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KEY CONCEPTS OF FINANCE

A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Businesses can be structured in 3 ways: 1. 2. 3. Proprietorship: business with a single owner. Owner has complete liability for all debts of the company. Partnership: business with 2 to 10 equal owners. All partners share complete liability for all debts of the company. Limited company: Many owners with limited liability for debts of the business; this liability is only up to their capital contributed. There are t two types of limited companies: private and public. The former is held by 250 owners privately. The latter has unlimited number of owners, and any member of the public can be a part-owner.

A business has numerous transactions which need to be recorded following certain accounting principles and process.

Accounting Principles
These are called Generally Accepted Accounting Principles, or GAAP. Key GAAPs are 1. 2. 3. 4. 5. 6. Going Concern Concept: This principle assumes that a business will go on, that is, it will continue in the foreseeable future it has no finite life. We use this principle to project cash flows in the future. Legal Entity: The business is an entity separate from owners; even if its a small, one person business running out of home. Therefore the business accounts are taken separate from the owners. Conservatism: Be cautious and conservative while accounting. Recognize income only when its definite. Accrual Concept: Income and expense are recognized/recorded when a transaction occurs- not when cash changes hands. Income and expense are recorded irrespective of cash. Matching Concept: The business must match the expenses incurred for a period, to the income earned during that period. Cost Concept: All assets are recorded on the books at purchase price, not market price, with some exceptions.

Key Terms
Income: It refers to revenues/ financial benefits received by the business (not necessarily a cash inflow). Expense: Expense is the costs incurred directly or indirectly to earn income (not necessarily a cash outflow). Asset: Assets are resources with defined financial value owned by the business. Liability: Liability is the financial obligation to pay cash or provide goods and services. Owners Equity: It is the same as net worth which refers to funds belonging to the owner/s, currently held by the business.

Accounting Process 1. Transaction: The process starts with a transactions. Any action involving money, such as purchase, sale, loan, deposit is called an transaction. 2. Journal Book: It is a Book of accounts in which transactions are entered on a serial, per day basis. 3. General Ledger: It is a book of accounts where transactions are entered under categories. They are transferred from the journal into the GL. In an automated process, transactions are entered directly into the GL. 4. Trial Balance: It is a process where all debits and credits from the GL are balanced. The total of the debit side must equal the total of the credit side. 5. Financial Statements: Three main financial statements are cash flow statement, Profit & Loss statement & Balance Sheet. They are prepared after the Trial Balancing is done.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!

KEY CONCEPTS OF FINANCE


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Transactions are recorded using the Double Entry method; where every transaction has two entries. One is called a Debit (Dr) entry and the other a Credit (Cr) entry.
The main equation for a balance sheet is Asset = Liability + Owners Capital/Equity. The rules for passing Debit and Credit entries are as follows:

Assets Increase-> Debit

= Liabilities Increase-> Credit

+ Owners Equity Increase->Credit

An increase in an asset, leads to a debit entry in the asset account; on the other side of the equation, the result of an increase is the reverse: a credit entry

Therefore, it is obvious that: Assets Decrease-> Credit = Liabilities Decrease-> Debit + Owners Equity Decrease-> Debit

There are 3 steps while passing entries for a transaction: First, recognize which two accounts are affected by the transaction. Next, apply the above rule for one of them (best is for an asset account). Third, post the entry into the debit or credit side of the account, and the contra entry into the other account.

Concept of Depreciation and Amortisation


As per the matching principle, expenses must be matched to the revenues in a period. Hence for all large, one time expenses such as building of a plant, purchase of machinery, furniture, computers, or promotion of a new product, the expense is spread over time. That is, a portion of the expense is recorded each year. This expense is called Depreciation or Amortization. The term Depreciation is used when physical assets are purchased, whereas the term amortization is used when intangible assets are purchased, or for reasons such as the one mentioned above one time promotion/advertising expenses for the launch of a new product. Amortization is also used for land.

The concept of Suspense Accounts Suspense accounts are temporary accounts. They are created to hold amounts which are doubtful in nature that is, one is not sure of their source or where they should go. Suspense accounts are temporary in nature, and when books are closed that is, when the accounting period (such as a quarter or a year) is over, and final trial balance etc is being prepared suspense accounts should be cleared. How are they cleared? By posting adjustment entries, which clear the suspense account and post the balance to the correct accounts.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!

KEY CONCEPTS OF FINANCE


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Exercises
1.

Rahul has taken an educational loan from a bank on 1st January 2010. Terms of the agreement are Interest is to be paid semi annually. Repayment of principal starts after 2 years The bank however recognizes interest income internally, every month. What will be the accounting entries at the end of each month and end of 6 months for this year?

2. Savitha has a savings account with New Gen Bank. She deposits INR 50,000 on 1st July. She withdraws INR 15,000 on 15th July. On 31st July, bank pays INR 30 to her account as interest. What are the entries in the bank's books on 1st July, 15th July & 31st July?

Answers: 1. End of each month: First, which are the two accounts affected? The bank is earning interest, so interest income is one account. But, this interest amount is not yet received as the bank will receive this interest at the end of 6 months. Therefore, interest outstanding or interest income receivable is the other account. All income is a credit entry. Hence the interest income account is credited and the interest receivable account is debited. Note that the interest receivable account is a temporary/suspense/adjustment account. End of 6 months: Rahul will pay the interest due. Which are the two accounts affected? The banks Cash account and the interest receivable account. The cash account is an asset account. An increase in assets is a debit entry. Hence cash a/c is debited and interest outstanding/receivable is credited. The net effect is a debit to cash and a credit to interest income, as the suspense account of interest receivable is now cleared by the balancing debit and credit entries. 2. 1st July Savitha is depositing cash. As always, first identify the two affected accounts. They are the banks cash account and Savithas account with the bank. Cash, an asset account, has increased. An increase in asset is a? Thats right, a debit. Therefore, cash is debited and Savithas saving a/c credited. 15th July Savitha withdraws money. Cash is going out, cash is credited and Savithas saving a/c is debited. 31st July The two affected accounts are Interest expense account and Savithas account. Interest is an expense for the bank. Therefore, it is debited. Savithas saving a/c is credited.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!