Introduction to Financial Accounting

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
FOFA: Accounting Part
Topic: Measuring Income

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 1
Business Activities

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Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 2
Income Measurement Basics

➢ Income measurement
➢ Net profit
Financial year or reporting period
➢ Revenues, gains
➢ Expenses, losses

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Accrual System and Cash System

➢ Cash system
✓Receipts and payments
✓Historical cash flows
➢ Accrual
✓ Right to receive, obligation to pay
✓ Better matching of efforts and accomplishments
✓ Future cash flows
✓ Companies Act 2013

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Income Measurement Principles: Revenue Recognition

➢ Realization principle (or revenue recognition)

➢ Steps in revenue recognition
✓ Identify the contract with a customer
✓ Identify the performance obligations in the contract
✓ Determine the transaction price
✓ Allocate the price to the performance obligations
✓ Recognize revenue when the entity satisfies a performance obligation
➢ Shipping terms
FOB Shipping point means “Free on board at shipping point”, i.e. the buyer incurs all transportation costs after the merchandise has been
loaded on a train, truck, ship or aircraft.
FOB destination means “free on board to destination”, i.e. the seller ships the goods to their destination without charge to buyer.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 5
Income Measurement Principles: Expense Recognition

➢ Expense recognition
➢ Matching principle
➢ Difficulties in matching expenses

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Income Measurement Mechanics

➢ Deferral
✓ Cash received but revenue not earned
✓ Cash paid but expense not incurred
➢ Accrual
✓ Revenue earned but cash not received
✓ Expense incurred but cash not paid

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The Adjustment Process

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Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 8
Adjusting Entries: Deferral

➢ Apportioning recorded expenses

✓ “Paid but not expensed”
✓ Prepaid expenses
✓ Office supplies
✓ Depreciation
❖ Contra asset account
➢ Apportioning unearned revenue
✓ “Received but not earned”

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 9
Adjusting Entries: Accrual

➢ Recording accrued expenses

✓ “Incurred but not paid”
❖ Salaries payable
➢ Recording accrued revenues
✓“Earned but not received”
❖ Unbilled revenue

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The Adjustment Process

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Flow of Merchandise from Manufacturer to Consumer

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Income Measurement for a Merchandising Organization
➢ Revenue from sales
➢ Cost of goods sold
➢ Gross profit
➢ Operating expenses
➢ Operating profit (or PBIT)
➢ Interest expense or income
➢ Profit before tax (or PBT)
➢ Tax
➢ Net profit

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 13
Revenue from Sales

➢ Importance of sales
➢ Invoice
➢ Sales returns and allowances
▪ Sales return
▪ Sales allowance
▪ Credit note
➢ Trade discounts
➢ Sales discounts

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Cost of Goods Sold

➢ Merchandise inventory
❖ Beginning
❖ Ending
➢ Cost of goods available for sale
➢ Cost of goods sold
➢ Periodic inventory

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Cost of Goods Sold, continued

➢ Net cost of purchases

➢ Purchases
➢ Purchase returns and allowances
➢ Purchase discounts
➢ Freight on purchases
✓ Shipping terms
➢ Inventory losses

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Operating Expenses

➢ Importance of operating expenses

➢ Selling expenses
➢ Administrative expenses

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Financial Statement Analysis: Profitability of Operations

➢ Gross profit ratio (or gross margin)

➢ Operating profit ratio (or net margin)
➢ Conversion ratio

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Overview of the Accounting Cycle

➢ Temporary accounts
✓ Revenues, expenses, dividends
➢ Permanent accounts
✓ Assets, liabilities, equity
➢ Steps from transactions to the financial statements

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The Accounting Cycle

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Closing Entries and Reversing Entries

➢ Closing entries
✓ Revenues
✓ Expenses
✓ Statement of profit and loss
✓ Dividends
➢ What are reversing entries?
➢ Why do we need reversing entries?
➢ Do’s and don’ts for reversing entries

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 21
Special Cases of Revenue Recognition

➢ Special terms of sale

✓ Bill and hold arrangements
✓ Consignment arrangements
✓ Repurchase agreements
✓ Sales to distributors, dealers, or others for resale
✓ Instalment sales
✓ Subscriptions to publications
➢ Licensing

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Earnings Quality

➢ What is earnings quality?

➢ High quality earnings
✓ Continuing operations
➢ Low quality earnings
✓ Less foreseeable
➢ Importance of earnings quality analysis

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The Earnings Quality Spectrum

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