Lecture – 2: Financial reporting

and Accounting
Project Financial Management
 Learning Outcomes
• Accounting

• Financial Reporting

• Some Basic Concepts

• Financial Statements

• Balance Sheet

• Income Statement

• Cash flow Statement

 Accounting
• Accounting is the systematic and comprehensive recording of
financial transactions pertaining to a business, and it also refers to the
process of summarizing, analyzing and reporting these transactions to
oversight agencies, investors and tax collection entities.

• Accounting is one of the key functions for almost any business; it may
be handled by a bookkeeper and accountant at small firms or by
sizable finance departments with dozens of employees at large
companies.
 Financial Reporting
• Financial reporting is the process of producing
statements that disclose an organization's financial status
to management, investors and the government

• Financial reporting includes the following: the

external financial statements (income statement, balance
sheet, statement of cash flows, and statement of
stockholders' equity) the notes to the financial statements.
 Basic Concepts
• Business Entity Concept

– The business is treated as a separate entity apart from

its owners. The accounting records are maintained for
the business entity. An entity is assumed to own its
assets and incur liabilities.
 Basic Concepts
• The Reliability (or Objectivity) Principle
– The primary objective of financial reporting is to
provide information useful for making investments and
lending decisions. To be useful, this information must
be relevant, reliable and comparable.

– The objectivity principle is the concept that the

financial statements of an organization be based on
solid evidence. The intent behind this principle is to
keep the management and the accounting department
of an entity from producing financial statements that
are slanted by the opinions and biases of the company.
 Financial Statements
• Financial statements (or financial report) is a formal
record of the financial activities and position of a
business, person, or other entity.

• Relevant financial information is presented in a structured

manner and in a form easy to understand. They typically
include basic financial statements, accompanied by
a management discussion and analysis
 Types of Financial Statements
• Balance Sheet
– A balance sheet or statement of financial position,
reports on a company's assets, liabilities, and owners
equity at a given point in time.

•  Income statement
– An income statement or statement of comprehensive
income, statement of revenue &
expense, P&L or profit and loss report, reports on a
company's income, expenses, and profits over a period of
time. A profit and loss statement provides information on
the operation of the enterprise. These include sales and
the various expenses incurred during the stated period.
 Types of Financial Statements
• Cash Flow Statement
– A cash flow statement reports on a company's cash
flow activities, particularly
– Its operating, investing and financing activities.

• Statement of Change in Equity

– A Statement of changes in equity or equity
statement or statement of retained earnings, reports
on the changes in equity of the company during the
stated period.
Balance Sheet
Statement of Cash flow
Income Statement
 Some Basic Accounts in a Balance Sheet
• Asset
– Anything tangible or intangible that can be owned or
controlled to produce benefits and that is held by a
company to produce positive economic benefits is an
asset.

– The balance sheet of a firm records the monetary value of

the assets owned by that firm. It covers money and other
valuables belonging to an individual or to a business. One
can classify assets into two major asset classes: tangible
assets and intangible assets. 

– Recorded on the left side of the Balance Sheet

 Asset Types on a Balance Sheet
• Current Assets
– In accounting, a current asset is any asset which can be
expected to be sold, consumed, or exhausted through
the normal operations of a business within the
current year.

– Typical current assets include cash, cash equivalents,

short-term investments (marketable securities), account
receivable,  inventory, supplies, and the prepaid
liabilities, sometimes referred to as prepaid expenses,
which will be paid within a year
 Long term Assets
• Long-term assets are those held on a company's balance
sheet for more than one year. Property, plant and
equipment are typical examples of long-term assets.
– Long-term Investments
Long-term investments are securities or other
instruments that have a maturity date of greater than one
year. It could be stocks or bonds the company plans to
hold for a long time. 
– Property, Plant and Equipment
Property, plant and equipment, often called PP&E,
includes all types of physical assets, such as machines,
factories, buildings, office equipment, computers,
vehicles, fixtures and land.
 Account Receivables
• Accounts receivable 
– It is the money that a company has a right to receive
because it had provided customers with goods and/or
services. For example, a manufacturer will have
an account receivable when it delivers a truckload of
goods to a customer on June 1 and the customer is
allowed to pay in 30 days.

– A note receivable is a written promise to receive a

specific amount of cash from another party on one or
more future dates. This is treated as an asset by the
holder of the note.
 Inventory
• The cost of the product purchased or produced but not yet
sold is reported in the account Inventory . Inventory is
reported as a current asset on the company's balance
sheet. 

