost of Sales Account

Salary Expense Account

Maintenance Expense Account

This ledger presents a clear and organised record of all transactions and their effect on each account, making it easier to prepare financial statements.

The trial balance

The trial balance lists every closing balance in two columns and checks that they agree. In the course's layout the left column holds assets and the right column holds liabilities, equity, revenue and expenses, with expenses carried as negative figures so that the two columns tie to the same total. All figures in Rs. lakhs.

Common trap: the printed course solution carries a "Suppliers' Due 30" line in this trial balance and in the balance sheet. That figure is a leftover. Transaction 8 settled the Grasim account in full, and the cash balance of 85 already reflects that Rs. 30 lakh payment. Carrying the 30 as well would count the same obligation twice and would push the right-hand column to 180 against assets of 150. Check the equation, not the printed line: $50 + 100 + 15 - 10 - 5 = 150$.

Income statement from the exercise

Income Statement for the period (Rs. lakhs)

Answer: profit for the period is nil. Revenue of 15 exactly equals total expenses of 15.

Balance sheet from the exercise

Balance Sheet as at the closing date (Rs. lakhs)

Answer: the balance sheet totals Rs. 150 lakhs on each side.

The answer is the same whether the transactions are recorded through the double entry system or through the accounting equation. That equivalence is the whole point of the exercise.

1.8 Comprehensive Exercise: Pharma Asia Limited

This is the module's capstone. A full set of transactions for a start-up pharmaceutical company is recorded in the accounting equation, then a trial balance, a profit and loss account and a balance sheet are prepared from it. All figures are Rs. lakhs, and the accounting period runs to 30 September 2023.

The transactions

Raising capital

• Six promoters (three R&D executives of a large pharma company and three friends) contribute Rs. 100 lakhs each as share capital: 600.
• A venture capital fund contributes a further 200 of equity capital.
• A long-term loan of 800 is taken at 12% per annum.
• A working capital loan of 400 is taken at 14% per annum.
• Interest on both loans is payable half-yearly, at the end of June and the end of December.

Setting up the plant

• A 10 acre land parcel is taken on rent for 30 per year, payable 15 on 1 January and 15 on 1 July. The first instalment of 15 is paid.
• Advance of 20 paid to Ranjan & Co., the civil contractor, against a factory building contract of 120.
• Machinery worth 600 ordered from Alpha Level; advance of 80 paid.
• Second instalment of 80 paid to Ranjan & Co. and the building is completed and handed over on 31 March. The building of 120 is recognised, the 20 advance is reversed, and 20 remains payable.
• Furniture and fixtures of 60 bought for cash on 1 April.
• Deposits paid: 40 to the electricity board and 20 to the water supply board, 60 in total.
• Machines received on 30 April; a further 320 paid. The machine of 600 is recognised, the 80 advance is reversed, and 200 remains payable to Alpha Level on 31 December.
• Raw material of 200 purchased: 150 cash from Joy Brothers and 50 on credit from Best Chemicals.
• 1 June: the plant is commissioned and inaugurated by the health minister. This is not a financial transaction and no entry is made.

