Accounting Principles and procedures

Question 1.        What is meant by Balance sheet?

In financial accounting, a balance sheet or statement of financial position is a summary of a person's or organization's balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a snapshot of a company's financial condition. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time. (Asset – Liability = Equity)

A company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first and are followed by the liabilities.

Question 2.        What is meant by assets and the liabilities

The difference between the assets and the liabilities is known as equity or the net assets or the net worth of the company and according to the accounting equation, net worth must equal assets minus liabilities.

Another way to look at the same equation is that assets equal liabilities plus owner's equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner's money (owner's equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections "balancing."

Question 3.        What are the elements of typical Consolidated Financial Statement of a company

·         Director’s Report

·         Auditor’s report

·         Consolidated income statement

·         Consolidated balance sheet

·         Consolidated Cash Flow statement

·         Statement of Changes in equity

·         Notes to financial statements

Question 4.        What is meant by double entry book keeping system?

Records of the values of each account or line in the balance sheet are usually maintained using a system of accounting known as the double-entry bookkeeping system.

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they can not, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words businesses also have liabilities.

Question 5.       The Profit & Loss Account

The Balance Sheet is a snap shot in time of a company's overall worth. The Profit & Loss Account (P&L) is a report of the company's profit on the sale of their goods or the provision of their service over a trading period, normally one year.

Question 6.       Statement Profit and loss account

Statement of the profit or loss of a business organization is taken from its accounts. Profit and loss accounts comprise three main elements: the trading accounts detailing sales revenues less production expenses to give a gross profit or loss; an account of any income from other sources (for example, rent from let properties) as well as administrative and other expenses or costs (overheads) to give a net profit or loss figure before the deduction of corporation tax; and the appropriation of profits for the payment of dividends and retention of profits in the company after the deduction of corporation tax. In the UK companies are required by company law to file profit and loss accounts with the UK Registrar of Companies.

Question 7.       Income statement (profit and loss statement)

Income statement, also called profit and loss statement (P&L) and Statement of Operations, is a company's financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the "bottom line"). The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.

Charitable organizations that are required to publish financial statements do not produce an income statement. Instead, they produce a similar statement that reflects funding sources compared against program expenses, administrative costs, and other operating commitments.

Revenue – expense = Net income

Question 8.        What is a capital expenditure versus revenue expenditure?

A capital expenditure is an amount spent to acquire or improve a long-term asset such as equipment or buildings. Usually the cost is recorded in an account classified as Property, Plant and Equipment. The cost (except for the cost of land) will then be charged to depreciation expense over the useful life of the asset.

A revenue expenditure is an amount that is expensed immediately—thereby being matched with revenues of the current accounting period. Routine repairs are revenue expenditures because they are charged directly to an account such as Repairs and Maintenance Expense. Even significant repairs that do not extend the life of the asset or do not improve the asset (the repairs merely return the asset back to its previous condition) are revenue expenditures.

Revenue expenses are costs in the day to day running of the business for example servicing a machine, spare parts etc. Revenue expenditure is normally charged against profit in the Income statement in the year it is expensed.

Capital expenditure is on an item that will help generate profits over the longer term (12 months or more) so a purchase of a machine or van etc. The item is depreciated over the items useful life and each depreciable amount is charged to the Income statement in the year the item has help generate profit.

Question 9.        Cash flow (S- Curve mechanism)

Cash flow refers to the movement of cash into or out of a business, or project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used

• to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return, and net present value.

• to determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.

• as an alternate measure of a business's profits when it is believed that accrual  accounting concepts do not represent economic realities. For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares, or raising additional debt finance.

• cash flow can be used to evaluate the 'quality' of Income generated by accrual accounting. When Net Income is composed of large non-cash items it is considered low quality.

• to evaluate the risks within a financial product. E.g. matching cash requirements, evaluating default risk, re-investment requirements, etc.

Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net cash flow', operating cash flow and free cash flow.

Question 10.        Difference between employer’s cash flow and contractor’s cash flow items – Compared to a contractor’s cash flow, a client cash flow considers fee to government authorities, consultant fee, land acquisition charges, marketing, sales charges etc.

Question 11.        Cash flow statement

In financial accounting, a cash flow statement or statement of cash flows is a financial statement that shows how changes in balance sheet and income accounts affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the International Accounting Standard that deals with cash flow statements.

People and groups interested in cash flow statements include:

• Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses

• Potential lenders or creditors, who want a clear picture of a company's ability to repay

• Potential investors, who need to judge whether the company is financially sound

• Potential employees or contractors, who need to know whether the company will be able to afford compensation

Question 12.       Audit

The general definition of an audit is an evaluation of a person, organization, system, process, project or product. Audits are performed to ascertain the validity and reliability of information; also to provide an assessment of a system's internal control. The goal of an audit is to express an opinion on the person / organization/system (etc) in question, under evaluation based on work done on a test basis. Due to practical constraints, an audit seeks to provide only reasonable assurance that the statements are free from material error. Hence, statistical sampling is often adopted in audits. In the case of financial audits, a set of financial statements are said to be true and fair when they are free of material misstatements - a concept influenced by both quantitative and qualitative factors.

Audit is a vital part of Accounting. Traditionally, audits were mainly associated with gaining information about financial systems and the financial records of a company or a business (see financial audit). However, recent auditing has begun to include other information about the system, such as information about environmental performance. As a result, there are now professions conducting environmental audits.

In financial accounting, an audit is an independent assessment of the fairness by which a company's financial statements are presented by its management. It is performed by competent, independent and objective person(s) known as auditors or accountants, who then issue an auditor's report based on the results of the audit.