• Inventory is the raw materials, work-in-process products

and finished goods that are considered to be the portion of
a business's assets that are ready or will be ready for sale. 
 Fixed Assets
• Fixed Assets
– Fixed assets, also known as tangible assets or property, plant
and equipment (PP&E), is a term used in accounting for assets
and property that cannot easily be converted into cash.

– Moreover, a fixed/non-current asset can also be defined as an

asset not directly sold to a firm's consumers/end-users. As an
example, a baking firm's current assets would be its inventory
(in this case, flour, yeast, etc.), the value of sales owed to the
firm via credit (i.e. debtors or accounts receivable), cash held in
the bank, etc. 

– On a balance sheet, assets will typically be classified into

current assets and long-term assets.
 Liabilities
• LIABILITIES

– A liability is a company's financial debt or obligations that arise during

the course of its business operations. Liabilities are settled over time
through the transfer of economic benefits including money, goods or
services. Recorded on the right side of the balance sheet, liabilities
include loans, accounts payable etc.
– Businesses sort their liabilities into two categories: current and long-term.

– Liabilities are reported on the right side of the balance sheet

 Current and Long Term Liability
– Current liabilities are debts payable within one year, while long-term liabilities
are debts payable over a longer period. For example, if a business takes out a
mortgage payable over a 15-year period, that is a long-term liability. However,
the loan payments that are due during the current year are considered the
current portion of long-term debt and are recorded in the short-term liabilities
section of the balance sheet.

– Ideally, analysts want to see that a company can pay current liabilities, which
are due within a year, with cash. Some examples of short-term liabilities
include payroll expenses and accounts payable, which includes money owed to
vendors, monthly utilities, and similar expenses. In contrast, analysts want to
see that long-term liabilities can be paid with assets derived from future
earnings or financing transactions. Debt is not the only long-term liability
companies incur. Items like rent, payroll and pension obligations can also be
listed under long-term liabilities.
 Accounts Payable
• Accounts payable (AP) is an accounting entry that
represents an entity's obligation to pay off a short-term
debt to its creditors. In balance sheets, the accounts
payable entry appears under the heading current
liabilities.

• When a company orders and receives goods (or services)

in advance of paying for them, we say that the company is
purchasing the goods on accounts payable.
 Owner’s Equity
• Generally speaking, equity is the value of an asset less the
amount of all liabilities on that asset. It can be represented
with the accounting equation:

• Assets -Liabilities = Equity.

• On a company's balance sheet, the amount of the funds

contributed by the owners (the shareholders) plus
the retained earnings. Also referred to as stockholders'
equity or shareholders' equity
 Accounting Equation / Balance Sheet
• Assets = Liabilities + Capital/Equity
• Investment by Owner
• Mr. Khan started a business by establishing a workshop
by the name of Khan Autos. During the month of January
2016 following transactions occurred.
• Mr. Khan invested. Rs.1,000,000 of his personal funds in
the new business. It resulted in an increase of an asset,
Cash, for the business and corresponding change in
owner’s claim in the business.
  Assets = Khan’s claim

  Bank    
1 1,000,000   1,000,000
 Purchase of Rights
• Purchase of Rights
• Khan Autos hired premises for workshop at a monthly
rent of Rs.5,000. The landlord asked for two-year advance
of Rs.120,000.
Assets = Khan’s claim

  Bank   Prepaid rent    

1 1,000,000       1,000,000

  (120,000)   120,000    

2 880,000   120,000   1,000,000

 Purchase of an Asset
• Purchase of an asset
• Purchased furniture for Rs.80,000 paying by cheque.
  Bank Prepaid Furniture   Khan’s
rent claim

2 880,000 120,000     1,000,000

  (80,000)   80,000    

3 800,000 120,000 80,000   1,000,000

 Purchase of an Asset
• Purchase of an asset (tools)
• Purchased tools for Rs.100,000 paying by cheque
  Bank Prepaid Furnit Tools   Khan’s claim
rent ure

3 800,000 120,000 80,000     1,000,000

 
  (100,000)     100,000    

4 700,000 120,000 80,000 100,000   1,000,000

 Purchase of an Asset
• Purchase of an asset
• Purchased Equipment from Raja Autos worth Rs.900,000/-.
Paid Rs.600,000 by cheque and remaining to be paid within a
year .
• It also requires another decision as to when should it be
recorded. Should it be recorded when the order was placed,
the equipment was received or when the full payment was
made? In accounting we keep on haggling these types of
issues.
• Classification
• Recognition
– Contract between seller and purchaser to this effect
– Transfer of major chunk of risk from the seller to the
purchaser which implies the transfer of title of owner ship.
 Accrual Accounting / Cash Base
• Accounting
Accounting method that records revenues and expenses
when they are incurred, regardless of when cash is
exchanged. The term "accrual" refers to any individual
entry recording revenue or expense in the absence of a
cash transaction .