Trading

• 15 June: credit sales of 90 (Global Pharma 40, RC Pharma 20, Vetech Enterprises 30), due 31 July.
• 16 June: raw material purchased, 300 cash from Joy Brothers and 200 on credit from Best Chemicals.
• June operating expenses paid in cash: salary 30, electricity 20, other expenses 30.
• 30 June: Best Chemicals paid 50; Ranjan & Co. paid 20.
• 30 June: half-yearly interest paid on both loans.
• 1 July: second lease rent instalment of 15 paid.
• July: credit sales of 200 (Global 100, RC 50, Vetech 50).
• July: collections of 90 from the June customers.
• July operating expenses: salary 30, electricity 30, other 40.
• 31 July: Best Chemicals paid 200.
• 15 August: credit sales of 700 (Global 300, RC 200, Vetech 200) due 30 September, plus cash sales of 600.
• 15 August: raw material of 800 purchased on credit, Joy Brothers 500 and Best Chemicals 300.
• August: conference expense 12 paid in cash; advertisement of 10 (employee advertising 2, corporate image building 8) taken on credit from One Image & Co., payable 30 September; machine repairs 2 paid in cash.
• August operating expenses: salary 80, electricity 50, other 70.
• August: collections of 200 from customers.
• 1 September: fire insurance premium of 12 paid for a policy running to 31 August of the following year.
• September: credit sales of 1,200 (Global 600, RC 200, Vetech 400).
• September: raw material of 700 purchased on credit, Joy Brothers 500 and Best Chemicals 200, due 30 October.
• 30 September: One Image & Co. paid 10; the 15 August suppliers paid 800 (Joy Brothers 500, Best Chemicals 300).
• September: collections of 200 from customers.
• September operating expenses: salary 120, electricity 180, other 100.

The five closing adjustments

These entries record no cash movement. They exist so that the period's profit is true and fair.

1. Interest accrued but not paid. Interest was last paid on 30 June. Three months of interest (July to September) has accrued on both loans and is payable only on 31 December.

Given: long-term loan 800 at 12%, working capital loan 400 at 14%, period 3 months.

Answer: interest payable 38, interest expense 38.

2. Raw material consumed. Total raw material purchased over the period is $150 + 50 + 300 + 200 + 500 + 300 + 700 = 2{,}200$. The stores department counted closing raw material of 1,200 and the production department confirmed no work in progress and no finished goods.

Answer: raw material consumption expense 1,000; raw material asset closes at 1,200.

3. Depreciation. Charged from the date each asset became available for use.

4. Prepaid rent. Rent of 30 was paid for the full calendar year, but the books close on 30 September. Three months (October to December) of the second instalment of 15 is prepaid.

Answer: prepaid rent asset 7.5; rent expense 22.5, which is nine months of a 30 annual rent.

5. Prepaid insurance. The annual premium of 12 was paid on 1 September for cover to 31 August next year. Only one month belongs to this period.

Trial balance before tax

Check: $2{,}138 + 800 + 2{,}790 - 2{,}002 = 3{,}726$, which equals total assets. The equation holds.

Profit and Loss Account for the period ended 30 September 2023

Answer: profit after tax is Rs. 551.60 lakhs.

Balance Sheet as at 30 September 2023

Answer: the balance sheet totals Rs. 3,726 lakhs on each side.

Receivables tie-out

Total revenue is credit sales 2,190 plus the August cash sales of 600, giving 2,790, which matches the profit and loss account.

Cash tie-out

Inflows are equity 800, loans 1,200, collections 490 and cash sales 600. Outflows are every cash payment for assets, deposits, materials, suppliers, expenses and interest.

Memory hook: the profit and loss account and the balance sheet are joined at exactly one point. The profit after tax of 551.60 leaves the P&L and lands inside equity on the balance sheet. If a balance sheet does not tie, that link is the first place to look.

1.9 Module Summary

• Financial accounting records transactions as they occur, summarises them at period end, and presents them as three statements: the income statement (how much was earned and spent, and the resulting profit or loss), the balance sheet (sources and uses of capital at a point in time) and the cash flow statement (all cash inflows and outflows).
• The four forms of organisation differ mainly on liability, capital raising, liquidity and voting. Only the LLP and the company give limited liability. Only the co-operative gives one vote per member.
• Every transaction has a two-fold effect. Under the traditional system that effect is expressed as debit and credit through the three golden rules. Under the accounting equation it is expressed as plus and minus across five columns. Both give identical answers.
• The mechanical chain is journal, ledger, trial balance, adjustments, financial statements. Subsidiary books compress the journal; subsidiary ledgers compress the ledger; neither changes the totals.
• Closing adjustments (accrued interest, consumption of inventory, depreciation, prepayments) carry no cash but are what turn a cash record into a true and fair profit figure.