Question 13.       Financial Ratio Analysis / Financial bench marking

The Balance Sheet and the Statement of Income are essential, but they are only the starting point for successful financial management. Apply Ratio Analysis to Financial Statements to analyze the success, failure, and progress of your business.

Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends  that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them.

Question 15.       Financial bench marking

Is the process of comparing a company’s financial performance with that of standard benchmarks derived from average performance of similar business in same industry. For this, compare financial ratios of a company with the benchmark values.

Question 16.       Balance Sheet Ratio Analysis

Balance Sheet Ratios measure liquidity and solvency (a business's ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors' funding). They include the following ratios:

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital.

Current Ratios.

The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:

The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.

If you decide your business's current ratio is too low, you may be able to raise it by:

·         Paying some debts.

·         Increasing your current assets from loans or other borrowings with a maturity of more than one year.

·         Converting non-current assets into current assets.

·         Increasing your current assets from new equity contributions.

·         Putting profits back into the business. Quick Ratios.

The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity.

The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: "If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.

Question 17.       Working Capital.

Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number.

Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to minimum working capital requirements.

A general observation about these three Liquidity Ratios is that the higher they are the better, especially if you are relying to any significant extent on creditor money to finance assets.

Question 20.        Credit control

Policies aimed at serving the dual purpose of (1) increasing sales revenue by extending credit to customers who are deemed a good credit risk, and (2) minimizing risk of loss from bad debts by restricting or denying credit to customers who are not a good credit risk. Effectiveness of credit control lies in procedures employed for judging a prospect's creditworthiness, rather than in procedures used in extracting the owed money. Also called credit management

Question 21.       What is the meaning of credit control? - For any businesses which provide "open terms" policy to their customers, it is important to have a cap on the amount of credit given. Every customer is given different amount of credit in relation to their sales turnover. These credits are monitored on a daily, weekly or monthly basis according to individual company’s requirement.

A person from the finance dept or marketing is appointed to ensure the total invoice value at any point of time do not exceed the credit amount agreed.

Question 22.       Insolvency

Insolvency means the inability to pay one's debts as they fall due. Usually used in Business terms, insolvency refers to the inability for a 'limited liability' company to pay off debts.

Business insolvency is defined in two different ways:

• Cash flow insolvency  - Unable to pay debts as they fall due.

• Balance sheet insolvency  - Having negative net assets – in other words, liabilities exceed assets. A business may be 'cash flow insolvent' but may not be 'balance sheet solvent' if it holds liquid assets,

particularly against short term debt that it cannot immediately realise if called upon to do so. Conversely, a business can have negative net assets showing on its balance sheet but still be cash flow solvent if ongoing revenue is able to meet debt obligations, and thus avoid default – for instance, if it holds long term debt. Many large companies operate permanently in this state.

Insolvency is not a synonym for bankruptcy, which is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency.

Question 23.       Bankruptcy

It is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor ("involuntary bankruptcy") in an effort to recoup a portion of what they are owed or initiate a restructuring. In the majority of cases, however, bankruptcy is initiated by the debtor (a "voluntary bankruptcy" that is filed by the insolvent individual or organization).

Question 24.       Limited liability

Is a concept whereby a person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a company or partnership with limited liability. In other words, if a company with limited liability is sued, then the plaintiffs are suing the company, not its owners or investors. A shareholder in a limited company is not personally liable for any of the debts of the company, other than for the value of his investment in that company. This usually takes the form of that person's dividends in the company being zero, since the company has no profits to allocate. The same is true for the members of a limited liability partnership and the limited partners in a limited partnership. By contrast, sole proprietors and partners in general partnerships are each liable for all the debts of the business (unlimited liability).

Question 25.        Consequences of insolvency

The principal focus of modern insolvency legislation and business debt restructuring practices no longer rests on the liquidation and elimination of insolvent entities but on the remodeling of the financial and organizational structure of debtors experiencing financial distress so as to permit the rehabilitation and continuation of their business. In some jurisdictions, it is an offence under the insolvency laws for a corporation to continue in business while insolvent. In others (like the United States with its Chapter 11 provisions), the business may continue under a declared protective arrangement while alternative options to achieve recovery are worked out. Increasingly, legislatures have favoured alternatives to winding up companies for good.

It can be grounds for a civil action, or even an offence, to continue to pay some creditors in preference to other creditors once a state of insolvency is reached

Question 26.       Late Payment of Commercial Debts (Interest) Act 1998

The Late Payment of Commercial Debts (Interest) Act 1998 is an Act of the United Kingdom Parliament enabling businesses to charge other business customers interest on overdue accounts and to obtain compensation. The Act extends to Scotland and Northern Ireland.

Originally it was only designed to give small and medium sized businesses (with 50 or fewer employees) the right to charge interest to larger businesses and public sector organisations of any size.

Question 27.       Statutory interest

The right to charge interest applies to overdue accounts relating to a sale of goods, the hiring of goods or to a supply of services. The court can modify or exclude the provisions if the conduct of the supplier has been such as to make the imposition of interest, in whole or in part, against the interests of justice.

Interest can accrue from the latest of

•        30 days after the goods are supplied or the service is completed,

•        30 days after receipt of invoice (or the customer is told the amount due is payable).

•        the agreed date for payment.

The "statutory interest" rate chargeable, which is simple and not compound, is the Bank of England base rate plus 8%. The increment was set to allow the small business to cover late payments by bank borrowings.

Question 28.       Compensation chargeable

Once statutory interest begins to run in relation to a qualifying debt, the supplier is also entitled to a fixed sum

(a)  for a debt less than £1000, the sum of £40;

(b) for a debt of £1000 or more, but less than £10,000, the sum of £70;

(c) for a debt of £10,000 or more, the sum of £100.