• The cash basis is a method of recording

accounting transactions for revenue and expenses only
when the corresponding cash is received or payments are
made. Thus, you record revenue only when a customer
pays for a billed product or service, and you record a
payable only when it is paid by the company.
  Bank Prepaid Furnitur Tools Plant &   Khan’s claim Raja
rent e Machinery Autos
  claim

4 700,000 120,000 80,000  100,000     1,000,000  

  (600,000)       900,000      300,000 

5 100,000 120,000 80,000 100,000 900,000  = 1,000,000 300,000

 Balance Sheet
• Balance Sheet
– The accounting equation, also known as balance sheet
equation, provides the following information at any
point of time:
– Sources of funds, i.e. creditors’ and owners’ claims
– Composition of funds provided by different sources,
i.e. the percentage of total amount provided each by
creditors and by owners
– The use of those funds, i.e. the composition of assets
acquired
– It portrays the financial position of an organization at a
particular point of time.
Balance sheet of Khan Autoes as at January 31, 2016
 Information from Khan Autos Claims
• Sources of funds, i.e. creditors’ and owners’ claims
• Composition of funds provided by different sources, i.e.
the percentage of total amount provided each by creditors
and by owners
• The use of those funds, i.e. the composition of assets
acquired
• It portrays the financial position of an organization at a
particular point of time.
 Income Statement / Profit and Loss Account

• An income statement or statement of comprehensive

income, statement of revenue &
expense, P&L or profit and loss report, reports on a
company's income, expenses, and profits over a period of
time. A profit and loss statement provides information on
the operation of the enterprise. These include sales and
the various expenses incurred during the stated period.
 Income Statement Accounts
• Revenue
– In accounting, revenue is the income that
a business has from the sale of goods and services to
customers
• Expenses
– The result of costs incurred to generate revenue are
defined as expenses. An expense may be incurred by
payment of cash, promise to pay or consumption of an
asset (IAS-18).
• Losses
– Losses can result from a number of activities such as;
sale of an asset for less than its carrying amount, the
write-down of assets, or a loss from lawsuits.
 Income Statement
• Mr. Zahid has recently completed his MBA and has set up
a small business with the name of Zahid Computers. His
transactions for the month of January, 2013 were as
follows.
Date Purchases Sales Price/unit Total Amount

Jan01 10 units 50,000 500,000

Jan 10 10 units 60,000 600,000

Jan 25 20 80,000 1,600,000

 Income Statement for Zahid Computers
• Let us calculate the profit of Zahid Computers for the
month January. Assume that all transactions were on cash.
The investment by Mr. Zahid became Rs.1,100,000. The
profit and Loss Account will be as follows.
•  
Zahid Computers
Profit and Loss Account
For the period ending January 31, 2013

Sales Rs. 1,600,000

Less Cost of goods sold 1,100,000
Gross profit Rs. 500,000
 Balance Sheet for Zahid Computers
Zahid Computers
Balance sheet as at Jan.31, 2013

Assets Liabilities and Capital

Cash/bank Rs.1,600,000 Trade creditors Rs. 0

    Zahid Capital  

    as at Jan. 1 1,100,000

    add profit 500,000

    as at Jan. 31 1,600,000

Total Assets Rs.1,600,000 Total Liabilities and Rs.1,600,000

Capital
• Consider the following scenario
Date Purchases Sales Price/unit Total
Amount

Jan01 10 units 50,000 500,000

Jan 10 10 units 60,000 600,000

Jan 25 15 80,000 1,200,000

• Now the calculation of profit becomes a subjective matter.
We need to determine the composition of 15 units sold.

• The amount of profit calculated will depend on our

assumption. The actual flow may entirely be different
than the assumed flow. As a result just from three
transactions we end up with three different profit figures.
The value of remaining five computers (Stock in trade)
will also depend on our assumption.
 Profit calculation for Zahid Computers
 

First in Last in
  First out   First out Average
 
Sales 1,200,000   1,200,000 1,200,000
 
Less Cost of Goods Sold        

 
 
Cost of goods sold (800,000)   (850,000) (825,000)
 
Profit 400,000   350,000 375,000
 
         
 
Value of Closing Stock 300,000   250,000 275,000