These notes deal with the Basics of Financial Management. They are not likely to come for the exam but they provide a strong base for future learning (especially for non commerce students)
3 terms used in an inter related manner are Accountancy, Book Keeping, and Financial Management
When any financial transaction takes place in a business organization it must be taken down.
For:
1) Future References
2) To calculate profits i.e. the differences between earnings and cost.
3) Sheet for government to charge a person for tax on profits.
4) Investors should know whether the organization is profitable or not.
When any financial transaction takes places, any recording that takes place is called Book keeping.
In book keeping, the 2 books of accounts are:
- Journal
- Ledger
Documents in the journals and ledger are:
1) Profit and Loss account
2) Balance Sheet
The profit and loss account and the balance sheet requires the skill accountancy.
Financial Management goes beyond book keeping and accountancy, it looks towards the adequate allocation of capital.
Accounts and financial management work on certain rules that are generally accepted and cannot be questioned.
These concepts are:
Entity Concept: Every business is regarded as a separate entity from the owner or the person who runs the business. The liability of the business does not extend to the owner. Any amount invested by the entrepreneur in the business is treated as a loan given by the business man to the business. The business has the responsibility of giving this capital back to the business. Thus capital lies on the liability side of the balance sheet.
Going Concern Concept: Once a business has been established, it is assumed that the business is going to go on forever, it is going to be continuous until it is dissolved by the owner. The legal form of a business can change, its activities can change but it is assumed that the business will be evergreen.
Cash Concept (Money Concept): Only transactions that can be expressed in money terms are mentioned in the books of accounts. Intangible assets such as brands and goodwill was generally not included in the financial statements of most companies. Now they are included – they have to have precise values tough. One cannot put a range on the valuation of the brands. The flaw with this is that certain intangible assets like star employees etc cannot be recorded.
Accrual Concept (Prudence): If losses or expenses are anticipated, then they must be recorded. However, if incomes and gains are expected, do not record them unless they have materialized. (You might want to look up the link below - it says something entirely different.)
http://www.develop.emacmillan.com/iitd/material/DirectFreeAccessHPage/FNFE/ch1_accountingp.html
Historical Accounting Concept: Whenever an asset is acquired, its value has to be entered in the books of accounts at the value at which it had been acquired previously. The year of the acquisition has to be stated.
Fundamental Accounting Identity (Basic Accounting Identity): Assets = Liabilites. Liabilities can be divided into capital and non capital liabilities.
Modified Equation is thus:
Assets = Capital + Other liabilities.
Thus if capital is not given; Capital = Assets – (Other) Liabilities
After sufficient time has elapsed for a business to register profits (1 year), then
Assets – (other) liabilities = Net Worth
Keeping the FAI in mind, the insight for businesses is that any transaction has 2 aspects (an asset and a liability). Every transaction has something beneficial and also something that has a potential to be bring forth a liability (eg. If I pay fees to a college, I may not receive any real education and thus that sum may become a liability).
This method of recording the asset and liability sides of a transaction is called Double Entry Book Keeping.
Each transaction results in at least one account being debited and at least one account being credited, with the total debits of the transaction equal to the total credits.
Debit refers to all the transactions that result in losses.
Credit refers to transactions that lead to an increase in income.
Thus at the end Debit = Credit
Journals and Ledgers
Journal is:
1. The book of prime entry.
2. As soon as transaction originates it is recorded in journal
3. Transactions are recorded in order of occurrence i.e. strictly in order of dates.
4. Narration (brief description) is written for each entry.
5. Ledger folio is written
6. Relevant information cannot be ascertained readily e.g. cash in hand can't be found out easily.
7. Final accounts can't be prepared directly from journal.
8. Accuracy of the books can't be tested.
9. Debit and credit amounts of a transaction are recorded in adjacent columns.
10. Journal has two columns one for debit amount another for credit amount.
11. Journal is not balanced.
12. With the computerization of accounting journal may not be used for routine transactions like receipts, purchases, sales etc
Transaction could be with:
1) People
2) Assets
3) Losses and Profit
All transactions undertaken are recorded in a statement form, which is known as an account.
Thus there will be accounts of:
1) Persons/ institutions (Personal Accounts)
2) Assets (Real accounts)
3) Accounts with respect to Profits and Losses (nominal accounts)
Each and every account has a debit side as well as credit side.
There are certain fundamentally accepted rules all over the World.
1) In case of personal accounts, Debit the receiver and credit the giver.
2) In the case of real accounts, debit what comes in and credit what goes out (Inventory). In this case, of a factory, if it sells goods, and gains cash for it, the cash becomes debited and the goods account becomes credited (because capital is a liability under the Fundamental Accounting Identity Concept)
3) For nominal accounts, debit all expenses and losses, credit all incomes and gains.
Lecture 3. Prof. Patki, 1/ 12/ 2007
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