Financial Accounting

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Accounting concepts applied in Financial Statements are:

- Going Concern Concept: The basic assumption that the business will indefinitely continue in the future, is the basis of all financial statements. For example, since the business is assumed to continue on in the future, all future based business transactions are therefore carefully calculated in financial statements using the concepts of depreciation and amortization. Also the classification of assets and liabilities of a company into long term and short term would have no further meaning unless it is assumed that the business has reasonably long life.

- Business Entity Concept: The separation of an owner from a business entity is very vital in the usage of financial statements. The distinction between the owner and the business entity forms the basis for accounting of the transactions and determines the performance and financial position of a particular entity without confusing it with the owner’s personal transactions. This provides a very good understanding of a company’s financial health since the separation of business accounts of both the owners and the entity are clearly distinguished from one another.

- Conservatism Concept: Since the prospective losses of a company are recorded and prospective profits are ignored, financial statements can use this concept to find the underlying link between the level of expenses and gains made by a company over a period of time. Recording of losses and expenses in a financial statement helps an organization understand its financial weaknesses as well as proactively preventing future losses and expenses of the business.

- Matching Concept: Under this concept, the business must match the expenses incurred during a particular period to the income earned during that same period. Financial statements typically record the incomes and expenses of a company during a specific period of time for the sole purpose of gaining a better understanding of a company’s financial health, its level of profitability, extent of business losses etc. The matching of business expenses and gains within financial statements are crucial in determining the state of a company and as such the matching concept is very vital towards developing this understanding.

- Cost concept: All assets are recorded on the books at purchase price (historical cost), not market price, with some exceptions. Financial statements typically record the original purchase price of assets and avoid mentioning the current market price of such assets. This is done in order to calculate the depreciation costs of an asset over its original purchase price. The depreciating value of an asset is thus calculated using cost concept

- The company has incurred huge amount of expenditure on advertisement of a new product launch, how would this impact the accounting equation of the company?

Since the company has incurred a huge amount of expenditure on the advertisement of a new product launch, the accounting equation of the company would be reflected in the following way:

- Assets of the company would decrease thanks to the huge amount of expenditure. This is because cash is an asset.

- Owner’s Equity would also decrease, since expenditure on advertising is nothing but an expense.

- There would be no change in liabilities since the company does not owe any money to lenders.

Assets = Liabilities + owner’s equity

Owner’s equity = Revenue – (expenses + dividends)

- The company had sales of 250 crores of which 70% were on credit and 5% of credit sales were bad debts, Classify the elements into income, expense, assets and liabilities and state the effect of transactions on the company’s books of accounts?

Total sales = 250 Cr

Credit Sales = 70% of total sales = 175 Cr

Cash sales = 30% of total sales = 75 Cr

Bad debts = 5% of 175 Cr = 8.75 Cr

Effective credit sales = 95% of 175 Cr = 166.25 Cr

The bad debts are recorded as expenses while cash sales are recorded as an income. The

remaining credit sales are considered as assets as they are income receivables.

Income: 75 Cr

Expense: 8.75 Cr

Assets: 166.25 Cr

Effect on the account books are:

The income is debited to the cash account. The expenses are credited from the cash account. The

assets are debited to the purchases account.